Your sales team should always be looking for effective ways to attract new customers, cut down on customer acquisition costs (CAC), and increase customer satisfaction and retention (especially since some level of customer churn is unavoidable).
But do you know how much each new customer is worth to you once they’re acquired? If not, then how do you justify marketing and sales budgets?
Understanding your customer lifetime value allows you to predict how much revenue a new deal will bring in over the course of the customer relationship.
What is Customer Lifetime Value Exactly?
Customer lifetime value (CLV) is the amount of value a customer contributes to your business over their lifetime – which starts with a new customer’s first purchase or contract and ends with the “moment of churn.”
Sometimes referred to as LTV (shortened from ‘user lifetime value’), CLV is one of the most significant metrics for businesses and should be measured at regular intervals.
In this article, we’ll dig into these key aspects of customer lifetime value:
- The value of knowing your CLV
- The difference between historic and predictive CLV
- How to calculate CLV (including a simple formula and the traditional method)
- Tips to increase CLV for your business
- What a good CLV:CAC ratio looks like for SaaS companies
The Importance of Understanding CLV
Looking at CLV can help you define clear marketing goals and sales strategies to reduce acquisition costs, improve retention, and encourage existing customers to spend more over their lifetime with your company.
Understanding CLV can help your business answer these critical questions:
- How much can we comfortably spend on marketing and sales for customer acquisition?
- How much should we spend on customer service to retain an existing customer?
- Who are our most valuable customers and how can we better target this demographic for future sales?
Remember, not all customers are equally valuable. For most businesses, a small cohort of specific customers is generally the most profitable. Assessing your CLV can allow you to dedicate more resources toward the acquisition and retention of high-value customers – thereby increasing profits overall.
The Role of CLV in Startup Growth
One of the most valuable applications is using CLV to frame a better understanding of your customer acquisition cost (CAC). Your CLV:CAC ratio reveals a lot about the health of your business model.
Many startups and small businesses struggle to grow because their CAC is higher than their CLV. Once you calculate CLV, you can focus on optimizing this ratio – which ensures your business continues to grow at a healthy rate.
The Role of CLV in Startup Growth
Without measuring CLV, a business might be spending too much to acquire customers whose lifetime value simply isn’t worth the cost. Once you’ve identified your most valuable group of customers, you can focus on providing customer service tailored to their needs to ensure they stick around as long-term clients.
How to Calculate Customer Lifetime Value
Now that we know CLV is integral to your business’ ability to grow, let’s talk about how you can calculate it. Measuring CLV requires looking at the length of the customer lifespan, retention rate, customer churn rate, and the average profit margins per customer.
However, there are several different ways to calculate CLV, including the simple and traditional formulas that we’ll look at today. CLV can also be historic or predictive depending on the data used.
Historic CLV is the sum of all profits from a customer’s past purchases. This number is based on existing customer data from a specific period of time.
Predictive CLV allows you to project how much revenue a customer will generate for your business over the course of the customer relationship. This is considered a more complete method of assessing CLV.
The predictive model uses transaction history and behavioral patterns to determine the current value of a customer and to forecast how customer value will evolve with time. As you collect more data to include in this calculation, the value will become increasingly accurate.
The Simple CLV Formula
The most basic way to determine CLV is to add up the revenue earned from a customer (annual revenue multiplied by the average customer lifespan) minus the initial cost of acquiring them.
(Annual revenue per customer * Customer relationship in years) – Customer acquisition cost
Here’s a quick example of the simple CLV formula in action:
Let’s say a SaaS company generates $3,000 each year per customer with an average customer lifetime of 10 years and a CAC of $5,000 for each customer.
The company could calculate CLV like this:
$3,000 * 10 - $5,000 = $25,000
Not bad, right? Looking at your CLV through this lens makes it easier to justify the sales and marketing budgets required to land new customers in the first place.
The simple approach can be used if a customer’s annual profit contribution remains somewhat consistent. For example, if you run on a subscription-based model with only one or two tiers, then each your customers can be expected to provide a relatively stable source of revenue.
The Traditional CLV Formula
On the other hand, if your annual sales per customer are not relatively flat, a more in-depth CLV equation is needed. This traditional version of the formula takes rate of discount into consideration and provides a more detailed understanding of how CLV can change over the years.
The detailed CLV equation breaks down the individual costs and profits of each year. Here’s what you need to know to calculate it:
- Average gross margin per customer lifespan
- Customer retention rate
- Rate of discount
And here’s how it works:
Gross margin * (Retention rate / [1+ Rate of discount – Retention rate]
This traditional method allows for fluctuations in customer revenue over time and each year is adjusted by a rate of discount to account for inflation. If you’re not sure what rate of discount is appropriate, consider that a rate of 10% is commonly used by SaaS companies.
How to Improve Your Customer Lifetime Value
Now that you know what your CLV is, you can take action to increase it and improve your CLV:CAC ratio. Not sure what ratio you should be aiming for? Most resources suggest a ratio of 3:1 as a safe minimum for SaaS companies.
Here are a few tips for driving up your CLV:
1. Create a Loyalty Program
Incentivize repeat purchases and you’ll automatically increase retention along with the lifetime value of your customers. Repeat customers are always more profitable than those who make a single purchase - and they cost less to retain than acquiring a new client.
2. Improve Customer Relationship Management
Offering better customer service and a consistent user experience will keep your clients satisfied and lengthen your average customer lifespan. This also allows you to recognize opportunities for upselling and cross-selling, which would further boost your CLV.
3. Target Your Most Valuable Customer Type
When you calculate your current CLV, you can identify your most profitable customer type and use that information to improve your CLV going forward. Refine your marketing to target those high-value customers who are more likely to make repeatedly bigger purchases throughout their lifespan.
The Other Side of the Coin: Customer Acquisition Cost
Remember, improving CLV isn’t the only thing necessary to grow your business. Another key factor to look at in conjunction for LTV is your customer acquisition cost. Aim to increase your LTV and decrease your CAC for an optimal LTV:CAC ratio that will bring you long-term success.
Another way to reduce CAC is to use a CRM like Propeller. Want to spend less time on data entry and tracking while generating more leads through cold email? Start your free trial today so you can focus on making connections and landing new customers.