For B2B companies, determining how much money to spend on acquiring customers has been common practice for years. Traditionally, the calculation was easy, with customers purchasing software once every few years, or purchasing a software license and annually renewing their maintenance. The SaaS model made rough calculations more difficult, as each customer had to be fought for on a monthly basis.
Some companies were able to make rough calculations and go with it. More professional companies, though, have been using a classic formula, taught in the leading business schools, called Customer Lifetime Value (CLV).
Customer Lifetime Value
Customer Lifetime Value is a far more important business metric to pay attention to than the metrics digital marketers frequently pay attention to: bounce rates, visits and traffic, and short-term conversions. However, understanding customer lifetime value helps marketers and business leads determine how much to spend on customer acquisition.
Customer Lifetime Value is the net present value (NPV) of all future streams of profits that a customer generates over the life of his/her business with the firm. In simple terms, it’s the current value that a customer will generate over a lifetime with your company.
Essentially, the CLV formula is basically the net-present value formula that anyone who studied finance. However, most marketers didn’t get started in finance.
To calculate the CLV, use the below formula:
* discount rate ** – retention rate
This may be complex for some, but this is also why – in practice – it’s important for companies to hire marketing and business executives who have a business education, such as an MBA.
Customer Lifetime Value is not the same as cost of a lead in Google AdWords or how much money it costs to acquire a lead. Rather, that cost is part of the acquisition cost. If each lead costs $50 and you need 10 leads to close one customer, than your acquisition cost is $500 plus the relative cost of your sales and marketing staff devoted to closing a single customer. Your acquisition costs can be calculated by the following formula:
Using closed-loop optimization and funnel reporting in marketing automation and CRM tools, you now have all this data in-house: how much it cost to acquire a customer, how long the customers stay at your company/using your service, and the financial information like discount rate you can get from your CFO or financial advisor.
Do You Know Your Inputs?
Of course, the old saying “garbage in, garbage out” applies. That is, you need to know what inputs to enter in order to get CLV. For example, when looking at retention rate (also known as “churn rate”). This is particularly important in SaaS companies, where you may lose a lot of customers in the first few months – but they weren’t necessary big customers to begin with and you may still be left with large customers who stick around for life. If not, you’re in bigger trouble than trying to figure out how to calculate your lifetime value. If you have two groups of customers: In one group, 50% of your customers leave after the first month of a $10 a month plan (having received the first month free) but in the other group, 100% pay $50 a month and stay for 12 months, you don’t have a churn rate of 50%. Rather, you may have multiple customers and multiple retention rates.
Of course, it is far cheaper to keep a customer than to find a new customer. Frederick Reichheld of Bain & Company noted in a 2001 Harvard Business Review article that it is “six to seven times more expensive to gain a new customer than to retain an existing customer.” The higher your churn rate, the lower your customer lifetime value.
Starting out as a new company, or switching to a new model, you may need to invest more in sales and marketing and so your acquisition costs should go down over time, as you scale.
CLV and AC are not static formulas that once you plug in once, you are done. As your inputs change (an increase in interest rates may lead to a higher discount rate, changes in support, an economic boom or bust, or a new competitor may affect your retention rate, and a new bundling or pricing change may affect your margins)
If a SaaS company wants to increase their CLV, they should look at a few key things such as:
Increasing margin – cross and upsell. Bundle additional packages. SaaS companies can often increase their revenue by charging per usage and so their revenue will increase as customers increase their usage.
Increasing retention – perhaps offering an annual discount, encouraging bundling and encouraging users to pay on an annual basis, so they are committed to your product and you don’t have to worry about fighting for them each month.
As they say, it’s cheaper to keep an existing customer than to get a new one so invest in customer support, making things easy for your customers to join and keep them happy and coming back for more.
For a more detailed description of how to calculate CLV for your SaaS business:
SaaS Metrics 2.0
Avinash Kaushnik, Google’s digital marketing evangelist