What is LTV, and why does it matter?
LTV, or lifetime value, is a benchmark for the health of a business, no matter the industry or model. A high LTV can indicate brand loyalty, good product-market fit, and viable unit economics. In contrast, a low LTV could suggest issues with customer retention, product selection, or even marketing. Steadily improving lifetime value will grow your bottom line.
According to HBR, a 5% increase in customer retention can increase a company’s profitability by 25% to 95%. To achieve those kinds of results, it’s crucial to understand LTV and start incorporating it into your startup metrics as soon as you start collecting customer data. In this piece, we’ll define lifetime value, explain why a healthy LTV is essential to your business, and offer a few tips for calculating LTV and fitting it into your reporting cadence.
What is lifetime value?
Think of lifetime value as the sum of money a customer will bring your company for the duration of your relationship. Take a second to pause and think about your personal LTV for your favorite coffee shop, clothing store, or gas station. Yikes for you, good for them!
Of course, there are other places that you’ve only patronized once in your whole life, right? So LTV varies from customer to customer. As a business, you want to reduce the number of customers who are “one-and-dones” and draw in prospects who will stick around and bring you the most value over their lifetimes.
Several things influence LTV (customer satisfaction, product-market fit, etc.), so many companies use LTV as a point of reference and start digging in when the number goes up or down. While calculating the total number of orders for each customer seems simple, it gets more complex as you start to consider the unique ways your business operates and how it might grow and change in the future.
How do you calculate LTV?
Depending on who you ask, you might get a different answer for how to calculate LTV. That’s because how much data you have and how you structure your business have a lot to do with it. However, as a baseline, the simplest way to measure LTV is:
Average Order Total ($) x Average Number of Purchases (per year or month) x Average Retention Time (years or months)
The formula represents the lifetime value of your average customer in dollars. The more orders you have to go off of, the more accurate this number will become. This is where eCommerce companies have the edge over SaaS companies with much longer sales cycles (at least at first). It’s also important to note that this basic LTV formula does not consider profit margins or the costs associated with acquiring each customer.
LTV can drastically differ from customer to customer, so companies segment their customers into targetable personas (age, gender, product purchased) and see how the average LTV changes. Groups with low LTV are prime candidates for customer research. For example, you might find that one of your products works particularly poorly for a certain segment of your customer population because of its specific characteristics.
You might’ve also heard the term “CLV” or customer lifetime value. CLV is essentially LTV, just at the individual customer level. Sometimes, companies will include acquisition cost and profit margin to make the number more precise:
(Lifetime Value (Order Total x Number of Purchases x Retention Time) × Profit Margin) – Acquisition Cost
Regardless of what method you choose, LTV can help you brainstorm better promotion, retention, and acquisition strategies.
Why are LTV and CLV important?
Once you’ve nailed down your method of calculating LTV and CLV, you’ll be ready to delve deeper into how each lever (order value, purchase frequency, and customer lifespan) affects your business outcomes. To pull out more details from your LTV calculation, here are some questions you can start to ask:
- Why are order values high/low? Is there some kind of messaging that’s convincing people to buy more expensive products?
- Are we making or losing money in the long-term by offering free samples or discounts?
- Are we spending an awful lot on customer acquisition on Facebook and Google but only getting low LTV customers to convert?
- Should we implement a loyalty program to keep our high LTV customers around and bump low LTV customers up a level?
- Who is our most valuable segment, and how can we acquire more of those customers?
- What do our customers think of our product quality? Are they running out of our product and buying more or simply not coming back?
- Should we consider a subscription program to hit our retention goals?
- Are there signs that we might need to expand our ideal customer profile to include other types of prospective customers?
If you want to get really fancy, you can start to forecast LTV. Keep in mind that you need several years’ worth of data for sophisticated modeling and LTV prediction. But if you can manage to do it, it will help your finance team with FP&A, your product team with new launches, and your marketing team with enhanced segmentation.
How does lifetime value fit into other company metrics?
LTV is informative, but it becomes even more powerful in the context of other metrics your startup will be tracking. Here are just a few:
- Customer acquisition cost - Otherwise known as CAC, refers to the cost of gaining a new paying customer. Typically companies compare LTV to CAC as a way of determining whether their marketing spend is reasonable. If a company’s LTV:CAC ratio is less than 1, they’re not doing so hot. There could be issues with the customers they’re bringing in, or they are spending too much money on acquisition, or both. If the LTV:CAC ratio is greater than 1, the company is generating value, but more could be done. An LTV:CAC ratio greater than 3 is often considered healthy.
- Revenue retention - Your net revenue retention (NRR) is the percent of recurring revenue from existing customers during a set period. LTV comes into play because it encapsulates the purchase frequency (more applicable to consumer goods) and the average order value (more applicable to SaaS and subscription businesses with consistent purchase timing but flexible order value). Breaking out NRR from LTV can help you figure out whether to focus your efforts on more conversions, upsells, and cross-sells.
- Churn rate - If you recall, customer retention is a major part of the LTV equation. So if your churn rates start to skyrocket, you’ll feel it in your LTV. A quick way to think about this is to measure your customer lifetime as 1/churn rate. Let’s say you’re looking at a monthly churn rate of 4%. In this case, the customer lifetime will be 1/.04, or 25 months. If you can get that down by one percent, your customer lifetime will extend by 8 months (33 months - 25 months). If your average order value, purchase frequency, profit margins, and CAC stay the same, that means you’ve gotten a massive boost in LTV.
LTV in the early days of your startup
Frankly, it’s hard for early-stage startups to pay close attention to LTV. With things constantly changing, it’s hard to tell what might be moving LTV up or down. And to do even the most basic calculation, you need customer data. That said, LTV will matter in the future, particularly in relation to CAC, if you’re going the product-led growth route. So now that you know what subcomponents you need to calculate LTV and CLV, make sure you have a plan to capture the proper customer data points over time. Not only will LTV help you identify ways to strengthen your business model, it will also help you attract the highest value customers and develop the best products in the market.
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