What is Customer Lifetime Value and how to calculate it
Updated: Aug 24, 2022
Customer Lifetime Value (CLV), more commonly referred to as Lifetime Value (LTV) is the total revenue that your startup can expect to generate from a single customer over the course of the business relationship — hence the term “lifetime”.
LTV is one of the most important Startup KPIs for a SaaS business and closely monitored by investors and Board. It is a strong indicator of your startup's viability as a business.
Further, knowing your startup's LTV will help you understand a customer's long term value to your business and avoid tactics and decisions that may improve business performance in the short term but jeopardise the long-term business relationship.
Overall, a strong LTV is a sign of deep product/market fit and customer's affinity to your product and therefore the brand loyalty that you've built up.
How to calculate LTV
There is more than one way to calculate LTV. At its simplest, LTV can be calculated by following these steps:
Amount that the customer pays for a selected period, for example a customer may pay £100/month for your product
Duration for which the customer stays with the business, for example the customer may buy your product for a total duration of 12 months
In this example, LTV = £100 x 12 = £1,200
The above approach calculates the LTV for a single customer. This approach can work for your entire business if all of your customers pay exactly the same amount, each month and stay with the business for the same duration.
In reality though, most businesses will have more than one pricing tier and different numbers of customers and customer duration within each of the pricing tiers. Therefore, a more prevalent and pragmatic approach to calculate LTV is to utilise:
Average Revenue Per User (ARPU): This is the average revenue your make across all your customers and pricing tiers.
Churn: This is the number of customers your startup loses within a given period, typically calculated for a month or a year
With ARPU and Churn available, you can calculate LTV using the formula:
As your business matures, you can use the same formula to calculate multiple LTV values, one for each product line or one per pricing tier, as relevant to your business model.
This will enable you to get a more granular (and therefore a more accurate) view of your startup’s LTV numbers.
Typical pitfalls when calculating LTV
It’s all too easy for early-stage startups to underestimate or overestimate LTV. This happens primarily because there is minimal data to work with during early stages and results can be misleading due to a small sample size.
Given this, the most common pitfalls to watch out for are:
Not revisiting LTV regularly: It is critical to revisit your LTV calculation at regular intervals during the early stages of your startup. You will find that as more data becomes available and you have a more diverse customer behaviour in the mix, your LTV figure will change.
Limiting LTV calculation to revenue only: While the formula that is listed above to calculate LTV is a great starting point to have an indicative LTV, it is critical to adjust ARPU for costs of sale i.e. subtract costs from the revenue and utilise gross profits (not gross revenue) to calculate LTV for a more accurate picture.
Is there an industry benchmark for LTV?
As with Customer Acquisition Cost (CAC), it is impossible to benchmark LTV because of how hugely it varies based on stage, size, industry, product and market.
The most prevalent approach to assessing your startup’s LTV is alongside CAC, as a ratio referred to as LTV:CAC.
This is the ratio of the two KPIs that shows you how much your startup gains from a customer verses how much it has to spend for acquiring that customer. For investors, this metric is an indicator of profitability and growth potential.
For SaaS businesses, a ratio of 3:1 is widely considered as optimal, which signals that you are investing in customer acquisition and making good returns on that investment.
Whilst it may seem counterintuitive, ratios of higher than this, 4:1 or 5:1, are not desirable during the growth stage. At these levels, you are likely under-investing in customer acquisition – there is a demand for your offering, but a lack of sales and marketing activity could mean that you are missing out on opportunities.
Ultimately, it is important to have a good grasp on the underlying drivers and use the ratio to identify the right strategy, in line with the stage and goals of your startup.
To learn more about SaaS KPIs that matter, check out our Ultimate Guide to Top 5 SaaS KPIs that investors care about.