May 18, 2022

How to calculate customer lifetime value (LTV formula)

You need to understand customer lifetime value (LTV) as a SaaS business to anticipate growth, create a sales and marketing strategy, and know how to calculate your projected customer lifetime value.

There are many metrics that startups need to measure to understand if they’re profitable and to plan for future growth. If you have a SaaS business or use a recurring revenue model, then how these are calculated are different to what traditional businesses use. Ideally, you want to understand why these metrics are important and what they aim to measure so you can be sure that you’re applying them correctly to your business model. Take a look at what customer lifetime value (LTV) is, why an LTV calculation for SaaS business is different than for companies selling physical products, and how to use the metric once you understand it.

What is customer lifetime value for SaaS businesses?

The goal of customer lifetime value (LTV) is to understand the total revenue you bring in from an average customer across the entire time you have a relationship with them. For a traditional business selling physical products, this is relatively easy to calculate, by looking at the average price of the products your customers buy, and the average number of times they come back and buy from you again.

For SaaS or recurring revenue models, how you calculate this metric depends on how you view customer relationships and what you sell. This could include a period where potential customers are trialing your subscription for free or at a heavy discount, and include periods where you cross or upsell them, or they upgrade their subscription as their business grows. This means that there isn’t a one-size-fits-all lifetime value calculation for SaaS businesses.

Why does a SaaS business want to know their customer lifetime value?

Understanding your LTV helps you understand the financial health of your business, which is useful for a number of reasons. First, if you’re thinking of applying for financing in any form, whether venture capital equity or a loan, then financial companies are going to want to look at your metrics, including LTV. If you understand what your LTV shows about how you retain customers and how much revenue you bring in from them over that time, then you can explain any discrepancies that a financer might ask about, or you can work on improving these numbers before you look at obtaining financing.

Second, you can generally improve your profitability by understanding your LTV metrics and looking at where there’s room for improvement.

LTV is dependent on a number of other metrics, and is used as part of a larger calculation for metrics like LTV/CAC ratio, and so if you want to take a big picture view of how your business is doing and how fast it’s likely to grow, then LTV is an essential part of that.

Customer acquisition costs (CAC) are an important cost to measure, especially for a new or fast-growing business. As you’re no doubt aware, it generally costs about 5 times as much to bring on a new customer than retain an existing one, and so being really clear on both churn rate (how fast you lose customers), and the cost of acquiring new customers as you grow, is essential to predicting your financial sustainability long term.

If your LTV and CAC are even close to being the same number, then it’s clear that you’re not making much, if any, profit as you bring on new customers. As this ratio changes, either by improving LTV or lowering your CAC, this ratio will hit a sweet spot that suggests you’re growing your business sustainably. 

Why are there different LTV calculations?

The number of different formulae for calculating LTV reflect the different types of industries and business models - the goal with each one is to provide an accurate assessment of the ROI on your customer base.

If you’re a startup with only a few months of providing your service, then it may be hard to calculate LTV in a way that helps predict what will happen in your business 6 months from now.

If you have a variety of different subscription options and each one retains clients at a very different rate, then it may be more useful to calculate your LTV for each subscription individually.

Obviously for SaaS and recurring revenue businesses, LTV is incredibly useful to understand potential profitability in the future, and therefore it’s important to assess how you’re going to calculate it and justify that to potential financing partners.

What metrics do you need to calculate LTV?

Your LTV calculation can be done in a number of different ways, depending on if you want a very simple way to understand it, or if you’d prefer to use a more complex lifetime valuation calculation for SaaS businesses that reflects the metric more accurately.

Here are the metrics you need to understand in your business to calculate LTV one way or another.

Churn rate: This is the rate at which you lose customers during a specific time period. Depending on what you offer, there may be a heavy drop off point (or ‘cliff’) at a particular time after a customer subscribes, for example after the first month, and so when you calculate churn rate, consider whether it’s accurately reflecting that drop-off rate. Generally, the longer the period you calculate your churn rate over, the more accurate a reflection it will provide.

ARPU: This is the average revenue per user, and is normally calculated by dividing your total revenue by the number of subscribers.

Customer lifespan: This is the average period of time a customer pays you for their subscription. If you segment your different customers by the subscription models you offer, then you would want to note when a customer ‘leaves’ you in relation to one pricing option, and then starts working with you as a new customer on a higher package.

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How do you calculate LTV?

While there are a number of different options, moving from basic and simple calculations that allow you a general sense of what’s happening, to more complex, nuanced formulae that allow you to take into account the specifics of your business or niche, the goal of each one is to reflect the return on investment (ROI) of the money you spend acquiring customers and creating and delivering your services.

The most common options are as follows:

LTV = ARPU x average customer lifespan 

So if your ARPU is $100 over a month period and your customers stay with you on average for 20 months, then your LTV would be $2000.

OR

LTV = ARPU/ churn rate

So if your ARPU is $100 a month and your churn rate is 0.05 (i.e. you lose 5 out of 100 customers in a month) then your LTV would be $2000.

If your churn rate is not uniform but varies widely (i.e. you have a cliff after a month of people signing up, and also a general annual churn rate) then you can consider applying a discount (of less than 1) to this equation to factor that in.

LTV = (ARPU/churn rate) x discount

A more accurate, but complex way to calculate LTV for SaaS business is as follows:

LTV = (ARPA x Gross margin %)/Revenue Churn Rate

Where you calculate:

ARPA = MRR/total number of accounts

Gross margin = total revenue - cost of goods (COGS)

Revenue churn rate = (revenue lost in a specific period - upsells)/revenue at beginning of the period)

How can you increase the accuracy of your LTV calculation?

To make your LTV calculation as accurate as possible, you want to use the more complex of the calculations listed above, if you can. 

In relation to churn rate, you might want to consider calculating your churn rate over as long a period as possible, and carefully considering what discount to apply to reflect your varying churn rates across offers. It’s also worth considering what sample size you use when calculating churn rate, with the larger the sample size the better.

You could also consider segmenting your offers and calculating a different LTV for each one, so you understood which of your offers is most profitable. 

What is an ideal LTV/CAC ratio?

One of many reasons you might want to understand your LTV is so you can figure out your LTV/CAC ratio.  This is the balance between how much revenue your average customer brings in, and the cost to you to acquire them. It’s generally accepted that you don’t want that ratio to be lower than 3:1 for a profitable business. 

If you segment your offers and calculate an LTV for each one, you can then look at understanding which of your offers are profitable, and which ones might be loss leaders but worth using if there’s consistent upselling to the more profitable offers with a better LTV/CAC ratio. This also allows you to consider the cost of sales and marketing, and understand where to put efforts into retaining existing clients and trying to extend their average lifetime with a service, and where to focus on lowering CAC so that you can bring in more new customers.

Understanding the benchmarks for your industry or niche, or for your competitors and peers if you’re in a new market sector, can help you assess whether your business is growing at an acceptable rate or not. It can also be useful data to show potential financing partners if you’re looking to grow faster and bring on equity or debt funding.

Capchase provides non-dilutive financing options for growing SaaS businesses, and our team of Growth Advisors work with customers to provide insights on key metrics like your LTV/CAC ratio to scale and support your growth.