Calculating the Value of Churn Reduction, Part 2: Discounting Future Cash

In the last article we introduced the Customer Lifetime Value (CLV) formula of Gupta & Lehman, and we began to explain it, starting with the expected lifetime of a customer. So was that it? The lifetime value of a customer is expected length of the customer’s subscription times the profit you make on them each month. That is:
CLV=M/c
So if the churn rate is 10%, the CLV is 10 times the recurring margin, if the churn rate is 5% the CLV is 20 times the margin, and if the churn is 1% then the CLV is 100 times the margin. This approximation to CLV is widely used, but it has some serious flaws and as we will see it can significantly overstate CLV. This article will explain why.

Discounting a Safe Cash Flow

As we all know, money promised in the future isn’t as good as cash in hand! So if you want to know the lifetime value of a customer you must “discount” future payments, or adjust them for the fact that you have to have to wait to receive the money (and for that matter may never receive it.) Both of these reasons, waiting and risk, contribute to making future money less valuable today and we will describe them in turn, below. This is an idea known to anyone who has taken a college level course in business or finance so if you already know what cash flow discounting is and why it is important you can skip this section – this article will just cover the basics.

Why is this subject important for subscriber acquisition and retention? Because if you’re thinking about spending some money to acquire or retain new customers you are going to spend that money right now or very soon. But the money you will collect from those subscribers is going to trickle in over months or years. If you think the value of present and future dollars are the same you will reach incorrect conclusions about how to get the most value for your hard earned marketing budget.

To understand how to compare present and future money, you need to use a fundamental concept of finance, which is called cash flow discounting. The simplest version of this idea is this: if you have some money you can put it in a bank account and the interest makes the money grow over time. Now turn it around and imagine receiving money after waiting some period of time: money you have to wait for is worth less than money now because you could take less money today, invest it for the waiting period, and after that you would have the full amount. The amount you have to invest now in order to have the full amount after the waiting period is called the present value of the future payment.

Let’s make a concrete example: If you are to receive say $100 at the end of the year, and interest rate is now 5%, it is the same as having around $95 today because if you had the $95 now you could put it in the bank and have $100 at the end of the year. The mathematics of how money grows with interest is described in the Appendix section below, and conversely how to calculate exactly the present value of money if you have to wait for it. This calculation depends on the interest rate that you could invest at. (If you want to know why $100 after a year with 5% interest is worth “around” $95 and not exactly $95 see the details in the appendix.)

Now an important point: what does a bank deposit and a subscriber to a service have in common? They both pay repeatedly, in installments. The periodic payments in both cases make up a “cash flow”. That is why we use the idea of cash flow discounting, borrowed from finance, to analyze the value of subscribers.

Discounting a Cash Flow with Risk

Okay, that wasn’t too hard – you have to reduce the future money to be received by “discounting it”, which depends on the interest rate. That’s the basic idea. But here’s the catch: What we just said assumes that you will get the money in the future with 100% certainty, like in an FDIC insured certificate of deposit (CD). So the interest rate we were talking about is the rate on a safe deposit. But at the time of this writing in 2014, the interest rate on savings account is practically nothing, maybe 2%. What if instead of investing your money in a safe investment, you lent it to a more speculative venture, like lending your money to your friends crowd sourced loan on Prosper.com? You’d earn a higher interest rate, of course. These days a savings account may only give you 2%, but if you invest in a venture on Prosper.com you may earn interest anywhere from 6% to 30%. That’s great if you get your money back, but if the borrower goes bust you’ll get much less, maybe nothing at all.

There is added risk, but notice that lending money to a small business venture is still similar to safe bank deposits and subscribers because you get paid periodic interest. That means that the same ideas apply, but because of the risk the interest rate should be larger. Lending at a higher interest rate, your money will grow faster if you make a risky loan, as long as you do in fact get paid. And the flip side is that money promised to you in the future by a risky investment is worth less today when you discount it than money promised by a safe investment. And here’s the point for customer lifetime value, if it’s not obvious already: cash expected from subscribers to a service should be considered like a risky investment and discounted at a high interest rate! Not the interest rate on a safe investment like a savings account.

The impact of a safe interest rate and a risky interest rate are shown in the table below. The way to read it is that $1 to be paid to you in 10 years by a safe investment (2% discount rate) is worth 82 cents today, but $1 to be paid to you in ten years by the risky investment (10% discount rate) is worth only 39 cents today – less than half as much.


Table: Discount factors at different times for low (2%) and high (10%) discount rates

What interest rate should you use to discount the future cash streams from subscribers to a service? If you don’t already have a system in place for choosing your own discount rates, we recommend discounting with the effective yield of a CCC junk bond, around 9-10% at the time of this writing. That’s probably too generous, meaning the rate for discounting subscriber payments should probably be even higher for most services. (That’s because CCC is just the worst rating for a rated company that issued a bond. Any company that can even issue a bond is way ahead of even smaller, risker ventures.) But the CCC bond rate has the advantages that the rate is readily available in published sources, it will adapt to changing times, and CCC is pretty risky.

Adapting to changing times is important: if the economy goes into recession, many things will happen, most of them bad for your subscribers and for your business. As a result, you should probably discount expected payments more heavily if there is a recession. And in a recession, the CCC bond rate will rise, because all risky ventures are likely to have a tougher time so investors will demand a higher interest to loan to junk companies. So an increased CCC bond rate will automatically increase the discounting of future subscriber cash in an appropriate way. Why would you want to value your customers less in a recession? Because in a recession you should probably be more conservative with your marketing and retention spending : reducing the calculated value of your customers is a principled and objective way to do this. (You might argue that in a recession you will need to bolster your numbers by valuing your customers more highly. That’s great if you want to make a presentation to investors – just take a more careful approach when you decide how to spend those investor’s money!)

Appendix: Mathematics of cash flow discounting


If you are mathematically inclined, the relationship can be expressed as:

where r is the annual interest rate (i.e. a percent as a decimal number like .02 for 2%) and N is the number of years. (1+r)N is the accumulated (compounded) interest rate. You can turn that equation around (by dividing both sides by the compounded interest rate) and write:

And now you can clearly see money in the future is worth less than money today because you divide the future dollars by the compounded interest you would accumulate over the time if you had the money today. (Note that (1+r)N is always greater than one whenever the interest rate is greater than zero, so future cash is always worth less than present.)

toucanBox And Sparked Improve Playtime For Kids Everywhere

Sparked & toucanBox Improve Playtime For Kids Everywhere

UK-based toucanBox is a monthly subscription box of creative and fun hands-on activities for children aged 3 to 8 years old, delivered right to their door. Each box contains everything that’s needed to keep children engaged for hours, including all the materials to complete at least 4 projects, colorful step by step instruction manuals, and a picture book, improving the quality of their playtime.

Every month, a different box is released, with themes ranging from ‘bugs’ to ‘outer space’. The boxes are tailored to suit each child’s developmental stage, and the content of the boxes differ accordingly. However, in order to be truly effective, it’s important to know what works and what doesn’t. Some boxes do better than others and in order to improve, we’ve got to identify the high performers. That’s where Sparked comes in.

Sparked is now making sure that toucanBox can deliver even more delight to kids across the UK. By integrating toucanBox’s billing data from Recurly with usage data from their website, we have identified which boxes experience greater acceptance from their customers, and which ones could use some tweaks. Sparked’s unique Retention Radar product identifies customers who are at risk of canceling and even provides the reasons for their dissatisfaction – all in time to take action and make things right.

“We’re already seeing an improvement in our understanding of what our customers really want to see in the boxes. We can figure out what themes and concepts work best and see where we can improve each month, without having to use a less efficient method like a survey” says Virginie Charles-Dear, Founder and toucan Chief.

Like many companies in the fast growing Subscription Economy, toucanBox has a huge following of customers on social media platforms. And because it’s important to get the complete view of all customer interactions and map out their journey with toucanBox, Sparked will continue to integrate new data sources, including social media presence, support and other data. With this 360-degree view of the customer, toucanBox’s staff will have a never-seen-before picture of how their customers use their product and interact with toucanBox on various platforms. Taking decisions will finally be easier and faster and toucanBox will be even more efficient at being awesome.

All of which translates to better boxes with more interesting activities being shipped to happier kids and even happier parents, improving the quality of their Quality Time. -We like that tag line so much, we might just use it!

Calculating the Value of Churn Reduction, Part 1: The Correct Calculation Of Customer Lifetime Value

Much has been said about the value of retention and acquisition, and there are many different theories – unfortunately, much of this can be confusing and misleading. We are going to explain how to calculate these important metrics of a SaaS company correctly. First, we have to start with customer lifetime value (CLV) – many people often use simplified versions of CLV that can be very far off. In this article series I will explain the importance of cash discounting and its application in SaaS metrics. This is a slightly complicated subject (for those of us who never studied finance), but fortunately two professors, Sunil Gupta of Harvard and Donald R. Lehman of Columbia, have already derived a relatively simple equation that does it for you! The first three articles in this series will convince you why and teach you how. Later in the series we will go over the valuation of acquisition campaigns and the value of customer retention. But we can’t get to those until we get a really good understanding of CLV.

Main Result

The best formula for CLV was created by Sunil Gupta and Donald Lehman and first published in their seminal paper, “Customers As Assets [PDF]“, (Journal of Interactive Marketing, 2003, 17.1 pages 9-24). It is:
CLV=M * r/(1+i-r)
where:
  1. M is the margin on the customer(s), i.e.recurring revenue (RR) minus Cost of Goods Sold (COGS)
  2. r is the retention rate
  3. i is the interest rate for discounting project investments
The parameters of the formula (margin, retention and discount rate) can all be stated assuming either an annual or a monthly period (or any period you want, for that matter) as long as they are consistent. Consistency of the time period is the main “gotcha” when using the formula, and we will explain how to do it right.
If you know exactly what those three terms mean and you know how to convert them to a consistent time period, you may want to just skip to the article by Gupta & Lehman! My discussion here is for people who are either new to SaaS metrics or want to see the least math possible but still get the important points. In this post, and those that come after it, we will explain exactly what those terms mean, and explain enough to know why that is the best formula for CLV, but we will introduce the bare minimum of mathematical equations.

Expected Lifetime of a Customer

CLV means the value today of a customer, including the money you expect that they will pay you in the future. The first thing you need to know is how likely the customer is to last as a subscriber. For that you use the churn rate and this equation:
Expected Lifetime=1/churn
For the mathematically-minded, this equation is derived from an exponential decay model of customer lifetime. For the non-mathematical, the intuition is that if a customer has a 1 in 10 chance of cancelling each month, you expect they will stay about 10 months. Make sense? Sure! Note that if your churn rate is monthly, your expected lifetime is also in months, and if your churn rate is annual then the expected lifetime is in years. We’ll have more to say about this in a little bit. So if this is the expected lifetime, does that mean that the customer lifetime value is just monthly recurring revenue (MRR) times the lifetime, or CLV=MRR/churn? No! Although you see this equation used in some SaaS metrics articles (we won’t link any names) this is wrong and will overstate the value of a customer. It is wrong in two respects: it doesn’t include the cost of acquiring and maintaining the customers, and it doesn’t discount or devalue the cash that will be paid by customers in the future. Without accounting for these you will overestimate the value of a customer and make bad decisions about acquiring and retaining them. We actually won’t use the equation above directly, but it’s important to get an idea for how expected lifetime value comes into play and how you calculate it. So that equation is meant to give you some intuition more than anything else. Next we will explain discounting future cash flows in some detail. Here is a short preview of what to expect:

Calculating the Value of Churn Reduction, Part 2: Discounting Future Cash

In the last section we introduced the Customer Lifetime Value (CLV) formula of Gupta & Lehman, and we began to explain it starting with the expected lifetime of a customer. So was that it? The lifetime value of a customer is expected length of the customer’s subscription times the profit you make on them each month. That is:

CLV=M / c
So if the churn rate is 10%, the CLV is 10 times the recurring margin, if the churn rate is 5% the CLV is 20 times the margin, and if the churn is 1% then the CLV is 100 times the margin. This approximation to CLV is widely used, but it has some serious flaws and as we will see it can significantly overstate CLV…
To be continued…

Customer Churn Pipeline

The customer journey is fraught with key moments when a customer decides to leave. Typically, they say nothing. And the last indication that a company gets from customers before they go is one of positive sentiment. The Sparked infographic below documents when and why customers leave, but also shows key ways to keep your customers on board and happy. Sparked Killer Churn Infographic

Entrepreneur.com: 4 Steps to Knowing What Your Customers Want Better Than They Do

Sparked’s mission is to help companies deliver more value to their customers. And that starts with making sure you know your customer as well as possible. Sometimes, that means getting to know them even better than they know themselves. How is that possible? Well, in my latest article on Entrepreneur.com, I explore the methods that leading companies use to learn about their customers – methods that you can apply to your unique case as well.

4 Steps to Knowing What Your Customers Want Better Than They Do

TheNextWeb: How to avoid getting burned when hiring overseas

Sparked International! Sparked CEO Ben Rigby is in London this week with current and potential new clients, while Sparked Managing Director Joseph Pigato discusses how to build teams overseas. From assembling a battle-tested hiring team to mining your networks and ultimately making a rock-solid hire, this article on TheNextWeb should be your first stop if you’re looking to expand your company’s presence across the globe.

Worst Retention Call Ever

Warning, this retention call is painful. It’s so bad that it seems like it’s got to be a joke. If Comcast had a bit more insight into reasons for churn, they wouldn’t have had to comp their rep on getting through these questions… which has resulted in a good deal of reputation damage (already ~800k listens).

6 Teamwork Tips To Help Implement Predictive Analytics

Sparked MD Joseph Pigato recently wrote an article for InformationWeek.com on the 6 teamwork tips that companies can use to prepare for the coming transformation, where data teams and business managers work closely together.

Sparked’s Predictive Analytics and Machine-Learning powered product, Customer Radar, goes a long way towards easing the process of getting business managers to work with data teams, by providing an easy-to-master dashboard, rich with information that can be both easily understood and quickly acted upon.

Click here to read all six tips.

[Whitepaper] Customer Retention Best Practices

The Sparked Team has always had an eye out for compelling stories and case studies, which can help subscription companies better their customer retention rates. Although there are multiple approaches and a vast combination of factors to juggle, some companies manage to stand out in their execution of customer retention programs.

Whether it’s by using a tried-and-tested communication method in a new way, or coming up with innovative solutions to customer problems, the 10 companies in our whitepaper, Customer Retention Best Practices put their customers first and that’s ultimately what led to the successes we describe in their case studies.


Download: Customer Retention Best Practices

Deception of NPS

The Net promoter Score system, while useful in a few narrow applications, is not the general purpose tool that some companies claim it to be. Here are a few of the more obvious deceptions that an NPS score might be hiding…

Deception of NPS Sources:
http://experiencematters.wordpress.com/2014/01/27/why-net-promoter-score-may-not-align-with-business-results/
http://blogs.forrester.com/richard_evensen/11-04-18-stop_using_nps_net_promoter_score_but_please_save_the_question
http://www.measuringusability.com/blog/nps-ux.php
http://infoquestcrm.co.uk/2012/10/the-cassandra-phenomenon-and-customer-satisfaction-surveys/
http://wordofmouthindex.com/press-releases/foresee-releases-word-of-mouth-index-womi-benchmark-showcasing-customer-loyalty-scores-for-the-top-100-u-s-brands/