There are two new unit economics, which when used together, can measure business profitability and sustainability. They are the concepts of customer Lifetime Value (LTV) and the Cost of Customer Acquisition (COCA)
The Lifetime Value (LTV) is equal to how much a new customer is worth to your venture in profit over the lifetime of 5 years. Calculating the LTV of a customer is an educated guess in the beginning, and things will change. But as a business owner, you need to know what drives the value of LTV. It’s important to understand the underlying factors, your risks, and how to increase LTV over time. The financials are estimates, the process is everything. The financials tell the story of the business person, not the company.
LTV Conceptually – Key inputs in calculating LTV (see graphic below)
Calculating LTV can include many variables but we will look at a simple example. The LTV is calculated over a five-year period using the gross profit margin for each of your revenue streams. Gross profit margin is equal to the average selling price (ASP) of the product, minus the cost of goods (COG).
Gross Profit Margin GPM = Average Selling Price ASP – Cost of Goods COG
If there is reoccurring revenue, calculate the retention rate. Multiply your gross margin by the retention rate after year one. This will reduce LTV for each successive year if retention rate is less than 100%. For each successive year, after year 1, you will need to use the cumulative retention rate (retention rate multiplied by retention rate from previous year).
You will also need to reduce your LTV for each year based on your cost of capital. It’s important to note, that your cost of capital is not equal to the % rate of your loan, but the % of gross profit you will be utilizing to pay back your loan, which is typically in the range of 35-70% for most companies.
The key to this exercise is to understand that LTV is based on profit, not revenue. In the example below, though the revenue over the projected period is $3,000, the customer LTV is only $580.00! The LTV of this customer is 19.33% of what you would think, based on revenues!
Customer LTV Level tells a lot about your company and business model. For a low LTV ($20 to a few hundred dollars), you can do non-human, algorithm or data driven sales. The higher the LTV, the more field sales and personal touch will be required. Increased human touch increases the cost of customer acquisition (covered in the next blog article). Is an LTV of $20 Bad? It depends on your cost of customer acquisition (COCA). According to David Skok, for a sustainable software company, your LTV should be at least 3 times your COCA, and for a product/service company your LTV should be at least 5 times your COCA.
How can you increase LTV?
There are a number of ways to increase LTV including:
- Reoccurring revenue – The best customer is the one you already have!
- Product line expansion
- Scalable pricing
- Subscription services
- Lead generation for 3rd parties
- Reduce production costs or cost of goods
- Increasing retention rate
- Minimizing cost of capital
How can you decrease LTV?
You can also reduce your LTV (not desirable) by doing the following:
- Lower customer satisfaction
- Higher churn (customers leaving) or lowering retention rate
- Bad word of mouth
- Increasing production costs or cost of goods
- Rising cost of capital
- The Business Model decision is very important. Reoccurring revenue models (subscriptions) generate more revenue but often require more capital = higher cost of capital.
- Gross Margins make a big difference. Wrapping your core low margin product with high margin add on products substantially helps your LTV.
- Retention Rates are very important as well. The longer you keep a customer the better your LTV.
- Finding additional real upselling opportunities can be very attractive. Upselling additional products can significantly improve your LTV. Upselling existing customers is cheaper than getting new customers.
- Overhead costs are not negligible. To simplify LTV calculations, overhead is not included. BUT overhead can be significant. Overhead is covered by the LTV to COCA ratio.
Bringing it all together:
- Unit economics (LTV and COCA) don’t tell the story of the business, but of the business person’s understanding of the underlying financials.
- David Skok’s Law states that the LTV must be at least 3 times the cost of customer acquisition (COCA) for a sustainable software company (3:1). The ratio for a product/service company should be even higher at 5:1.
- LTV is about profit, not revenue.
Learn more about how to determine and improve your customer Lifetime Value (LTV) in the Disciplined Entrepreneurship Online Course.
Founder and CEO, Leadership Institute For Entrepreneurs