How Is Customer Lifetime Value Calculated?

How Is Customer Lifetime Value Calculated? The result of a customer lifetime value calculation may be a range rather than a precise figure. The first thing founders need to understand is what goes into customer lifetime value. In other words, the goal is not to find a single number, but to understand the factors behind it. That makes it possible to see where the risks lie and how customer lifetime value might be improved. This step is also useful once a company has paying customers. You should analyze their lifetime value and how it is changing over time. With that information, you can adjust the business in time to ensure that its unit economics support its survival, continuity, and growth. The following are the factors to consider when calculating customer lifetime value. 1. One-time revenue, if any * A product sold with a one-time, upfront payment generally generates one-time revenue. 2. Recurring revenue, if any * Service and maintenance fees, as well as repeat purchases of consumables, are forms of recurring revenue. 3. Add-on revenue * Add-on revenue refers to opportunities to sell additional products to existing customers. In this case, the sales team can sell add-on products without a corresponding increase in effort, generating additional revenue. Be sure to analyze the customer decision-making team and sales cycle identified earlier; underestimating either can lead to a mistaken conclusion. 4. Gross profit from each revenue stream * Gross profit is the difference between a product’s price and its unit production cost. This cost does not include sales and marketing expenses, which are counted in customer acquisition cost, or overhead such as research and development and administration. 5. Customer retention rate * For each recurring revenue stream, the retention rate is the proportion of customers willing to keep paying to use the product. It is usually stated as a monthly or annual retention rate. The opposite is the customer churn rate: the proportion of customers who stop paying for the product. For simplicity, assume that once a customer stops paying recurring fees, the company will no longer be able to upsell to that customer. 6. Product life cycle * For each one-time revenue stream, the life cycle is the expected period before a customer buys again or stops using the product. 7. Repeat-purchase rate * For each one-time revenue stream, the repeat-purchase rate is the proportion of customers willing to buy the same product from you again after the current product reaches the end of its useful life. 8. The company’s cost of capital * The cost of capital is expressed as an annual rate. It refers to the cost a company pays investors for capital raised through debt or equity. For inexperienced first-time founders, a reasonable range is 35% to 75% per year. This rate is high because it is difficult for investors to recover their capital all at once within a few years; the investment is illiquid. The company is also a new venture, and investors face substantial risk. For these reasons, investors charge a high cost for the capital they provide. (Robin’s note: When founders make estimates, they often forget to account for the cost of capital. One practical way to estimate it is to ask venture capitalists or angel investors what IRR they generally require. It is likely to be above 30%. If you ask three to five VC firms about their required IRR and use the average as the basis for your cost-of-capital calculation, the business’s value can look quite low once the high cost of capital is factored into the numbers.) --- Venture capitalist David Skok gives a direct conclusion: “For a SaaS company, the ratio of customer lifetime value to cost of customer acquisition should be at least 3:1.” First, customer acquisition cost does not include many of a company’s other expenses, such as research and development, financial management, and other day-to-day operating costs. These expenses reduce profit. Second, even when we try to be realistic and accurate, estimates of customer lifetime value and customer acquisition cost can still be overly optimistic. A 3:1 ratio leaves some room for error. Finally, startups face considerable uncertainty. Setting this ratio at 3:1 or higher can help a company absorb unexpected events, such as product delays, competitive responses, or an industry downturn. Customer lifetime value matters because it can support sustainable growth without excessive reliance on external resources. But understanding the facts behind the number is even more useful: it helps prevent unwarranted optimism and supports decisions based on real data, while clarifying the specific sources of revenue. #DisciplinedEntrepreneurship