LTV has become untrustworthy in recent years. VCs and investors take it with a pinch of salt as it has become too easy to manipulate.
Personally, I have not come across a client who has calculated it properly when I turn up and sometimes it can be 2-3x overstated if several of the errors below have been employed.
In one case, my LTV calculation reduced the previous client-calculated LTV by nearly 80%.
That didn't go down well...
Having said that, LTV is an essential part of your toolkit as a founder/CEO. It is the basis on which you can set your CAC and therefore dictates marketing budget, channel selection and potentially even target customer.
So here are the common mistakes people make and how to do it right.
LTV Mistake #1: Using gross instead of net revenue
This is the most common and also the worst LTV crime going.
The value of a customer to your business is not 100% of the price they paid.
The reason (if it's not obvious) is Cost of Sales. For every £1 they spend, you will only get a proportion of that, depending on your gross margins.
Yes, I can see it might be tempting to put a higher LTV in your pitch deck. But you will be found out. Don't do it.
So for the numerator in your calculation, take the average gross profit of a customer, not the revenue.
And DEFINITELY not the sales price with VAT added (yup - I've seen that too).
LTV Mistake #2: Not recognising the 'time value of money'
A couple of years ago, the cost of capital was not too relevant and I confess to on occasions ignoring this fact. Especially as it could be netted off against inflationary price increases.
But now with interest rates at 4+%, the cost of capital is a a real consideration and must be included in your LTV calculations.
If you are new to this concept, here is a brief explanation (if this is old news, skip to the next paragraph):
The key concept at play here is know as the 'time value of money'
This simply states that £100 today is not worth £100 in 5 years time. Why? Inflation. Assuming 5% inflation, you would need to have £128 for it to be the same value.
So assuming a 24 month lifetime for a customer, paying £125 per year at 20% gross margin at 5% inflation would look like this:
Year 1: £125*(1-.2) = £100
Year 2: (100*1/1.05) = £95
Total = £195
Sidenote: I am not taking into account the Weight annual cost of capital (WACC) in my calculations. Why? Because LTV is generally a useful tool to understand unit economics. It is not in my view a calculation that should determine whether a company is a good place to deploy capital as an investor. There is so much uncertaintly for small businesses about WACC that any use of it is fraught with risk of being a long way off. There is some debate on this but I will not tackle it here.
LTV Mistake #3: Understating Cost of Sales
We return to Mistake #1 here in part.
The truth is that the vast majority of small (sub £10m revenue) companies understate the Cost of Sales.
SaaS and othe online companies nearly all understate their CoS by leaving out some of the categories below.
I often see CoS around the 10-15% mark where in most businesses, it should be 20-40%.
This is what you should include:
Hardware/Manufacturing costs
Technical support. ie the cost of all inbound phone, chat, and web support for customer requests, issues, and bugs.
Professional Services. i.e. the cost to implement and configure software and train customer on its use
Customer Success. i.e. the cost associated with retaining customers and identifying potential customer expansion.
Dev Ops. i.e. the cost to maintain hosting infrastructure (i.e., AWS, Azure), customer upgrades, and hosting service level agreements (SLA’s).
Transaction and Fulfillment Costs. e.g. Stripe fees and delivery costs
Unless you are including all of these in CoS, you are almost certainly overstating your LTV
LTV Mistake #4: Assuming crazy-long lifetimes and understating churn
Lifetimes and churn errors are two sides to the same coin so I will deal with them together.
Often you will see articles on LTV saying to use the calculation 1/churn * net profit.
This is a quick and easy way of estmating it but here is why it is a mistake in my book:
Firstly, early-stage companies oftne have low churn. This can be for many reasons but often customers have purchased at discounted prices, they are getting a conceirge services for being an early customer and/or they haven't been customer long enough to show true churn rates.
Secondly, even a low churn today does not mean a low churn in 3 years time when you are selling to more than just 'early adopters'. Competition, customers will want to shop around, and you will probably start ading in annual price increases.
Lastly, even if the calculation is right, it is not reasonable to assume in most cases any more than a 36 month lifetime for any customer of a small business. Just too much can change in that time.
In maths terms, imagine a 2% churn rate. The teaxtbook approach suggests 1/2% = 50 months customer lifetime.
50 months! Nearly 5 years.
I would recommend capping at 24 months or 26 months maximum.
How do calculate LTV like a pro...and avoid that eye roll from a VC
In summary, this is how you should do it:
Use Gross profit, not revenue as the starting point
Reduce this by your (correct, not overerstated) gross margin percentage
Factor in the time value of money
Use a lifetime of 36 months maximum
Use a conservative churn rate
See below an example of a multiple different LTV calculation methods and the impact that small mistakes can have. As you can see the difference between the top (worst method) and the correct one is about 100%!
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