LTV: Another Metric in SaaS?

I recently had an interesting conversation with a very smart hedge fund buddy of mine.  We were of course talking about investment ideas, given many of us were holding either cash or gold, and I threw out Salesforce.com.  It is generating 15-20% free cash flow margins, growing revenues at 30%+, with a solid recurring base.  This led to a discussion of valuing SaaS companies.

As venture folks trying to build companies, we tend to focus on operational metrics like Annual Contract Value (ACV), Monthly Recurring Revenue (MRR), Average Selling Price (ASPs), and Churn.  Both Byron Deeter of Bessemer and Will Price formerly of Hummer Winblad have done very nice posts here.  My friend’s perspective was entirely different as a public market buyer.  He looks at everything through the valuation lens.  He said the metrics above are all interesting, but he and his peers tend to focus on Lifetime Value of a Customer.  Essentially wrapping many of the components above to look at the DCF value per customer.  It is very similar to how analysts look at cable companies on the overall value per subscriber.  An obvious point he made, but framed from an entirely different angle, was that small changes to churn assumptions would lead to drastic changes in the overall valuation and associated multiples of a company.  While one can focus on the revenue or FCF multiples, it’s really the LTV that he cares about.

[UPDATE: Many searching for specific LTV calculations come to this site – a great summary of the formulas to use can be found here by Joel York of Chaotic Flow].

As a venture investor, I had never really thought about the public market perspective on my companies.  But it got me thinking about adding it to the key list of metrics our SaaS CEOs think about, because someday, we hope they will be selling that LTV metric to the Street.  Its component parts are made up of all the metrics we track, but creating an explicit metric often generates focus, and it’s probably one to think about early on in building value.

What do you think?

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5 thoughts on “LTV: Another Metric in SaaS?

  1. AfricaCT says:

    I think you (and your friend) make a very good point. With heightened competition in technology industry and the ability for a customer to switch products or services quite easily the lifetime value of a customer is extremely important when considering growth opportunities and value of the business.

    I often think about similar loyalty programs that have existed in other businesses to retain customers and whether there are some opportunities there for SaaS co’s.

    The real significance I see for SaaS companies is

    i) your costs and ability to manage them are largely determined by how many customers you have and how long you keep them. Economies of scale are vital to the success of a SaaS business in my opinion.

    ii) SaaS provides (in most cases) lower barriers to entry and exit for customers. My ability to switch from Google Apps to Microsoft hosted services is pretty easy so, as you mention, those churn assumptions are crucial in the valuation process and long term growth opportunities for a SaaS business.

    In any event I think your point is very relevant.

  2. Jeff Lu says:

    I like the point that your friend made, however, with early stage SaaS companies, it’s hard to determine the LTV of a customer. For some companies, there just aren’t enough data points to determine a credible LTV. Companies would have to make assumptions that’s similar to the “churn” assumption and small tweaks to the value or life of a customer could really affect the model as you scale up.

    How are some ways that you’re calculating the LTV for your SaaS portfolio?

  3. Amish – this makes a ton of sense. I’d love to get your thoughts on how companies with limited operating history can calculate their LTV. It many cases if you just roll out your churn rate, the ltv can be for 10+ years which can seem unreasonable. As you get more data, this is easier…but what about for years 0-4?

  4. Jeff Lu says:

    Scratch my last comment. My question was addressed by Philippe Botteri of Bessemer in this great presentation:

    http://www.salesforce.com/community/crm-best-practices/dreamforce08-developer-sessions/2008-tdf-saas-finance-101.jsp

    • ajnyc says:

      Jeff,
      Sorry about the delay, but I think you found a great link… I was in the process of posting a spreadsheet but I think the Bessemer guys covered it very well.
      Amish

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