Customer Success Financial Foundations – Part 2
Customer Lifetime Value… The Math
If you’re a Customer Success leader, Customer Lifetime Value (LTV) is one of the most important metrics for you to understand. With that said, there are some pretty “creative” ways that people define it, which for something this important, probably isn’t a good thing. However, there are three commonly used variations that once understood, make you an LTV guru.
Definitions, Formulas, and What They Tell You
To help you better understand LTV we’ll look at some common definitions, show you the math, and talk briefly about their pros and cons. In your career you’ll probably use (or get asked to use) all three, and this is what you should know about each of them before you do.
LTV is the total amount of money a customer is expected to spend on your products, during their lifetime.
So this equation is the simplest, but I’d only use it when someone insists that you do. On the positive side, it’s simple. On the downside, since the “V” in LTV stands for value and a customer’s value is a function of profit, ignoring it seems like a pretty drastic step. Sure gross margins may be tough for early-stage companies to get a handle on, but that doesn’t mean you should simply leave it out.
- LTV is a prediction of the net profit attributed to the entire future relationship with a customer.
So by just adding a gross margin percentage, this equation becomes much more valuable (pun intended:). In reality, from a financial perspective, LTV is about profit and simply adding gross margin gets you there. Just think about it, it makes sense for LTV to include profit since unprofitable customers are of questionable value over their lifetime. From a practical perspective, even if you don’t know your gross margin, throw in a reasonable estimate like 80%. That way, as you narrow in on your real gross margin, your LTV won’t tank overnight.
- LTV is the present value of the future cash flows from a customer during their entire relationship with your company.
So the first equation was really simple, and without adding much complexity the second one is a lot better, and honestly, this equation is much more complicated which begs the question… Why use it?
The answer is… It reflects reality. As such, it is infinitely more useful when making business decisions (as opposed to a pretty chart). Remember, recurring revenue businesses and the subscription economy are all about the value of a customer over time and as you can see below… How you do the math will impact your business decisions.
LTV is critical in helping decide how much you should invest in customer success, and where that investment should be focused. Of course, there are reasons why you might choose to calculate LTV in different ways, but bottom line… You need to have a really good understanding of LTV because ultimately it is what determines how successful your company will be.