When Customer Lifetime Value is a Moving Target

May 23, 2015

With any analysis, it is only relevant if you understand how the data was calculated and the context of how it relates to your business.  The data has to be credible for the analysis to be useful. And when comparing to benchmarks, it becomes doubly important to make sure that both the benchmarks are credible and that your data accurately represents your business. Customer Lifetime Value (CLV) is one of the key SaaS metrics used to define whether a company is building a healthy business based on a profitable customer revenue stream.  CLV is calculated by multiplying  Average Monthly Recurring Revenue (MRR) for a Customer times Gross Margin over Churn (1/churn = the customer lifetime).  

Recurring Revenue Gross Margin versus Total Company Gross Margin - What's Right?

As with many of the defining SaaS metrics, the devil is in the details on calculating CLV.  Last year, we heard from some companies that were concerned about using total company gross margin in the CLV calculation which produced a lower CLV than if you use just the recurring revenue gross margin in the calculation.

For example, if a company is selling consulting services at a very low margin, as many of the fastest growing SaaS companies are to help on-board customers, then total company gross margin will be lower, and reduce CLV in turn.

This year, we’ve developed benchmarks for CLV calculated with recurring revenue gross margin only, as well as total company gross margin.  Take a look at this example where a company’s CLV calculated with their recurring revenue GM is 130% of the benchmark, whereas when CLV is calculated with the total company GM, they are about 20% below their peers with a similar average contract value:

CLV Variations

It may well be an acceptable strategy to be below the benchmark for a period, and then to rise above the comparable peer group, or it may be a problem that needs to be fixed.  Either way, you can't explain your numbers if you don't know the comparison.

Every SaaS Company Increases Prices, Cross Sells and Upsells Customers

On top of Gross Margin being a moving target, what if your average MRR per customer is increasing?  If your company is executing on a strategy to increase prices, and/or upsell existing customers into bigger contracts, as many or even most early to growth stage SaaS companies are doing, your average MRR per customer will increase, driving up your CLV.  You may have a starting value CLV for your current point in time and an assumed increase in value on a yearly basis.  In addition, different customers or different customer cohorts, have different CLVs.

Dave Key, in his blog post, “Don’t be a Customer Lifetime Value Simpleton,” does a good job of laying out variations of the calculation to take into account changing prices as well as using a Weighted Average Cost of Capital (assuming that the value of cash today is higher than some time in the future).  Basically, you can calculate CLV by adding to the value of MRR year-over-year either with set assumptions, or actually adding the actual amount.  It is safe to assume, though, that you can’t increase MRR at the same rate indefinitely (dream on!).  

Read Dave’s blog for a fuller (and better) description here, which shows how to use more complex calculations as your SaaS business evolves.

The bottom line is that CLV is critical to quantifying the predicted value of a revenue stream from a customer so it is worth getting the calculation right.  It helps you determine how much to spend on acquiring customers, and by looking at it in the context of gross margin, helps you see the impact of a too high cost of service.  It also shows the strong effect of churn on your revenue streams and helps focus your attention (and resources) on reducing churn.

Customer Lifetime Value Represents Your Customer Equity

While CLV is a good guide to helping you evaluate and manage your costs, taken as a whole, it represents your company’s customer equity.  Comparing your company’s CLV to your peers – and to that of leadership companies – shows you how far off – or above – the standard benchmark you are.    You can use the benchmark both internally to focus resources on improving CLV, and externally to present the value of your company.  A good reason to benchmark your performance regularly with credible benchmarks.