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SaaS businesses need to focus on LTV to determine their present safe marketing spend and future revenues. However, LTV can be abused and provide inaccurate projections. What issues arise when focusing on LTV and how can you fix them?
One of the metrics that most subscription based businesses focus on is the Lifetime Value (LTV). In simple terms, this is the revenue expected to be realized from the customer over the course of subscribing to the service.
Marketers use LTV as a benchmark to determine how much they should spend on acquiring customers i.e. Subscription Acquisition Costs (SAC). However, since LTV offers a future value, it can be a dangerous metric to rely on when predicting revenues.
The Dangers of LTV
In a healthy business, the desirable scenario is the SAC being lower than the LTV. However, since the LTV is simply a mathematical formula, relying on it 100% disregarding your growth strategy can be dangerous in the long term.
LTV does not take into account future uncertainties that are a reality with all businesses. The metric is modeled on the notion that everything will go on as planned. Bill Gurley, a VC at Benchmark Capital, outlined the dangers of relying 100% on LTV for your growth strategies. As SaaS entrepreneurs, keeping costs and churn low are paramount. However, these are affected by SAC and LTV.
Calculating future revenues based on the LTV of a customer can paint a rosy picture of the revenue recognized. For example, if you are selling service subscription at $12 and are offering customers a one year contract, your recognized annual revenue will be $144. Based on this projection, you may plan for the money before it is in the bank. For most SaaS businesses, the biggest spends are on new hires, marketing and customer support.
However, the recognized revenue may be different from the realized revenue in the bank. Planning your spend based on LTV’s recognized revenue is flawed because you assume everything is constant.
For instance, if you offer a price package, the recognized revenue does not consider variables like upgrades and downgrades. Moreover, even if you factor a certain percentage of churn, other variables that are out of your control can change. For example, the SAC can increase when a competitor with a bigger marketing budget gets into play.
How to use the LTV
With the LTV affected by different variables, it is important to find a balance and know what data to trust. Ultimately, you should take steps to control your spend rather than wait for the market to dictate how much you should spend on SAC.
Keeping the SAC down is crucial to realizing profits in the long run. Implementing a combination of search marketing, social media and good PR (public relations) will cushion you from the uncertainties that affect the LTV and therefore ensure your recognized revenue will be as close as possible to the realized revenue.
SaaS companies like Hubspot have identified the right balance between marketing spend on SAC and acquiring customers through search engine optimization, social media and good PR. This Forbes article offers a good explanation on how you can use LTV in a way that will not break the model.
LTV is important for businesses as it helps them compare and contrast different marketing channels. While the formula is simple, it requires a thorough implementation and tweaking since it is affected by variables outside the control of the business. Knowing when to follow LTV data and when to rely on marketing experience and intuition is ultimately the foundation of a strong subscription based business.
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