In the startup cauldron cash flow and burn rate can feel like the only financial measures that matter. You must keep focus on the kitty to survive but money in the bank is not how your business generates value. Many founders find it hard to pin down the measures that show progress in value creation. There are a number of ways to look at this but one common approach is to understand and measure customer lifetime value or CLV.
The fundamentals of CLV
Simply CLV is the total revenue you will receive from a customer over the whole time that individual or company is your customer (R) less the direct cost of sales to that customer (C) less the cost of acquiring that customer (A). R-C-A=CLV.
It should be obvious that this matters to any business but it is especially important to many startups.
For pretty much any business model, R-C needs to be greater than A. If not then the cost of acquiring a customer exceeds the benefit and you cannot hope to generate value. Note in this case that a customer and a user are not the same. Google for example has millions of users who contribute no revenue. This is fine so long as there is also a market of paying customers.
CLV can be a measure of value creation
Once you understand how much value each customer generates then you can start developing a long term model of business value and capital requirements. If 10,000 customers generate £10 million of CLV for example you can estimate the running costs and for a given amount of sales and marketing investment you can figure out how long it would take for your business to reach this number of customers. While this rule of thumb works for many businesses, it is especially useful for SaaS or other subscription based models.
CLV provides a window on operational metrics
CLV can also be a guide to understand which operational measures really matter. Every startup today has a bewildering variety of analytics at their fingertips. Which need to be monitored constantly and which are just interesting? In a fairly typical freemium SaaS business for example, A will be calculated by looking at the cost of sales and marketing divided by the number of customers that sign up and then multiplied by the rate of conversion into paying customers. Once the business has enough information to estimate the rate of churn, this can be used to estimate customer life. So if you lose 20% of your customers every year, typical life is 5 years. Multiply this by your average monthly revenue and hey presto you have a value for R.
Now your SaaS business can focus on number of sign ups, cost per sign up, conversion rate, average subscription and churn rate. Track direct costs every month and you have the complete model in 6 figures.
Of course each of the numbers in this kind of model is tough to estimate. When you start out you don't know how much your customers will pay or for how long. Figuring out how much it costs to sign up 100 customers might be quick but how many of those turn into loyal customers paying regular money? The risk increases if you need to employ a sales force to acquire customers.
Use seed funding to test CLV potential
These are all great questions. In my mind the purpose of raising seed funding is to answer them as robustly as possible. Test out how much it costs to acquire customers. Get feedback on what people will pay and how you can improve the design to make them more loyal - from a CLV point of view a year of extra usage may be worth more than a 10% increase in price for example. Demonstrate you can scale your product and your team to meet demand and that you know how much this costs.
Build a CLV model to demonstrate value
Once you have a robust proven model you have a basis on which you and other investors can make projections about future growth. You can show how you would spend that £5 million Series A round and calculate the value your business would create as a result. Your company will still be a high risk investment but you will have a model to work with at least.
Different companies require different approaches but CLV is a widely understood and applied concept. Build a model that demonstrates how your early progress creates CLV and you will have a great conversation with potential investors.
Kenny Fraser is the Director of Sunstone Communication and a personal investor in startups.