A “dangerous seduction” revisited…
Metrics are wonderful. In good hands they imbue business operations with a sense of control and transparency, shedding light on weakness like a company-wide MRI. But any good metric can be rejiggered, watered-down and commandeered to paint business reality over with a nice, sugary varnish. (Ahem…Groupon GRPN -1.89%.)
In The Dangerous Seduction Of LTV, Bill Gurley of Benchmark Capital points out ten pitfalls associated with one increasingly notorious metric: lifetime customer value (LTV). At its simplest, the formula is meant to compare revenues generated by customers to the costs of acquiring them. But, as Gurley argues, marketing departments too often hijack the formula to fatten budgets and delay accountability while sabotaging the model with shoddy inputs.
With the right oversight though, LTV has its place. HubSpot, a Boston-based company that sells inbound marketing and CRM software to businesses, has used a simplified version of the model while boosting revenues more than ten-fold since 2008.
The graphic below shows first a steady, then spectacular improvement in HubSpot’s LTV model. Here, CAC is cost of customer acquisition, MRR is monthly recurring revenue and software margin is the cash they keep for each customer after accounting for support and other costs. We arrive at LTV via this equation: (MRR x Margin)/Churn.
Lifetime Customer Value Model
Brad Coffey, head of corporate development for the company, likens the formula to a machine: Put a dollar in at the top and the LTV:CAC ratio will tell you roughly how many dollars come out at the bottom. If your money isn’t multiplying, “you’re going to want to spend some time tuning that machine,” he says.
In the vein of a very informal case study on HubSpot’s use of LTV, here are five tips for effectively applying the formula to your business.
1.) Prize Customer Experience Above All Else: This is a maxim worth pinning to the insides of your eyelids. Gaining the loyalty and adoration of your customers is absolutely the only way to build a sustainable long-term brand. How to win their love and adoration? Easy – just sell a fantastic product at a reasonable price.
HubSpot managers are judged first and foremost on the customer success metrics coming out of their departments. In addition to satisfaction, churn, engagement and anecdotal evidence, the company measures its software’s effectiveness by tracking the number leads and sales customers generate after signing on.
Putting the customer on a pedestal is not a revolutionary idea. But a devoted customer-base improves your LTV math in two key ways. First, it decreases churn, a variable with significant leverage in relation to the formula’s final outcome. Second, it enhances your company’s word-of-mouth marketing, spurring organic customer acquisition and tamping down unit marketing costs. The five-horsemen affect that Gurley describes, where each LTV variable tugs at one another so that increasing MRR, for example, also increases churn, is only negated by excellent customer experience.
The customer comes first, second and third. Then LTV.
2.) Keep The Variables Clean: The thing about fancy formulas is that their resemblance to reality depends on the validity of their inputs. “Garbage in, garbage out,” as they say. The costs to acquire a customer aren’t confined to your marketing budget, for example. They include the salaries and expenses of every sales rep, every marketing executive, and the support structure surrounding those employees, among other things. Go ahead and fudge the numbers – it’ll be sweet soma and bad business.
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For HubSpot, they need to be delicate with their inputs in a couple of ways. First, they’re careful to recognize that the expense of onboarding a customer is a onetime charge that should count towards acquisition costs rather than software margin. The company’s churn ratio is measured in dollars rather than customers – meaning that if 100 customers pay $1 each in a month, then three leave while two others upgrade to $2 plans, churn is one percent. Upgrades, therefore, get counted towards the churn rate but NOT to MRR. Including upgrades in both would be double-counting a positive input – and painting an overly rosy scenario.
3.) Isolate Customer Segments, Then Apply: The key here is understanding your customers. HubSpot’s customer-base can be divided into four main segments: small businesses, medium-sized businesses, enterprise and international clients. Each one faces different problems, different incentives, and uses the product in a different way. Each requires a different strategy for improving unit economics.
For the small business segment, the company cut customer acquisition costs in half by ditching its direct sales strategy and investing heavily in a reseller model. For medium-sized businesses, they improved their product to offer better lead management options, reducing churn in the process. To increase monthly revenues for all customers, they personalized users’ homepages to better target clients for upgrades.
Divide and conquer, just like Caesar.
4.) Don’t Rely On Conventional Marketing (Unless You Want Acquisition Costs To Blow Up): LTV doesn’t just scale up seamlessly, which is one Gurley’s main points of contention. As HubSpot CEO Brian Halligan points out, “You can’t just close your eyes, double marketing spend and wait a year.” In addition to the five-horsemen effect, per-unit marketing costs inevitably rise with increased spend, especially in channels like Google GOOG -0.3% AdWords and other conventional media. ”Some of the most efficient forms of marketing are viral, social and effective PR,” Gurley says, lamenting that most LTV-focused companies avoid these high-leverage techniques in favor of traditional marketing.
Part of the reason that LTV works so well for HubSpot – and that their CAC stays so flat – is that the company excels in all three of the areas that Gurley mentions. Each one of the company’s blog posts gets 350 retweets on the low-end and a comparable number of referrals across other platforms. They have 240,000 Twitter followers, nearly 200,000 Facebook FB +0.5% likes and 17,000 followers on LinkedIn.
In terms of PR, if you’re reading this post, you are Exhibit A for their mastery of the press. How could I not write about a company that opens up their internal numbers so I can riff away on LTV? A glance at their press page shows an endless list of clippings from niche blogs and national newspapers alike. They made a decision long ago to trade transparency for press coverage, which means that they are a business journalist’s dream of a private company. This open kimono policy gets them a ton of cheap exposure and enhances the brand by lending an air of integrity to the business. Clearly, they have nothing to hide.
5.) Maximize LTV To A Point, Then Scale: Beyond seed funding, there’s only one good reason for diluting your equity stake and accepting growth capital: the opportunity is so big, you need to move quickly to capture market share. LTV is purely a tool in determining whether or not your company is going to burn cash or make a profit during that land grab. To use Coffey’s metaphor, you can fiddle with the machine ad infinitum, but if you’re pumping out 20 dollars for every one thrown in the top, it was probably time to start scaling long ago.
HubSpot likes to see an LTV:CAC ratio of three before they feel comfortable expanding. This gives them a buffer to stay profitable if they find the model breaking down.
Otherwise, if the model starts breaking, it’s time to start tweaking.