While working on some course material for entrepreneurs, I realized that it would be useful to build a foundational set of posts on calculating and using customer lifetime value. In a follow-on post I’ll discuss how to think about customer value through out the steps of the customer journey and use that to make technology and marketing investment decisions.
Whether you are thinking through a new business idea, evaluating marketing channels, or trying to raise money from investors, you need to understand customer lifetime value (LTV). You will use LTV to convince yourself and others that you can make money on a per customer basis. Your LTV should exceed your cost of customer acquisition so that when you have enough customers to cover your overhead you will be profitable as a business.
This basic concept applies to any type of business, whether you make money on consumer transactions, SaaS subscriptions to businesses, or advertising. I will run through a transaction business below (think e-commerce for physical or digital goods), and then show how the approach is modified for other business types.
There are four important factors in understanding customer lifetime value: transaction margin, purchase frequency, customer lifetime, and a discount rate.
I have seen examples of calculating LTV using gross revenue, but this is disastrous when using the LTV to determine what you can afford to spend to acquire a customer. I strongly recommend using transaction margin rather than gross revenue. To calculate the variable margin from a transaction take the revenue of the transaction minus the variable costs. Be honest with yourself about the costs in addition to the direct product costs (cost of goods) and shipping and handling costs (for physical businesses), including: a returns percentage, a percentage of transactions that require customer support, credit card fees, marketing discounts and coupons, etc. For example, if 5% of transactions require support, then add (.05 times the average support cost) to your total variable cost per transaction. Any cost that grows directly with the number of transactions should be subtracted from the gross revenue to calculate the transaction margin. If you have variable sales or marketing costs like a one-time commission to an inside sales person or channel partner, those are customer acquisition costs and are not part of your margin calculation.
If you are selling coffee like Starbucks is, your purchase frequency might be five times a week. If you are selling cars, it is more like once every three to five years. Purchase frequency is an incredibly powerful lever, and the role of retention marketing is to get your customers to come back as often as possible. Subscription businesses are popular because you are automatically increasing the purchase frequency. If you don’t have a lot of history, you’ll have to make an educated guess as to what the typical purchase frequency might be.
Even before you have real repeat customer activity to analyze there are a couple of ways to triangulate to an educated guess. One approach is to benchmark your offering against other businesses and try to get some understanding of their purchase frequency by talking to them or their customers. Alternatively or complementarily, you can gather insight into purchase frequency from customer interviews, and then haircut the stated frequency as actual purchase behavior is often less than stated intent.
This is the most subjective measure for early stage companies that don’t have a lot of customer history. I saw an example of a hypothetical LTV calculation for Starbucks that estimated the lifetime of the customer at 20 years. That’s pretty optimistic, but by now they may have the history to justify that. It is tempting to think that your customers will be with you forever, but you will lose customers for many reasons. Looking at the music business at Amazon for example, which I was directly involved in, we were acquiring incremental CD customers and we had ten years of history of Amazon customers to analyze. But some percentage of the CD customers moved to digital downloads as the CD format lost favor. Digital downloads then decreased across the industry in favor of streaming music services. As another example, Quicken consumer software had a long history of loyal customers but those customers are now moving to the free Mint SaaS product. No company or product is immune to losing its customers. If you are selling baby supplies, your customer will outgrow the need in a year or two. The general lesson is that your customers’ needs and wants evolve and their options for solving their problems and achieving their goals are constantly evolving.
For an early stage company with limited cash reserves, I would advise being very conservative on lifetime for another reason. If it takes a long time to recoup your customer acquisition cost, then you may not have the cash left to see the day that your margin from that customer recoups the cost of acquisition. At a minimum it will constrain your ability to grow if it takes a long time to recoup your customer acquisition cost. Ideally you can recoup your acquisition costs within a year, and I would think hard if your business model requires more than two years to recoup the cost.
This is the percent by which you should discount the future cash flows when performing an LTV or ROI calculation. Established companies typically use a number such as their weighted average cost of capital (WACC) to discount future cash flows for investment analysis. This might be 5% to 15%. For early stage companies I would suggest discounting the future cash flows by a much higher percentage for two reasons: 1) to account for the high degree of risk of those future cash flows, and 2) unless you have hoards of cash, you will need to acquire incremental cash through the sale of equity. In the latter case, you are giving up some percentage of all future cash flows of the company, and that hopefully is worth a lot.
Putting it together
Lifetime Value (LTV) is calculated by summing the margin on the transactions over the lifetime of the customer, while using the discount rate to reduce any margin that after year one. So if an average customer buys $50 of product with a margin of 50%, their average transaction value is $25. If they purchase four times a year, then their annual value is $100. If you estimate a lifetime of two years, and discount the second year’s cash flow by 25%, then their LTV is calculated: $100 + ($100 x .75) = $175. The present value formula for the year 2 margin is Margin x (1 – discount rate); for year 3 margin, it is Margin x (1 – discount rate) x (1 – discount rate), and so on.
If you cover your customer acquisition cost on the margin from your first transaction, then you are in great shape. If you don’t (and many companies don’t), then you need to calculate the LTV. It is critical to understand that your business will work on a per customer level. The margin they generate for the business over time, i.e. the customer lifetime value, needs to exceed the cost to acquire them. Then once you understand your marginal profit per customer, you can calculate how many customers you will need to cover your overhead at various stages of growth.
Calculating customer acquisition costs is obviously important to this process. How you calculate your acquisition costs is a function of the type of marketing channels you use and is beyond the scope of this post.
Revenue vs. margin
As I mentioned above, I have seen examples of using revenue rather than margin to calculate a customer lifetime value. This makes sense if you have no per customer or per transaction costs. For example, in some SaaS businesses all the cost is in the overhead of developing the software and in the hosting infrastructure. There might be a minimal additional server cost per customer or a small amount of support, but that is likely not worth factoring into your calculation. You can use revenue rather than margin, since they are essentially the same, and compare that to your customer acquisition cost. Businesses based on an advertising revenue model fall into this category as well. You pay to get your eyeballs (your customer acquisition costs) but there is not an incremental cost to deliver value to an incremental site visitor.
Often a company uses multiple channels to acquire customers. To the extent possible you should track the source of those customers against their behavior over time so that you establish an LTV for the customers from each channel and compare it to the customer acquisition cost for the channel. You may find for example that customers you acquire through an aggressive discount program don’t become loyal customers (they are bargain hunters) and so their value is negative when you compare their LTV to the cost to acquire them.
Once you know your LTV for your repeat customers you can start to make informed decisions about many other aspects of your user experience and how you allocate financial and technical resources. That is the topic of another blog post.
I hope this has been helpful. Please reach out with any questions.