How LTV Lies To You
Lessons from Bill Gurley
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LTV is a deeply misunderstood concept.
Applied correctly, it's a very helpful framework.
Applied incorrectly, Iâve seen it kill companies.
The key is to understand the nuance of how to apply it.
Arguably the best thing ever written about it is this post from Bill Gurley.
If you donât know who Bill is, heâs an OG of the tech world.
General Partner at Benchmark Capital for 20 years, which is a top tier VC.
Early investments into: Uber, Grubhub, OpenTable, Zillow, Stitch Fix, GoodRx, NextDoor, HotelTonight
Was historically correct across multiple predictions such as the ride sharing wave, the SaaS valuation bubble, and the opening of the AI wave.
6â9â which as my friend OâDuffy would say, is suspiciously tall.
Thereâs an argument that heâs on the Mount Rushmore of VCs.
If you want to learn business fundamentals, the best places online are the old school VC blogs and his is no exception.
Most of the content was written in the 2010s. The posts look like they were designed in 2005, but they're full of great insights.
Weâre going to be diving deep into this famous post about LTV.
He makes 10 points. Weâre only going to cover 4. You should read the whole thing.
To Understand LTV, You Need to Understand ALL the Factors
LTV calculations can get very complicated. Here is his simplification.
n â average customer lifetime in years (1 / annual churn)
ARPU â Average Revenue Per User, you can decompose to Price x Renewal Cycles
Costs â annual cost to support the user
SAC: Subscriber Acquisition Cost, which is now commonly called âCAC**â** or âCustomer Acquisition Costâ
WACC â weighted average cost of capital
x â Time period as this is technically a discounted cash flow model. You can plug in the years youâre calculating for or actually just ignore this.
A few quick notes for those already confused.
What heâs showing here is a discounted cash flow model, which is a fancy finance term for predicting the total value of all future cash collected in todayâs dollars. That's what the squiggly thing at the front means.
The common usage of these terms has evolved a bit, what heâs calling LTV here, I would say is now commonly called âNet LTVâ or âLifetime Profitâ as it already factors in 2 major cost buckets.
LTV is a Tool, not a Strategy
From Bill:
The LTV model does not create sustainable competitive advantage. You shouldnât confuse output with input.
The LTV formula is a measurement tool to be used by marketing to test the effectiveness of their marketing spend â nothing more and nothing less
The true scoreboard is arguably either enterprise value creation and/or profit.
LTV:CAC is an indicator that you may be on the right path to creating both.
As we talked about last time, what also matters is your ability to defend it.
The Invisible Rope Linking All the Inputs
This is maybe the best point in the whole article. From Bill:
Tren Griffin [Microsoft OG] ⌠refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all, and they are all facing different directions.
When one horse pulls one way, it makes it more difficult for the other horse to go his direction.
The variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality.
If you try to raise ARPU (price) you will naturally increase churn.
If you try to grow faster by spending more on marketing, your CAC will rise âŚchurn may rise alsoâŚif you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution.
Iâve seen multiple companies build their financial plans based on improving all the factors of LTV at the same time.
This never works.
You canât improve one without slightly degrading the others.
Typically if you raise prices:
Churn increases because your marginal users decide itâs no longer worth it and leave.
CAC increases because you have a narrower buyer poolâŚ
Support costs increase because people paying more expect better serviceâŚ
If you increase your number of customers, you also increase your support costs.
If you decide to spend more on CAC:
Churn goes up because you have to reach deeper into the demand curve and get lower quality users.
You have less money to service your customers
If you want to spend more money on support & product improvements:
You have less money for CAC
You get the picture.
This doesnât mean you donât try to improve these numbers, you still should.
But you should be aware of this dynamic and go into it with realistic projections.
Cost of Capital is Real
The money you are using to acquire customers was not free. You either
You borrowed it in the form of debt
You raised it by selling equity or something like it
You earned it from customers.
#1 and #2 have a direct cost. You are paying for this money via interest or equity.
Weâll cover #3 in the next section.
WACC or âweighted cost of capitalâ is the blended cost of every dollar funding your business.
Cost of debt â the interest rate you pay on loans. Usually 6â10%.
Cost of equity â the return your investors expect to make. For a VC-backed startup, 20â30% isn't unusual if you annualize the growth rates youâre expected to hit.
Putting a lot of effort into cost of capital calculations is too sophisticated for 95% of the people in this newsletter, as most of you are trying to scale revenue.
However, you should know this concept exists. If you want to read more, this is a good post.
Opportunity Cost is Real
From Bill:
If you are a company that spends millions and millions of dollars on marketing, wouldnât you be better off handing that money to the customer versus handing it to a third-party who has nothing to do with the future life-time value of the customer?
Providing a better value-proposition to the customer is much more likely to engender goodwill than spending on marketing.
A heavy marketing spend necessitates a higher margin (to cover the spend), and therefore a higher end user price to the customer!
So the customer is negatively impacted by the presence or âneedâ of the marketing program.
In retrospect, this is exactly what we did at Codecademy. We put millions into the free productâs development every year and that grew the brand, which led to lots of free organic traffic.
So What Do You Do With This Information?
In my experience, LTV is useful in two basic scenarios:
First, does your core business work at all?
If LTV - Support Costs - CAC doesnât have a decent amount of money left over per user, then your current model doesnât work.
You need to fix this model before you attempt to grow the company or youâll just die faster.
Secondly, this framework allows you to compare similar things such as the LTV of users in different countries, price tiers, acquisition channels, devices, etc.
This can inform where to invest and what product changes to make.
I had a client last year who was seeing more and more monthly plans as a percentage of sales each month.
This didnât seem like a big problem until we ran the math.
LTV on a monthly user was ~$80.
LTV on an annual plan user was ~$250.
If the trend continued, they would lose millions in ARR. LTV was very helpful in telling this story.
Good Luck Out There,
Dan
P.S - If your product does $2M ARR+ but your MRR, churn, or ARPU numbers arenât strong enough, reach out. I help successful products scale revenue. Book a free strategy call here
