How to Correctly Calculate Lifetime Value

Lifetime Value (LTV) is an important SaaS metric for operators and investors. Learn how to correctly calculate LTV and why it matters.

Calculate LTV

LTV is the number of months someone uses your product multipled by what they pay you each month.

Calculate Churn

Use an accurate churn value. We recommend your trailing three-month average churn to start.

Calculate Gross Profit

Revenue will overstate your LTV, we prefer using gross profit (revenue less cost of goods sold).

There are many important SaaS metrics, with two of the most common being Customer Acquisition Cost (CAC) and Lifetime Value (LTV).

In my experience as a consultant, advisor, operator, and as part of the diligence team at a venture fund, I have seen unique and creative calculations for both metrics. Which is not great.

This post walks through how to correctly calculate Lifetime Value and why it matters. We are also working on a companion piece for Customer Acquisition Cost.

Have questions? Contact Alluxo today for a free consultation to discuss your SaaS business.

How to Correctly Calculate Lifetime Value (LTV)

As the name implies, Lifetime Value is the total economic value of a customer over the life of their interactions with your brand. There are two drivers of LTV: retention rate and price.

You want, all things equal, a higher retention rate (to maximize the customer lifetime) and higher price (to maximize the value) for a better LTV.

My favorite way to think about the metric is...

Lifetime Value = Average Lifetime in Months * Average Value per Month

Let’s assume Acme Inc. is a B2B SaaS startup with a single $100/month plan and 95% monthly gross retention over the last three months.

Note: Your retention rate fluctuates month-over-month, so your LTV will change based on where you calculate retention over the last one, three, or six months. In our experience, trailing three months is a good starting point for most companies.

Next, we convert the retention rate into a churn rate by doing 1 minus retention rate.

Formula: 1 – Retention Rate = Churn Rate

Acme: 1 – 0.95 = 0.05

In other words, over the last three months, Acme lost an average of 5% of its customers each month. To get the customer lifetime, we now divide 1 by the churn rate.

Formula: 1 / Churn Rate = Customer Lifetime

Acme: 1 / 0.05 = 20

In our case, 1 divided by 0.05 is 20. Since the original rate was expressed in months, we can carry those units over as well. (If we started with an annual retention/churn rate, we would multiply the value by 12 to go from years to months.)

Now that we know the average paid customer stays for 20 months, we can update our formula:

Acme LTV = 20 Months * Average Value per Month

At this point, it may be tempting to plug in $100 for the average value per month. But that's not correct. We will now explore why revenue is not the right input for Lifetime Value (LTV).

How to currently calculate lifetime value (LTV) for a software as a service (SaaS) company.

Using Gross Profit Instead of Revenue

At 20 months and $100/month, our LTV would be $2000. This is quick, easy, and problematic.

First, due to payment processing and bank fees, you never actually receive the full revenue value. And second, there are direct costs associated with generating that revenue.

You want to account for these direct costs before calculating LTV, so that you do not overstate the amount of cash that you have available. Not including these direct costs will also make your payback period and LTV-to-CAC ratio look stronger than they really are.

Thankfully, accountants have already solved this problem. The costs directly attributed to generating revenue are called cost of goods sold (COGS) and you should already have these amounts tracked in your accounting software.

Instead of using revenue in your LTV calculation, we recommend using gross profit.

Gross Profit Formula: Revenue – COGS

There are several ways of calculating COGS, some people have a strict interpretation and others a loose one. But for a SaaS company, our rule of thumb is to include hosting costs and payment processing fees at a minimum.

Let’s assume Acme Inc. uses Amazon Web Services (AWS) for hosting and Stripe for payment processing. For a quick hosting cost per customer, you can take your previous month’s bill and divide by the total number of accounts from that month.

As a result, a $5,000 AWS bill for 1,000 accounts would be $5/month in hosting per account. We can also assume Stripe charges a flat 3% to accept payments for another $3/month.

Acme Gross Profit: $100 Revenue – $8 COGS

Acme Gross Profit: $92

In the simple calculation of 20 months times $100 per month, LTV was $2000.

By removing the cost of hosting and payment processing, we are able to get a better sense of the actual cash that will be usable by our company. The revised LTV calculation is 20 months and $92/month for an LTV of $1840.

Our example only has an 8% cost of goods sold, which leaves a 92% gross profit margin. This is an ideal case and only a handful of companies have a gross margin at or above 90%.

It’s more typical to see an 80-85% gross margin, which makes the difference even more pronounced between using revenue or gross profit in your LTV calculation.

Conclusion

Lifetime Value (LTV) is an important metric that shows how much you can spend to acquire a new customer. When properly configured, LTV also reveals a customer's contribution to your overhead – like rent, salaries, marketing expenses, and more.

Personally, I like breaking down the formula as:

Lifetime Value = Average Lifetime in Months * Average Value per Month

It provides an intuitive understanding of how to increase LTV. Here are some notes that you should keep in mind when looking at your company…

Retention Rate: We used a three-month average retention rate in this example. However, companies may select another date range that they feel is more accurate. Be sure to clearly define your LTV inputs when sharing the final number with your team, investors, and advisors.

Gross Profit: As discussed, there can be a large delta between using revenue and gross profit in your LTV calculation. We strongly advise every company to use gross profit. This avoids a common problem of overspending on CAC and overhead, thinking your LTV will save you.

Time Value of Money: For a more detailed calculation of Lifetime Value that includes the time value of money, David Skok has a fantastic blog post. Yes, this will also lower your LTV compared to how you are doing things today.

Multiple Plans: Our example had a single plan, $100/month billed monthly. However, most SaaS products have multiple plans and billing cycles. We advise calculating a retention rate for each distinct group, paying close attention to reactivation (e.g., customers going from inactive to active) and upgrades (e.g., going from a cheaper plan to a more expensive one). All of these factors influence LTV.

In short, oversimplifying your Lifetime Value calculation will hide valuable bits of information from you. The correct way to solve for LTV takes more time and effort, but the upside is big.

These more nuanced LTV calculations help founders, executives, and investors spot problem areas and make better business decisions.

Have questions? Contact Alluxo today for a free consultation to discuss your lifetime value (LTV). We help SaaS companies understand, visualize, and act on their data.

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