Managing a business is a little bit like flying an airplane. Keep your eyes on the speed, altitude, drag, and fuel and you’ll get to your destination fast. Try flying blind and you’ll crash and burn.
Who Should Read This
Startup founders, marketing managers, and growth hackers who are new to the growth game. Anyone who’d like to understand basic business metrics tech startups use. Here is why you might care:
- You’d like to grow your business faster and understand the highest-leverage areas to focus on
- You’d like to evaluate the performance of your marketing
- You’re raising a new round and want to be ready for the questions VCs are going to ask
So, let’s dive right in.
What We’ll Cover
Last time we focused on user growth. We looked into acquisition, retention, and virality metrics, as well as interactions among these three. Today, we’ll assess the dollar impact one user has on our business. To do it, we’ll learn to calculate and use another metric: customer lifetime value.
- Customer Lifetime Value (CLV) = dollar value a company can earn from serving one customer.
- Retention ↑ => CLV ↑
- Price ↑ => CLV ↑
- Discount rate ↑ => CLV↓
Customer Lifetime Value
Understanding how changes in acquisition, retention, and virality impact the number of active users is a great start. Now, let’s look at one of the ways we can assess the impact of user growth on profits. One of the best ways to assess this impact is to estimate customer lifetime value (usually abbreviated as CLV or LTV).
CLV is simply a dollar value a company can earn from serving one customer.
When we know this number, we can decide exactly how much we can spend on the acquisition of an average user and still break even.
It’s important to understand how CLV of a business compares to customer acquisition cost, abbreviated as CAC.
- If CAC is higher than CLV, the amount of money we need to spend to acquire one user than the amount of money we can earn from serving this user. This is a bad business to be in unless we can either increase CLV or decrease CAC in the future.
- If, on the other hand, if CLV>CAC, our marketing investment is justified: we can invest in acquiring new users because the return on investment is positive.
So how is CLV derived?
In some industries, calculating this number is super easy and straightforward, but sometimes it is moderately, or even extremely, complicated. The most generic formula looks like this:
- “GC” = yearly gross contribution per customer = Sales minus Cost of Goods Sold
For example, the annual subscription to a service minus the cost of providing this marginal subscription (which is often close to zero for some tech companies).
- “M” = retention costs per customer per year, if relevant. Often, M=0.
- “n” is the horizon (in years)
It depends on how comfortable we are as a company extrapolating far into the future, based on the historical data that we have. So it’s a very arbitrary number. Using “infinity” makes mathematical sense, but we can also start with something more conservative, for example, three or five years.
- “r” is the yearly retention rate
This is a critical component. The longer customers stick with us, the higher their CLV because we can expect to receive payments for a longer time. This is why it is so important to build a product that customers want and like to use.
- “d” is the yearly discount rate
The discount rate is a financial term that might deserve a separate chapter. But for our purposes, we can assume that d = the interest rate we need to pay to raise capital. In other words, if we finance our business by getting a bank loan at 4%, our d = 4%.
- “i” means a certain year, i=1 means year number one and i=n means year number n
Some might think that this is unnecessarily complicated. If you do, here is a simpler, more intuitive way to think about customer lifetime value:
- Subtract the cost associated with serving one marginal customer for a year from the price that a customer pays for a subscription per year.
- Multiply this number by the number of years you expect an average customer to keep using the service.
- Annual subscription = $69.99
- The annual cost to serve one more customer = $5 (for example, incremental hosting costs)
- An average customer uses our service for two years
CLV = ($69.99 – $5) * 2 = $129.98
Of course, we can also use days or months instead of years.
I’ve included built a CLV calculator on the second worksheet in the same Google Spreadsheet.
Using CLV for Business Decisions
Now we can estimate the dollar impact of improvements in acquisition, retention, or virality metrics by multiplying the number of users by CLV of each individual user.
Remember how we planned to improve retention from 40% to 70% because 70% was the industry average? We expected this improvement to increase anticipated user count by week 26 from 333 to 1,166. In other words, we expected 833 incremental users.
If each user is worth $129.98, our expected incremental profit is $129.98 * 833 = $108,273. Another way to interpret this number is that we can spend up to $108,273 to improve retention and still break even as long we get to at least 70%.
Advanced Uses of CLV
CLV is even more powerful when calculated for distinct customer segments. For example, a SaaS business might find out that CLV of its enterprise clients is higher than the CLV of SMB clients. At the same CAC can also be higher for enterprise clients.
CLV and CAC metrics also vary by marketing channel. In other words, it might be more expensive to acquire users through paid search advertising but these users might also have higher CLV that would justify the cost.
Having visibility into these granular metrics can help companies make strategic decisions, such as deciding what segments to target or what marketing channels to double down on.
What We Learned
- There are multiple variables that will define business growth dynamics
- Main ones are acquisition rate, retention rate, virality coefficient, customer lifetime value, and customer acquisition cost
- Customer lifetime value is primarily determined by how much you charge and how long you retain users
- At any given time you might choose to prioritize some of these metrics over others
- This decision will depend on the business strategy, available resources, customer feedback, stage of the product lifecycle, and hundreds of other factors
- Models like the one shown here can assist you in making better decisions by letting you see where your business will be at in the future under different scenarios
More on Growth
- Rahul Vohra’s “How to Model Viral Growth”
- Andrew Chen’s “Facebook Viral Marketing“ and “What’s your viral loop?“
- Key Metrics for Popular Growth Models
- Facebook Growth – Y’Combinator Startup School
- Book: Viral Loop: From Facebook to Twitter, How Today’s Smartest Businesses Grow Themselves by Adam Penenberg
- Book: Growth Hacker Marketing by Ryan Holiday
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