Customer Lifetime Value
Seasoned entrepreneurs say that revenue growth, profitability, and cashflow are the most important financial metrics to your business. Of course they are important, however we see one significant metric is often missed.
Customer Lifetime Value (CLV”)
Customer Lifetime Value is not a new concept but it’s an important metric to measure for your business.
Customer Lifetime Value is a prediction of the profit attributed to the entire future relationship with a customer.
If you don’t calculate your Customer Lifetime Value, you don’t know what a customer’s worth to you so you don’t know how much you can spend acquiring them and retain them.
The Customer Lifetime Value calculation can have varying levels of sophistication and accuracy, ranging from ‘have a guess’ (low cost and rubbery) to the use of complex predictive analytics techniques (higher cost and still rubbery). I’m just going to run through the quick, very basic version of the formula.
Put simply, Customer Lifetime Value is the annual gross profit per customer times the average number of years the customer remains with you.
What’s really important here is to use Gross Profit, not revenue. We see many businesses people incorrectly calculating Customer Lifetime Value using revenue. This grossly overstates your Customer Lifetime Value.
Let’s take an example:
I charge my client Bob the Builder $7,000 per annum for bookkeeping services. At a 50% gross profit margin, he is worth to me $3,500 in annual gross profit. I have a fairly good relationship with Bob (he’s my next door neighbour) so I estimate he’ll be with us for 5 years.
Customer Lifetime Value = $3,500 * 5
Customer Lifetime Value = $17,500
Why is it important?
1. It can assist with ranking your clients
By placing Customer Lifetime Values on each client in your portfolio, you can quickly rank your client base and assess which clients you should be investing the most time in.
For example, Client B may not be as profitable as Client A based on current year values, however over a lifetime value basis, Client B is actually more valuable to your firm.
2. It represents an upper limit on spending to acquire new customers.
Software as a Service (“SaaS”) businesses live and die by this metric. Client acquisition costs (“CAC”) take many forms but are traditionally in the form of marketing expenses and attributable salaries for sales staff. For professional services businesses in competitive bid scenarios, discounting is often the common approach to win new work.
So if I am going to ‘acquire’ or win a new client, how much should I pay, or in this case, discount?
You need to ask yourself “how much is that client worth to me?” If the client has a high chance of repeat business, the Customer Lifetime Value is intrinsically higher. Unless it’s for strategic reasons, the cost of acquisition must be less than this…otherwise you’re just taking on unprofitable clients for ZERO benefit.
The general rule of thumb for SaaS businesses is that the CLV/CAC ratio should be 3x or higher.
3. Your CLV is directly attributable to your business value
No brainer here. The higher your Customer Lifetime Value, the greater your business value. Do you want to maximise the price when you sell your business? Start by maximising the value of your client base.
How to increase your CLV
1. Secure recurring revenue
Look at how your business can move towards a subscription based service and secure recurring revenue. Now, this can be seen a bit of a fad. We’ve seen plumbers move to subscription based businesses. Sometimes that doesn’t work, but it’s very valid for a lot of businesses like startups or software businesses and even accounting firms like us. Moving to the subscription model allows you to get predictability over your revenue and allows you to gain insights that’ll get you to keep your customers for longer.
2. Upsell to existing customers
If you’ve got a customer you’re selling, say a $10 package for some software per month, you can nurture and foster that relationship to move them up into more premium products.
3. Focus on customer delight
Your focus should be on growing business by retaining existing customers that bring in real value. It is 5-10 times more costly to get a new customer than to retain an existing one. Studies indicate that increasing customer retention by 50% results in a profit increase of at least 25%.
Great customer relationships enforce the likelihood of the client using your services in the future. If you develop deep, resounding relationships with your customers, the more likely it is that your customers are going to use you again, which increases their lifetime value to your firm.