If you want to know whether your startup can scale up sustainably, you need to know 2 key metrics: Your CPA — Cost per Acquisition (aka CAC — Customer Acquisition Cost), and the LTV — Customer LifeTime Value. In a nutshell, if your LTV is several x bigger than your CPA, and your CPA decreases as a % of your revenue over time, then you’ve got a scaleable business model — congratulations!
So, how to calculate the LTV of an acquired customer?
Here is an approach building on Bill Aulet’s MIT Disciplined Entrepreneurship and William Sahlman’s Method for Valuing Investments:
Please note the final results should be a range as you’ll be working from assumptions until you can test cohort by cohort and validate your results.
- Revenue streams ($), both one-time and recurring (pending upon your business model) by customer
- Gross margin (%) for each of your revenue streams
- Retention rate (%)(loyalty, as opposed to churn)
- Product life (Length of Time)
- Next product purchase rate (%) (replacement product)
- Cost of capital ($) (how much it costs you in debt or equity to fund your business, ie the yearly interest rate for debt or expected rate of return for equity)
The LTV is the NPV (net present value) of your profits from year 0 to 5. If you’re confident you can get an income from your customer beyond year 5, you can add a Terminal Value, but for startups I’d recommend sticking to the first 5 years.
1- Compute profit $ for each revenue stream (using gross margin, retention rate and/or next product repurchase rate) for each of the 5 years (year 0 is the year the customer buys)
2- Sum total profits across all revenue streams for each year.
3- Compute the Present Value (PV) at Above the Cost of Capital.
For year 0, it is equal to that year’s profits.
For years 1 to 5, the formula is PV=Profit x (1-Cost of Capital Rate)^t where t = number of years after year 0
4- You can now add up the discounted (Present Value) profit streams and get the LTV. If you took total revenues rather than average revenues, you still need to divide by the number of customers. But if you are targeting different segments, you should do this calculation for each segment as well.
With this approach, you should also be able to understand the underlying factors and thereby your risks and how you can increase LTV over time (eg increase retention, up-sell, cross-sell, increase price, etc). It is critical to analyse how your LTV is trending cohort by cohort.
Having an LTV also helps you set up budgets: as a rule of thumb, your ratio LTV/CAC should be over 3:1, so if you take 1/3 of your LTV, then you have a MAXIMUM CAC to work from.
In conclusion, here is a key learning from working out an LTV: it is typically cheaper to keep an existing customer than to find a new one, so make sure you listen to your existing customers and iterate on improving your product and the customer experience until you have a product-market fit!