Small Business Finance Blog

Want to gain full control over your firm’s finances but aren’t sure where to start? You’re not alone and you’ve come to the right place. Read on and reach out if we can lend a hand.

Why LTV is Misleading (& How to Address It) | SaaS Metrics Playbook

How to Calculate and Use Customer Lifetime Value (LTV) – a key SaaS metric

Lifetime Value (LTV) seems like a straightforward SaaS metric. Its job is to simply measure the amount of revenue generated over the duration of a customer relationship. But, as is the case with many other SaaS metrics, there’s more to it. A lot more.

Like other metrics, it’s easy to oversimplify SaaS LTV.

It’s easy to misuse SaaS LTV.

It’s easy to misinterpret SaaS LTV.

It’s even easy to miscalculate LTV (yes, there’s more than one formula).

The resulting issues can range from minor miscommunications to flawed financial data that leads to grossly misinformed decision making. And, while inconsistencies and errors might go unnoticed within an organization, they won’t slip under the radar when investors—or a prospective buyer—perform due diligence.

Indeed, it is critical for SaaS firms to understand LTV and how to use it. 

One of the keys to this understanding is the relationship between churn and lifetime value. In other words, the impact of revenue leaving your business on the average value of a customer.

In this article, we’ll examine how different types of churn can influence LTV. You’ll see just how nuanced this metric really is, as slight variations of the LTV calculation can paint a very different picture when it comes to the value of a customer—and the profitability of your SaaS business.

 

cta-saas-ceo-guide-to-finance-and-accounting

 

Defining LTV for a SaaS Business

For a SaaS company, LTV refers to the total amount of revenue a customer will bring in during their relationship with the business.

Also called customer lifetime value (cLTV), this metric is essential to understanding the profitability of a SaaS business. LTV tells a SaaS company whether a new customer is worth the amount spent to acquire them. If the lifetime value of a customer exceeds customer acquisition cost (CAC), the company is turning a profit. If not, there’s a problem.

 

SaaS LTV and Churn Rate

While the revenue reflected in LTV may include onboarding, support, and other one-time charges, the majority will come from recurring subscriptions. The key to maximizing LTV for a SaaS company is to limit churn—revenue leaving the business from canceled and downgraded subscriptions.

For this reason, churn is inextricably linked to LTV. And, like LTV, churn is a highly nuanced metric. Understanding the different ways to calculate churn, and why they are useful, is paramount. In the following sections, we’ll explore the impact of different types of churn on LTV.

 

How to Calculate SaaS LTV: 3 Different Methods

Calculating LTV for a SaaS business can be as simple as multiplying the average revenue generated per user during a period (ARPU) by the average contract length (ACL).

LTV = ARPU x ACL

With this basic LTV calculation, however, you’re only getting a high-level overview of customer value. When you account for churn, this SaaS metric becomes more than a number. It becomes a strategic tool, helping you understand how much you can pay to acquire a customer, where to focus customer retention efforts, which product features are most successful, and which customer types are most valuable.

This strategic approach to SaaS LTV includes 3 key formulas, each using a different type of churn. Let’s take a closer look at each LTV calculation, along with their merits and limitations.

 

1. How to Calculate SaaS LTV Using Net churn

Churn is often viewed as a measure of customer attrition, or the percentage of customers that leave during a period of time. While this is a valuable metric for any SaaS firm, some customers are often worth more than others. If this is true for your business, you need to account for the amount of revenue lost, not just the number of customers.  

Net Churn refers to the rate at which revenue is gained or lost over time, factoring in both expansion revenue from existing customers upgrading products or services, and contraction revenue from customers downgrading or canceling.

When to use net churn for calculating LTV:

If your strategy is “land and expand” (that is, to win a new customer and steadily increase the amount of revenue they bring in), you’ll want to calculate LTV using net churn. This approach:

  • Incorporates the expected cash contribution over the customer relationship
  • Factors in the cost to deliver a solution with gross margin
  • Includes expansion sales expectations
  • Accounts for lost customers, contracted revenue and expansion revenue

How to use net churn to calculate LTV:

LTV = (Annual Contract Value x Gross Margin) / (1 - Net $ Renewal Rate)

Every LTV calculation has limitations. When factoring net churn into LTV, for example, you’ll run into a problem if you reach the (highly desirable) state of “negative churn.” 

Subscription-based businesses hit negative churn when revenue from retained customers is expanding at a greater rate than lost revenue from churn. When using negative churn in the LTV calculation, the result becomes infinite, breaking the formula. While there is a workaround for negative churn, the short explanation is that you may need to cap the number of years in the customer relationship for companies with net-negative churn.

 

2. How to Calculate SaaS LTV Using Gross Churn

Gross churn refers to the percentage of recurring revenue lost during a time period due subscription downgrades and cancellations. Unlike net churn, it does not factor in expansion (upgrades) and is strictly a measure of revenue contraction. 

Apart from cancellations, contractions may include customers moving to a lower or free plan, reducing the number of licenses in use, eliminating add-ons or service items, and even involuntary churn such as credit card declines. By not factoring in expansion, a SaaS firm can dig into the root causes of revenue contraction.

When to use gross churn for calculating LTV:

When your business model is based on a single offering with uniform pricing (not a lot of add-ons or opportunities for customers to upgrade), and the goal is to drive transaction volume, gross churn is better at capturing customer size or revenue per client. In other words, calculating LTV with gross churn is an effective way to account for the size difference in client contract value.

How to use gross churn to calculate LTV:

LTV = (Annual Contract Value x Gross Margin) / (1 – Gross $ Renewal Rate)


As for the limitations of this method, if you have (or will begin offering) additional services, upgrades, add-ons, or other opportunities for revenue expansion, your LTV will not be accurate. Your LTV will actually be greater than the figure produced by this formula.

 

3. How to Calculate SaaS LTV Using Logo Churn

Logo churn refers to the number of customers (logos) lost during a specific period and includes those who cancel or decline to renew their subscriptions. While net churn and gross churn both account for changes in revenue, logo churn is strictly a measure of SaaS subscriptions lost.

When to use logo churn for calculating LTV:

  • If you don’t have a lot of variation in customer contract size.
  • If you don’t have a mature company (limited view into ARR and dollar churn).
  • You simply need LTV based on customer count.

How to use logo churn to calculate LTV:

LTV = (Annual Contract Value x Gross Margin) / (1- Logo Renewal Rate)

In a business where some customers are worth more than others, logo churn won’t have a direct correlation to the bottom line. However, logo churn is still a valuable metric for customer success teams, as the cost of retaining customers is almost always less than the cost to acquire new ones. With segmentation and targeted efforts to keep specific customers longer, reducing logo churn can actually boost LTV across the board and contribute to revenue growth.

 

Avoid Common Mistakes with SaaS LTV

It’s not uncommon for a SaaS management team to believe there’s only one way to calculate lifetime value, and to compare their LTV to other SaaS firms or to industry benchmarks. But it’s important to determine the best way for your team to calculate LTV, not only to have an accurate figure, but also to better understand trends and other factors that impact revenue growth.

With different ways to calculate LTV and different use cases for each, it’s easy to see how confusion and misinformation can plague a SaaS company’s financials. It is critical that everyone in your organization—leadership, management, board, and other stakeholders—has a common understanding of the LTV calculation to be used, and that everyone is aligned on the KPIs that are moving the company forward. Your finance leadership should drive this organizational understanding and alignment by developing, defining, and documenting those KPIs.

Lastly, it’s ok to benchmark LTV, but you must ensure any benchmarks you’re using are also using the same formula. Otherwise, you’re not making an apples-to-apples comparison.

 

Get the Most Out of Your SaaS Metrics

Accurate, actionable metrics are fundamental to the financial health of your SaaS business. Too often, SaaS metrics like LTV and churn are oversimplified and misused, resulting in misguided decision making that undermines growth. When used correctly, however, SaaS metrics are powerful tools that help to minimize risk and maximize valuation.

Enabling your SaaS company to fully leverage metrics can be as simple as putting the right finance leadership in place. It’s never too early to benefit from CFO-level oversight and a complete SaaS finance and accounting team.

Learn more by scheduling an introduction to Driven Insights today. You’ll receive a free proposal and discover a cost-effective way to have all the finance resources your business deserves, today and as you grow.

 

Get a Free Proposal from Driven Insights

 


Dave Sears

Written by Dave Sears

Subscribe to Blog

Recent Posts

SCHEDULE FREE CONSULTATION
Our Accounting Technology Recommendations
New call-to-action