It’s prominent in the tech startup community, and many executives are loyalists to it. The LTV model– or, the Lifetime Value model has permeated the consumer internet business sector. In case you’re not privy, lifetime value is the net present value of a customer’s profit stream. This concept appears benign on the surface and is standard best practices to compare the cost of a customer to the positive cash flows that come from that customer over time. Generally, as long as the sum of the future cash flows are significantly higher than the subscriber acquisition cost, executives will push for the accelerator–or, burning capital and aggressively spending on marketing.
Here’s a basic breakdown of the equation:
Let’s break this down a bit:
- ARPU= Average revenue per user
- Avg Customer Lifetime, n= This is the inverse of the churn, n=1/[annual churn]
- WACC= Weighted Average Cost of Capital
- Costs= Annual cost to support the user in a given period
- SAC= Subscriber Acquisition Costs, occasionally referred to as CAC.
When the LTV formula is applied correctly, it can be used as a good tactical tool for monitoring and comparing similar variable market programs– for example, multichannel scenarios. However, like any model, the proper use of this formula is completely dependent on assumptions used in the model.
Many companies who tout the wisdom of this model, the formula eventually takes on more importance than it should. The practitioners become seduced by the model and often lose sight of the more crucial elements of their corporate strategy– becoming narrowly focused on the execution of the LTV strategy. This leads to the formula becoming confused, misused, and abused…much to the detriment of the organization. In the end, in many cases, it’s the customer that loses out the most.
Let’s discuss some reasons to avoid the obsession with the LTV trend:
- It’s a tool, not a strategy
The LTV model does not create sustainable competitive advantage. Do not confuse output with input. The LTV model is a measurement tool. You mustn’t forget this…it’s simply created to be used by marketing to test the effectiveness of their marketing spend. That’s it! If an organization decides that buying customers for less than what they charge is a corporate strategy, it becomes an arbitrage game– and those rarely last. There are too many variables out of of an organization’s control– specifically, ARPI and SAC. Nothing prevents your competitors from executing your exact strategy. Don’t kid yourself and believe it’s some proprietary strategy.
2.) It is built to rationalize market spend
Marketing leadership LOVES big budgets. This makes it much easier to grow the top line. The formula eases the pressure for near term profitability and justifies playing it forward- spend today for tomorrow’s benefit. It is not coincidence that the companies that rely heavily on LTV are the ones that experience massive losses as they scale.
3) The tug & war of the LTV variables
This may be the most important issue we discuss. The importance lies in the heart of why this model eventually breaks down and why it fails to scale infinitely. Think of the 5 variables of the LTV formula as the 5 horsemen. There’s a rope connecting them all and they all face different directions. When one horse pulls his way, it makes it more difficult for the other 4 to go his direction. The variables are interdependent, not independent as they are often considered…and they are an overly simplified abstract of reality. Raise ARPU? You’ll increase churn. Try to grow faster by increasing marketing spend? The SAC will rise…and churn may also rise as an aggressive program will likely capture customers of a lower quality. Let’s say you beef up customer service to improve churn, you will directly impact future costs and reduce potential cash flow.
4) Growing becomes difficult.
Let’s just say that your organization estimates it will do $100mm in revenue this year, $200mm the next, and $400mm the year following. To accomplish this, the company is going to invest heavily in marketing– 50% of revenues. How realistic is it to say that the SAC will decrease as you quadruple your spend? A basic supply and demand analysis will suggest the exact opposite outcome. Trying to buy more and more of a limited good will absolutely ensure that the price will increase. Online, the number one place on the planet currently for marketing spend is Google Adwords– make no mistake about it, this is a finite resource, and increasingly so. Clicks are not growing at a meaningful rate and keywords are highly contested in the marketplace. The assumption that you will ‘get better’ at buying while trying to buy more of this resource is a daunting assumption. It will likely become more difficult to get meaningful data and results, not easier.
4) Purchased customers underperform organic on most metrics
Organically acquired users generally have a higher NPV, higher conversion rates, lower churn, and are more satisfied than customers acquired through a marketing spend. Companies stuck on the LTV model are absolutely in denial about this. Many of them will argue that the customer dynamics are the same, however, this is rarely the case. Customers that choose your services are overall much more satisifed than a customer that is persuaded to buy through a spend. Name any high-marketing spend customer subscription company, and you’ll find an organization with numerous complaints at the better business bureau. These companies make it nearly impossible to terminate subscriptions…when you’re scheming on how to trap customers, you are not building a long term brand..
It’s not impossible to create and cultivate permanent equity and value with the LTV model, but it’s a dangerous game of timing. Let’s say someone starts a new business with early marketing capitalization of ‘X’. Using aggressive marketing techniques, and aggressive fund raising, they achieve amazing revenue growth and create a rather sizable organization. Eventually, however, gravity ensues, constraints come up, and the growth collapses. Early founders and investors will do ok, but will do so on the backs of later stage investors that helped fund the unsustainable push as noted above.
This piece is not to seal the fate of the LTV model, but just raise awareness of the lack of sustainability of it when used as a business model for long term plans. This is a marketing tool that is not hard to master, difficult to time, and hard to scale with.