Important pre-requisite to read before this post, "What is Unit Economics and Why is it Important for Startups?"
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What is Customer Lifetime Value (CLV)?
Customer Lifetime Value (CLV), or the Lifetime Value (LTV) of a customer indicates the total revenue that a business can (expect to) earn from a single customer account. The longer a customer continues to purchase from a business, the greater their lifetime value becomes.
SaaS startups predominantly focus on quarterly to yearly subscriptions, and hence they tend to enjoy a high LTV.
Why is Customer Lifetime Value Important?
Customer Lifetime Value (CLV) gives you great insights on:
How much (max) is to spend on marketing and sales to acquire (max CAC per customer) and retain the customers?
Plan and optimize your marketing spend (budget, promotions, channels, RoI, etc.)
You can now segment your customers based on CLV to retain more profitable customers, and/or fire the least profitable ones.
Using CLV, you can better predict revenues and profitability in the future.
CLV even helps you to tweak your pricing (beware it can be dangerous too).
How to Calculate Customer Lifetime Value?
The traditional formula to calculate Customer Lifetime Value is:
Customer Lifetime Value (CLV) = Average Order Value x Average Order Frequency x Average Customer Lifespan
Average Order Value: Average amount of money a customer spends per transaction.
[Formula] Average Order Value = Total Revenue Earned / Total No. of Transactions
Average Order Frequency: How often customers purchases from you (monthly/yearly)?
[Formula] Average Order Frequency = Total No. of Orders / Total No. of (Unique) Customers
Average Customer Lifespan (Retention): Average timespan (number of months/years) a customer keeps purchasing from you or average timespan that you’re able to retain a customer.
Another, Customer Lifetime Value Formula?
Some experts also add Average Gross Margins to the formula i.e.
Customer Lifetime Value (CLV) = Average Order Value x Average Order Frequency x Average Gross Margins x Average Customer Lifespan
Let’s take an example of Starbucks (with assumptions) for a better understanding:
Average Order Value: $5.
Average Order Frequency: 4 times/month
Average Gross Margins: 0.5 (50%)
Average Customer Lifespan: 120 (10 years)
The Average Customer Lifetime Value at Starbucks: 5x4x0.5x120=$1,200
In such a scenario each customer is likely to add $120 to its gross margin every year. Little wonder Starbuck's loyalty campaign is such a hit, globally.
Use our template to calculate your Customer's Lifetime Value.
What is the Ideal Customer Lifetime Value?
For fundraising purposes, most investors prefer those startups having LTV:CAC ratio of a minimum of 3:1 or above. It means that each customer is expected to spend 3X (purchases) against what it costs to acquire them. A study by Mckinsey, however, depicted that most US SaaS companies had comparatively lower i.e. 2.8:1 ratio.
How to Improve Your Customer Lifetime Value?
1. Segment your customers: Find out which (type/segment) of customers can be better served, and are more profitable. Apply the 80:20 rule here too.
You can’t serve every customer, so it’s ok to let go of those customers that have relatively lesser CLV or profitability. You’re better off adding those customers instead that fit your thesis (can be better served, will stay longer, and are more profitable.)
2. Reduce Your Churn: It’s 5-7 times more costly to acquire a new customer than to retain one, hence work hard to reduce churn.
Find out the key factors (irritants) that are responsible for churn. A 15%-20% churn will have a devastating impact on any startup, here’s how. 3 leading causes of Customer Churn are:
Poor On-boarding (23%)
Weak Relationship Building (16%), and
Poor Customer Service (14%)
Work on these areas to reduce churn.
3. Tweak Your Pricing: Beware it can be double edge sword if you don’t do this efficiently. Strongly recommend creating an altogether new package/product/service, where you charge modestly more for enhanced features. If you tweak prices on the existing product/service, chances are high that you might lose existing customers.
4. Cross-sell/Upsell: Spend time creating a promotion/upgrade offer to let existing customers sign-up either free / by paying a lesser differential amount (coupon/discount). The upgrade should only be optional, and not forceful. You can also try bundle offers by combining yours and a complementary product that can improve your order value.
5. Deliver Delightful Customer Service & Experience: Poor customer service is the greatest handy tool for your competitors to snatch away your customers. Turn the tables by building a customer-centric culture with your business, delighting your customers at every touch point, and delivering your product/service friction-less, and automated for self-service using FAQs, knowledge base (how-to guides, videos, articles, etc.)
Finally, regular hand-written notes (emails) to your customers, partners, and employees always win hearts!
LTV:CAC is a cornerstone metric for startups, especially when we consider the scalability and sustainability of a business model.
It serves as a critical metric for assessing the efficiency and financial health of startups.
Companies with higher LTV:CAC ratio generally enjoy higher margins and valuations, due to their ability to generate more profit from their customer acquisition efforts.
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