August 28, 2015
Customer Lifetime Value
Customer Lifetime Value, or LTV, seems to be the current darling of the SaaS metrics world, but it’s not the easiest metric to implement and use. One generally accepted formula for LTV is the following: Which can be simplified to:
Customer Lifetime Value = Average Revenue Per Account / Customer Churn Rate
This formula is simple enough to calculate; Average Revenue Per Account (ARPA) is fairly straightforward, and you should be able to calculate your customer churn rate with a number of tools available on the market. But the more relevant question here is, “Is such a simple formula useful to me in the first place?” Here are some key drawbacks to estimating LTV using the above formula:
- It doesn’t account for any MRR expansion. If your product has a steady expansion of accounts (fairly common if your pricing scales with the size of the customer) then the LTV estimate here is likely to be low.
- It assumes that churn occurs linearly, which is almost never true for SaaS businesses. In most cases this is some form of curve, with a higher churn rate earlier in the customer lifetime.
- It only accounts for gross subscription revenue. If you have significant revenue outside your core subscriptions, the estimate you reach may not be helpful knowledge at all.
- If you’re a young business with just a few customers, estimating LTV is not likely to be useful to you. Varying churn with such a small amount of customers would lead to a very volatile number that won’t be helpful in the long run.
Tip: You could also experiment with a 12-month LTV, which could lead to a more reliable estimate if you’re really struggling to get to a good estimate of the lifetime. According to the simple definition above, there are only 2 metrics you can influence in order to have an impact on LTV; Average Revenue Per Account (ARPA) and Customer Churn Rate. Increasing the former, or decreasing the latter will result in a higher LTV. But what steps can you take right away that are going to keep your customers longer, and increase the average amount they spend with you - at the same time as keeping them satisfied with your product?
1. Focus on customer success to reduce churn
Meet your new friend, the Cohort Analysis chart: This guy has a really useful function. He’ll expose which specific months in your customers’ lifetime are the highest risk for churn. Looking at churn rate per cohort is a great way to instantly identify where (if anywhere) you have a problem with churn, and to take immediate action by focusing your customer success efforts in such a period (or just before it). That is to say, if month 4 has a much higher churn rate than any other, talk to your customers who are entering month 4, and try to understand any problems they’re experiencing, or goals they’re not achieving with your product. Fixing this may require product improvements, or a better onboarding or support process. Tip: If your CRM tool allows it, set up customer segments, and corresponding alerts to let you know when a customer enters a high churn risk period. You could even go one step further and reach out to them with an automated message to kick off some dialogue. Bonus Tip: Send out a regular NPS survey. You’ll be amazed at the quality of feedback you get just from sending out a simple question. Result: Focused customer success = lower churn rate at critical periods = higher LTV
2. Scale your pricing to increase account expansion
A great way for SaaS businesses to increase their ARPA (and subsequently LTV) is to make sure that the pricing model allows for account expansion throughout the lifetime of the account. Scalable pricing is a great way to do this - it allows you to lower the barrier to entry for smaller customers and still leverage the higher margins found at the enterprise level. It’s possible to scale SaaS pricing based on one of a number of factors, commonly:
- Number of active customers
- Number of “seats” (operatives) required
- Customer Monthly Recurring Revenue
- Infrastructure requirements, e.g. cloud storage space
The requirements for all of the above are likely to increase over time as a company grows. If your pricing increases with the growth of your customers, this lays the groundwork for greatly increased LTV due to healthy account expansion. Result: Scalable pricing = higher account expansion = higher ARPA = higher LTV
3. Add “sticky” features inside your platform
This one’s interesting, and always brings up some conversation, including one term that I always hate to use in product discussion: “User lock-in”. The idea of adding metaphorical prison bars to your product to make it difficult for them to leave - even if they want to - goes against everything I’ve learned about making a great product experience. What does often make sense though, is likely what most people mean when they use the term “lock-in”, is this: Build features in your product that allow customers to create their own data and add further value inside your platform, that make them reluctant to leave, because it’s very difficult for them to make the decision to leave - they’ve invested time and effort into building inside your ecosystem what’s really valuable to them. Example 1: A cloud storage solution could add social features that allow users to add a notes, annotations and discussion layer on top of their files. Example 2: An analytics service could allow customers to build their own custom user segments and reports inside the platform. Result: Adding sticky features = lower churn rate = higher LTV
4. Re-engage inactive customers to improve customer satisfaction
The chances are, there’s a proportion of your customer base that hasn’t engaged with your product for a scarily long time. At this point, they’re basically churn to you. Putting in place a re-engagement strategy can be a great way to get them actively using your product again, and getting value from it. “But wait, what if those customers will be reminded that they don’t really want my service and the emails will prompt them to churn?” Yes, this might actually happen. And you might see an initial peak in churn when you do this for the first time. But in avoiding this, you’re really just fooling yourself about those inactive customers. If all that it takes for them to churn is a reminder that they’re still subscribed to your service, they’re simply inflating your Monthly Recurring Revenue (MRR). In the long run, actively keeping all of your customers engaged is much more likely to lead to improved customer satisfaction and loyalty, in turn driving higher LTV. Result: Email re-engagement = higher customer engagement = higher satisfaction = lower churn rate = higher LTV
5. Introduce premium features that entice customers to upgrade
Another great way to drive bigger account expansion is to entice customers onto a higher pricing tier, through introducing great “premium” features that suit enterprise or power-user customers. The best thing about this method is that there’s a much lower risk of angering customers by forcing them onto a higher priced plan. The ones who upgrade actually proactively choose to upgrade, because they want the additional features. Result: Premium tiers = higher account expansion = higher ARPA = higher LTV
Customer Lifetime Value is a mysterious beast, treat it with caution and respect
The strategies above represent some of the most common ways to extend:
- The length of the customer lifetime
- How much each customer pays
…which at the most simple level are the key ways to grow your existing SaaS business without acquiring new customers. The difficult part comes in really having a solid grasp on LTV estimation - and please, remember it’s only ever an estimation - that’s tailored to the characteristics of your business, and being able to achieve high-confidence measurable results from the above ways to grow your customer lifetime value.