How to Calculate Customer Lifetime Value (LTV) for a SaaS Business?By Jamie Toyne
In a SaaS business, it is not just making a sale that is important. The length of time your customer stays with you directly impacts the revenue they generate. Therefore the lifetime value of a customer is a key metric to determine the value of a client and make sure your SaaS business continues making the maximum profit possible.
It can help in everything from acquiring new clients to developing a marketing plan. Therefore if you own a SaaS business, it is important that you understand exactly what Customer Lifetime Value is, what it does and how to calculate it. We will walk you through everything you need to know about LTV, let’s get started.
What is LTV or Customer Lifetime Value?
So what exactly is Customer Lifetime Value, also known as CLTV or LTV? Customer Lifetime Value refers to the average total revenue generated by one customer for a business over the customer’s whole lifespan.
It does not just look at the revenue generated from a single sale, but by repeat sales, subscription lengths and so on. When we are talking about SaaS businesses, the longer a customer stays with the company, the more they spend and therefore the higher their LTV. The aim of course is that the Customer Lifetime Value is as high as possible, as this equals higher revenue generated.
Why is LTV important?
LTV is a highly useful metric that can help businesses track and estimate their net profits. When you compare the LTV to the customer acquisition cost (CAC) you are able to see how much net profit one client generates on average. This is extremely useful when determining and improving the business’s sales and marketing strategies.
As a rule of thumb for a profitable business, it is a good idea to aim for a CAC no higher than a third of the LTV. By calculating the LTV of your customers, you will be able to see more clearly how much cash you have free to spend on marketing budgets or sales bonuses.
The LTV of a customer can also serve as a good indicator of the customer management process and if it needs any improvements. Overall this metric is key to keep your business running smoothly and generating the best ROI possible.
The simple formula to calculate LTV
There are a few different ways that you can calculate the LTV of a customer. The first one we will look at is more simple and is great to get a quick ballpark figure of what your customers are worth. It is a good starting point when first getting started with LTV.
The other formulas we will look at, on the other hand, are more advanced calculations that provide a more accurate figure. This is mainly because the basic formula does not take into account expansion revenue in the Monthly Recurring Revenue (MMR), but we will look at this in more detail later.
So for the first simple calculation, you will need the following different metrics:
- ARPA – this stands for Average Revenue Per Account as a customer may have more than one account, it is usually easiest to calculate this monthly. You can calculate this by dividing Monthly Recurring Revenue ( MMR) / number of accounts.
- MMR – this is the recurring monthly revenue generated by your SaaS company. Calculate it by multiplying the number of customers x average amount billed per customer.
- Average customer lifespan – this is the average number of weeks, months or years that a customer keeps buying your service.
- Customer churn rate – churn refers to the percentage of people who cancel their subscriptions in a given period. Calculate this by dividing the number of churned customers / total number of customers. If your ARPA is calculated monthly, make sure the churn rate is also calculated per month.
Once you have determined these metrics you can use the following formula:
ARPA x Customer Lifespan = LTV
or this can also be expressed as
ARPA/ Customer Churn Rate = LTV
So for example if your business offers a subscription to an office team management tool, the calculation might look like this. If the monthly ARPA is $150 and the average customer lifespan is 2 years (or 24 months), the LTV of your customer is $150 x 24 = $3,600.
Advanced formulas to calculate LTV
So, what about the more advanced calculations? To get a more accurate picture you will need to take into account more variables. How your business works may determine which calculation is best for you.
A deeper look at churn rate
Let’s look at churn rate in a little more detail as this is important when calculating LTV. Churn rate refers to the rate at which your business loses customers. These might be through proactive churn which refers to customer cancellations, or passive churn referring to customers who fail to renew their subscriptions.
Churn rates are usually calculated per month but as different businesses may have completely different churn patterns it can be hard to calculate a completely accurate rate. For example, some business models are likely to have higher churn rates at the time of renewing contracts, while others may have a steady churn rate each month or experience most churn in the first month.
These variances in churn patterns can affect your LTV calculation. A simple way to adjust for this is to add a discount to the formula and leave you with a more modest estimate.
ARPA/ Customer Churn Rate = LTV x 0.75
If you are looking for a more advanced way to take into account the possible discrepancies of the churn rate, take a look at the Bayesian Approach. This is an advanced statistical approach that can be used to estimate the LTV.
Alternatively if you have a range of different sales types or sections in your customer base, it may also be useful to split these up and calculate a separate LTV for each. For example if you have clients that pay per year and others that pay each month.
Also Read: How to Decrease Churn Rate in SaaS?
We have already discussed adapting your calculations based on churn rate discrepancies. Now let’s take a look at another variable that is not taken into account with the simple LTV formula. Expansion or contraction revenue. Expansion revenue refers to additional revenue made from clients outside of the standard subscription payments.
This may refer to upsells for example customers that upgrade to more expensive plans. Contraction revenue, on the other side, could be if people downgrade. If your customers tend to stick to one subscription package their whole customer lifespan, then you can stick to the simple formula above.
If you do experience significant steady expansion in the MMR, for example if you bill per number of users on one plan, then you can use the following formula.
(ASP/ Customer Churn Rate) + (M (1-Churn rate/Customer Churn Rate²) = LTV
Let’s dissect this formula here to make sure everything is clear.
- ASP or Average Sale Price – this refers to the average price in MMR that new customers pay when they first sign up.
- M – here M refers to average monthly growth in ARPA per account.
As we have discussed, ARPA refers to the average revenue generated per account. This is usually calculated on a monthly basis in which case the churn and customer lifespan should be calculated in the same timeframe.
However, if the ARPA differs from a per month calculation and you want to get a more accurate picture of the LTV you may want to use a formula that takes gross margin into consideration.
LTV = (ARPA x Gross margin %) / Churn Rate
Let’s confirm bits of the calculation we have not yet covered.
- Gross margin – this is the total revenue generated by your business minus the price of the goods or operating costs.
Things to consider when calculating LTV
There are many different aspects to consider when calculating your LTV that can mean your results are not as accurate as you might like. Let’s take a look below at some of the important things to consider that can help you avoid these issues.
When making all your calculations, the size of your sample is important. If you use a sample of too few users or perhaps don’t have very many users, this can affect the validity and accuracy of your LTV calculation. It may mean that the estimated value fluctuates from one month to the next.
If you have fewer than 100 users try and use 50% or more of your user data to make your calculations. If you have between 1000 and 10,000 users, try and use at least 10% of users. If you have 1 million+ user a sample of 1% should provide accurate results.
Compare LTV by segment
While it is good to land on an average customer lifetime value for your business as a whole, splitting up the LTV and analyzing it on a deeper level can help you get some more useful insights. If you can break your customer base down into smaller groups you will be able to find trends for different market segments.
For example, if you compare customers on your cheapest plan to ones on your priciest plan, you may see that their LTV changes drastically. You can also break down your customer analysis into many other sections to extract interesting results.
Your business model
Every SaaS business model is different and it is important you calculate your LTV using the right formula for you. For example, there are many different churn rate patterns that can cause discrepancies in your calculations. If so, you may choose to use the formula that adds a discount to the calculation giving you a more conservative estimation to work with.
If you have steady expansion revenue then make sure to use the formula that considers any monthly growth in the MMR. These formulas can be edited and altered to fit your needs so think carefully before settling on your final calculation.
What to do with your LTV
Ok so you have figured out your LTV but what can you use it for? It is an incredibly useful metric to know, especially for a SaaS business. We outline some of the main things you can do with it here. Let’s take a look at what it can tell us.
- Understand your profits – Once you know the total revenue generated from a single client, make sure to compare this to the customer acquisition cost (CAC). This will help you figure out the actual profits made on every sale and confirm if you are doing as well as you thought. This can help you align your business and marketing strategies going forward.
- Retain most valuable clients – Your LTV can help you see which customers stay with you the longest and why. From here you will be able to put more effort into looking after and retaining the customers in this segment.
- Adapt your marketing plan – with an estimated LTV it will be possible to focus on targeting more highly qualified leads. It will also help you define a maximum marketing budget.
How to improve your Customer Lifetime Value
So what if you have calculated your LTV and feel like it could do with some improvement? Well there are many things you can do to improve the overall revenue brought in by each client which can have a significant impact on your profits.
Do some market research
To improve your customers’ experience, and therefore LTV, start by fully understanding them and what they get from your product. Try arranging some market research calls with customers who have a higher LTV than the average. Figure out what value they get from your product, why they signed up, how they use it, and any other comments.
This will help you target the kinds of people that will benefit most from your product, understand the best channels to target them on, as well as make any improvements based on their feedback. Aim to carry out this research with active users, you could even incentivize them with a discount or bonus offer for taking part.
Reduce your churn rates
Reducing churn rate is an important thing we can do to increase the LTV and boost the revenue of your business. First determine whether your churn rate is high for the industry. You can use online tools to compare against your competitors. Then identify exactly when and why your customers are churning.
You could do this by including a short survey as part of the cancellation process. Once you have determined the main reasons for churn, you can look at combating them. For example, if the problem is technical issues you may want to invest in improving backend maintenance. Or if the problem is price, perhaps introduce some special offers.
Increase your ARPA
Another way to increase your customer lifetime value is to work on boosting your ARPA, average price per account. How can you go about doing this? Two of the best ways are by either raising prices or through expansion revenue. Make sure to do testing and market research before making any drastic price hikes, but done right this can be a great way to boost revenue.
You can also go down the expansion revenue route which usually means upgrading users to more expensive plans or cross-selling them complementary products or add-ons. Selling to existing customers can be more lucrative than acquiring new customers as costs of marketing to current clients can be much lower, or free and they already trust you.
You could build expansion revenue into your Saas product, for example having several different subscription packages available or making it clear what advanced features your customers are missing as they use your product. You could also do email marketing to your existing customer base.
Reduce your customer acquisition costs
Another way to increase the lifetime value of every customer is by spending less to acquire them. If you do market research as suggested above, it will help you identify the most effective channels to bring in new customers. If you are wasting money on some ineffective ones, you may be able to save some cash here, as well as investing more into more effective ones. Alternatively, you could look at automating some of your acquisition and marketing processes.
There’s no time to lose. Whether you run a small SaaS startup or a multimillion-dollar global service, calculating your LTV should be at the top of your to do list. It can help you understand how your business works, identify where it needs to be improved, and help define your goals and strategies going forward.
If you don’t, you could be losing out on money and customers which could be easily avoided. Or chasing ineffective marketing strategies. If your business is fairly new, start small using the simple calculation formula. Then as your business grows and develops, you can take on the more accurate calculations. Keep your business operations running smoothly and watch it grow!