Customer Lifetime Value SaaS Defined

Customer Lifetime Value SaaS is a vital SaaS metric for quantifying the current/present predicted value of a particular revenue stream from a customer. This is especially because understanding the Customer Lifetime Value (CLV) is critical in getting to know how much is prudent to spending on customer acquisition.

This method of determining the value of business uses the unit economics of expanding the customer base. In addition, it dramatically displays the cost of churn, justifying additional resources spent on churn reduction by highlighting the impact on customer value. Summing up the customer lifetime value of all the customers of the company results in “Customer Equity,” – a vital measure of the value of the company.

Alternatively, the Customer Lifetime Value metric offers a method of comparing the economic data of the traditional licensed software model – usually with high initial revenue – with the SaaS subscription revenue stream model. Even though CLV is a very important metric for operating and assessing a SaaS business, various methods of calculating CLV yield widely varying values, making it difficult for anyone to have much confidence in the metric.

Furthermore, beyond the basic required churn and subscription revenue fundamental components of CLV, various formulas may either include or omit key determinants of the CLV, including the cost of capital, customer acquisition cost, and the cost of offering services to the customer. In addition, since CLV is quite predictive, this value greatly depends on the ability to accurately forecast future costs and revenue. With time, understanding additional insights into customer behavior generates more sophisticated CLV models that are used to improve its accuracy.

Described below are multiple methods of Computing Customer Lifetime Value SaaS to determine the most appropriate formula for the business’s stage and complexity.

Customer Lifetime Value SaaS Defined

1. Simpleton’s CLV Formula

The theoretic average lifetime of a customer (Customer Lifetime) is:

Average CL = 1 divide by % Churn

Revenue Churn is the recurring revenue lost from churn against the amount of recurring revenue earned during a given period. For purposes of computing the CLV, Revenue Churn is always used because the number of customers who churn is irrelevant to the calculations, but their lost revenue is an integral component (unless all customers have similar recurring revenue).

For instance, an average 10% churn would mean that the average age of a customer in the long run would be 10 years. CLV in its simplest/ least useful form would be equal to the Recurring Revenue multiplied by the average Customer Lifetime – the average time a customer remains a customer times the recurring revenue.

CLV = Revenue Recurring divide by % churn or CLV =Recurring Revenue X Average Customer Lifetime

However, the greatest weakness of CLV’s simple form lies in its failure to consider time value for money – valuing a dollar received today same as a dollar received in 10 years. Additionally, neither the churn nor the recurring revenue can be expected to be constant over the entire life of the customer.

2. Minimum Viable CLV Formula

The value of revenue received in future and the value of revenue received in the near future should be discounted in the CLV calculation. While this is not frequently practiced, it can be done easily by incorporating WACC – the Weighted Average Cost of Capital (interest rate) to discount/ reduce the value of future cash flows or revenue in the Customer Lifetime Value.

The WACC rates that apply vary substantially with startups having expensive capital – with sometimes an interest rate that could go up to 16% only if you can manage to get it. But for large companies, capital can be obtained at a much lower cost. However, virtually every company values the cash they have more than the one they may get in future, “a bird in hand is worth two in the bush.”

Normally, companies use a 10% WACC value as a placeholder until an appropriate interest rate that suits the business is established. Using the discounted “Minimum Viable CLV” produces much more accurate values than the Simplistic CLV where an implicit WACC rate of 0% is used. Discounting the future earnings using the WACC interest in CLV calculation portrays more realistic CLV.

3. Customer Lifetime Value SaaS after Cost of Service

In determining the CLV, the cost of service should also be deducted to reflect the customer’s gross profit, not just the particular revenue stream. And since the cost of service is unpredictable or may not be certainly known because not all the customer lifetime values include the cost of service. Therefore, it needs to be clear in its explanation of the CLV value even if it does not include the cost of service.

4. CLV with Increased Revenue

Maximizing the CLV is greatly dependent upon the ability to increase the sales revenue streaming into the organization – increasing the SaaS subscription price and reducing the churn. The customer having the same subscription revenue for his/ her entire lifetime is contrary to the SaaS “Land and Expand” mantra . Therefore, the customers’ subscription revenue should be increasing with any additional up-sells and cross-sells.

B2B SaaS vendors have the potential to increase pricing of the subscription every year to reflect the inflation and increase in subscription value as new features are added. Ideally, the ability to increase subscription pricing greatly depends on the competitive positioning as well as the absence of product commoditization.

5. CLV with Varying Inputs

Initially, it can be difficult to predict the trends without customer behavior data. So, using CLV equation’s fixed values may just be the only feasible method of producing an approximated CLV value. Forecast micro trends can be achievable for SaaS firms as they mature.

Customer Acquisition Costs Relationship to Customer Lifetime Value SaaS

Customer Acquisition Costs (CAC) form a key determinant of a SaaS business’s success. While most SaaS luminaries do not include CAC as a CLV negative input, some do not. Public SaaS firms such as Constant Contract usually include onboarding costs in their Customer Acquisition.

Conclusion

The CLV is a vital tool in predicting the value of a customer. While different methods used in calculating Customer Lifetime Value SaaS produce more accurate results, CLV should not be used without first discounting cash flows or revenue – the WACC as discounting future revenue gives more accurate values.  The Customer Lifetime Value SaaS drives value for your company and is a concept that you must understand.

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Omri Erel
Omri is the Head of Demand Generation, as well as the Lead Author & Editor of the SaaSAddict Blog. Omri established the SaaSAddict blog to create a source for news and discussion about some of the issues, challenges, news, and ideas relating to SaaS and cloud migration.
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