Friday, January 11, 2013

Customer lifetime value

The other day I attended a VC/Company founder seession at Lowenstein Sandler, where Devon Parekh, a partner with Insight Venture Partners spoke about customer lifetime value.While his presentation was skewed for enterprise type companies, the thinking has relevance for consumer companies too. In his view, it is one of the most important tools for estimating the value of a company, and as important, a means for management to manage and allocate assets.

Here's the summary of his thoughts:

  • First they look at the size of the market (e.g. # of potential customers, number potential of seats, multiplied by average value/seat)
  • Then they make assumptions, by distribtuion channel as to the number of seats a company may obtain (e.g. market share)
  • Next is to look at the existing business, where they look at customer retention metrics by month of sign up. For example, they will assume that in the second year 90% of customers will renew, and in the third year, 85% of these will renew again
  • They take these % and look at the components of customer lifetime value. They divide customers by market and simultaneously divide them by distribution channel (2 analysis)
  • They determine revenue and gross margin by customer segment and by distribution
  • Then factor in sales/marketing expenses (customer acquistion costs) to support the channel
  • They use this information to reach a net contribution (pre-overhead allocation) by channel and by market
  • They apply the customer lifetime value metrics to the potential addressable market
  • They discount the future cash flows and apply a market multiple to reach a valuation conclusion
While I find this type of analysis incredibly useful for management and for later stage companies, I am not sure it's so relevant for early stage investors which tend to invest in companies which zig and zag before reaching their true market calling. Of course, this analysis does highllight how mature companies, who build their economic models around lifetime customer values can be blindsided when a new competitor, or way of doing business comes on the scene. Just think of the pain Enterprise software companies are facing as they now have to rely on the equivalent of their maintenance streams, without the initial 'pop' of large sales, to compete with SaaS vendors.

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