Whether you are a new business owner interested in evaluating your startup’s financial position, or if you are an investor performing due diligence before entering an investment agreement with a new firm, it is worth understanding the concepts of Customer Lifetime Value (CLV).
Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLV/LTV) are two crucial components for business valuation. Both concepts go hand in hand, as ideally, their respective values should be inversely proportional.
What is Customer Lifetime Value (CLV or LTV)?
Customer lifetime value shows how much profits your business earns, on average, from a single customer over their course of your business relationship. It is essentially a measurement of how valuable a customer is to your company, not just for a single purchase, but across your entire business relationship.
The higher the CLV, the more valuable the customer is for your business. This is a very valuable metric for potential investors for several reasons:
- Firstly, it is compared against Customer Acquisition Cost (CAC) to determine whether it is worth it to invest money in acquiring a customer in the first place
- It allows investors to see how much a single customer’s business contributes to the revenues and profits of the firm
- It costs less to keep existing customers than it does to prospect new ones, so it is worth seeing how much value an existing customer is providing to the business
Therefore, investors will consider customer lifetime value when performing valuation of your business’ financial position as part of their due diligence.
The most basic formula for calculating CLV/LTV is as following:
Customer Lifetime Value =
(Customer revenue per year x Duration of customer relationship in years) – Total cost of acquiring/serving the customer
What is Customer Acquisition Cost and How Does it Relate to CLV?
Customer acquisition cost (CAC) shows investors how much it costs your business, on average, to gain a single client or customer. Costs include advertising fees, sales commissions, referral fees, and other marketing expenses.
CAC is closely investigated alongside LTV during financial valuation. This is because on one hand, CAC shows the total cost of acquiring a single customer, while LTV shows how much that customer will be worth throughout their lifetime with the business.
Very simply put, an investor will be more willing to invest in a business that has low CAC, and a much higher LTV. This is because it shows a greater potential for profit generation.
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