There has been a lot of good stuff written over the years on the topic of calculating customer lifetime value (LTV). Thus, it amazes me how many times I discover faulty thinking when I talk to entrepreneurs regarding their LTV math. One portfolio company executive confessed to me last week that he knows he is doing it wrong but he just didn't have the time to research the best way to do the LTV calculation.
Since I see a few common patterns of mistakes, I thought I'd add to the LTV literature and point out the top three reasons many investors roll their eyes when they see entrepreneurs present inflated, poorly constructed LTVs:
Step n°1 |
Your Churn Rate is Understated
One important component to an LTV calculation is the churn rate or cancellation rate. Many blogs suggest you simply divide 1 by your monthly churn rate to get to a number of months of duration that you can expect to collect revenues from your customer. Thus, if your average monthly churn rate is "c", the number of months of revenue you will receive over the lifetime of a customer is 1/c.
The problem is that many early-stage companies have no idea what their average, long-term churn rate really is because they are simply too young. When they have 6 month or 12 month or even 18 month cohorts, they extrapolate from those cohorts and come up with an absurd time period for their customers to stick around generating revenue. For example, if you have a 2% monthly churn rate in your first year, then some folks will extrapolate their monthly revenues out 50 months. A monthly churn rate of 1%? Then multiply that monthly revenue by 100.
As Jason Cohen points out, it's just not realistic that in a wildly competitive, dynamic technology market, a company can expect to hold on to its customer on average for 8-10 years. And, in my experience, you are so hyper-focused on satisfying and servicing your early customers that extrapolating your early churn rate just isn't going to be accurate.
To fix this potential issue, I recommend you pick a fixed cap number of months - conservatively 36, or three years - and recalibrate your LTV math accordingly. Your new expected months of revenue (N) would now = [1-(1-c)^36]/c. For example, if your churn rate is 1%/month, instead of assuming 100 months of revenue, you calculate 30 months. Anything beyond 36 months just doesn't seem credible - and shouldn't even matter that much when you think about the next issue - a start-up's cost of capital.
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by Jeff Bussgang General Partner/Co-Founder of Flybridge Capital Partners and Senior Lecture of Harvard Business SchoolFollow