SaaS Valuation FAQ Series – Part 2: Customer Life Time Value (LTV)

Q: Should I use revenue and churn alone to calculate LTV, or should I also consider COGS and the time value of money?

A: The answer is that you should consider COGS and the time value of money (discounting at your cost of capital), and the other marginal costs of servicing and retaining a customer. Few companies do all of the above.

LTV as it is often calculated, skews more as a vanity metric than one that reflects real managerial accounting or fully discounted economic value. Most companies do the following to calculate their customer LTV:

So, for example, if the ARPC of our MidChurn example company is $10k, and the churn is 10%, then the average customer lifetime is 1/10% = 10 years, and the customer lifetime value is therefore calculated as 10 years X $10k / year = $100k.

Further, if we calculate the average Customer Acquisition Cost (CAC) (not CAC delineated by segment, cohort, nor marketing channel, but just average CAC), is $50k / customer, then all appears absolutely fantastic: we acquire customers for 50% of what they are worth to us, and we should be spending up to 70 or 80% of our calculated LTV on new customer acquisition, all day long. So applying this logic, we are actually underspending on CAC relative to what makes economic sense.

But this approach is flawed, and in at least two major ways:

First, back to accounting 101, the real value of a customer is not measured by the revenue they drive, but rather the contribution margin they add, net of cost of goods sold (COGS). Furthermore, the real contribution to the bottom line, on an incremental basis, must also include expenses like customer success and support hours (and renewal admin, and some amount of R&D to keep the product fresh and relevant), which are often missed when burdening SaaS COGS (which often include only infrastructure and hosting costs, and don’t account for the other post-sales support resources that are necessary to retain customers and are therefore representative of the true ongoing COGS).

There’s more – the other miss here is that the value of dollars earned in the out years must be discounted at what is called the weighted average cost of capital, or WACC. In most growth stage SaaS businesses, one can comfortably use a figure of at least 20% as representative of the cost of capital (if the company has access to venture or mezzanine debt for growth), but is closer to 30% for any outside growth equity investor, taking their target internal rate of return (IRR) target as a proxy.

Calculating Your True LTV

Set against the backdrop of these facts, what is the real LTV of MidChurn? Well, without getting into the details of what goes into the various COGS and non-COGS expenses (the subject of future article), let’s assume that their income statement COGS is 30% of revenue, yielding a 70% gross margin. Further, let’s assume that another 10% can fairly be attributed to other SG&A costs, on an incremental basis. So, the real incremental contribution of each dollar of recurring revenue is 60%, or 60 cents. Finally, let’s take the lower end of the 20 – 30% range as the WACC for MidChurn, presumably because they are at sufficient size and scale to attract somewhat less expensive money.

The following table sets forth the real, discounted, annual incremental contribution dollar value, for the 10 year expected lifetime of the customer:

Another way to express this in a formula is:

Why is LTV important?

If the CAC of $50k prevails as accurate, then the customer that we thought was worth $100k, is worth just $25k.

What’s worse, we are literally losing $25k of economic value (spending $50k to extract $25k), for each customer that we acquire. MidChurn Inc is a money losing machine.

To right this particular ship, we would need to reduce CAC to at most 70 or 80% of the LTV, or let’s say $20k. And even then the CAC recovery time (the subject of a future article), would be 3.3 years, when a ‘healthy’ SaaS business should be aiming to fully recover CAC within 12 – 18 months at the most.

Curious to know how your real LTV stacks up?

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SaaS Valuation FAQ Series - Part 1: The Quick Ratio

Q: What’s more important as a determinant of financial value: growth or churn?

A: Probably the most common single question we get – and the Quick answer is the Quick Ratio, which accommodates both.

The Quick Ratio is the ratio between New/Upsold MRR and Lost (churned)/Downgraded MRR:

Let’s take a simple example of an early stage SaaS growth business (HighChurn Inc.) with an SMB focus, currently running @ $1.2M ARR ($100k MRR) and aiming to grow 50% heading into a new calendar/fiscal year.

To achieve this, they must add 50% x $1.2M = $600,000 of net new annually recurring revenue (ARR) over the course of the calendar 12 months.

Assuming no churn, the company would need to add $600k / 12 months = $50k of total new MRR (or $4,167 new MRR per month) to be on track to hit their growth target.

However, as an SMB focused offering with a typical 3% gross monthly churn (~31% annual churn), they will lose 3% x $100k = $3,000 of MRR in January of our example year, and so will need to add an additional $3,000 of new revenue to make up for that and stay on pace for their growth target for the year.

So, they will need to acquire or upsell a total of $4,167 + $3,000 = $7,167 of new MRR in January.

About 40% of their customer acquisition effort (and CAC) is committed to replacing lost revenue, and 60% goes towards acquiring new customers or upselling existing ones.

The quick ratio here is $7,167 / $3,000 = 2.4, and is only marginally above the minimum accepted healthy figure of 2.0, existing in a range where churn is clearly hurting growth prospects.

Quick Ratio In A Lower-Churn Market

How would these numbers differ if we were talking about MidChurn Inc., focused on the lower churning mid-market, where typical annualized churn is on the order of 10%? Let’s do the math: 10% annual churn implies just 0.9% monthly churn, ignoring up-sales and downgrades. MidChurn’s loss on a $100k MRR base is just $874 in a month.

Now, MidChurn can achieve the same growth target with just $4,167 + $874 = $5,041 of new customer acquisition in January.

And the Quick ratio? It’s $5,041 / $874 = 5.8, well above the ‘magic number’ of 4.0.

How much more quickly would MidChurn be growing if they achieved the same gross customer acquisition figure as HighChurn of $7,167 of MRR? MidChurn would add net $7,167 - $874 = $6,293 of new MRR in January, and would keep that growth up through the remainder of the year, ending up with 76% annualized growth, not having spent a single dollar more on customer acquisition (we are holding CAC constant, here).

Finally, how much would HighChurn need to add in new MRR in order to achieve the same 5.8 quick ratio that MidChurn sports? The answer: 5.8 X the $3,000 churned MRR = $17,299 new MRR each month.

That implies $17,299 - $3,000k = $14,299 of net new MRR monthly, $171,593 annually, for a 172% growth rate!

As you can see, it’s difficult for a high churning company to have both a healthy Quick Ratio and a realistic growth rate; it’s much more realistic – in terms of the raw volume of necessary customer acquisition – to achieve 50 – 100% annualized growth when your annualized churn is kept in the low double digits.

Stay tuned for future posts in this series, covering subjects like cohort and segment analysis, CAC recovery time, LTV:CAC ratios, whether or not to use gross margin or revenue in LTV calculations, and whether or not you should be discounting your LTV dollars in the out years of customer lifetime (and the resulting implications for real Life Time Value).

What Is Your Ideal Quick Ratio?

Only your data can answer this question. Please try our interactive Quick Ratio calculator, below. If you'd like to discuss your numbers and their implications further, please submit your email and we will reach out to discuss. Alternatively, please contact us directly.