This year at Red Gate, we’ve started providing a way to back up SQL Azure databases and Azure storage. We decided to sell this as a service, instead of a product, which means customers only pay for what they use. Unfortunately for us, it makes figuring out revenue much trickier.
With a product like SQL Compare, a customer pays for it, and it’s theirs for good. Sure, we offer support and upgrades, but, fundamentally, the sale is a simple, upfront transaction: we’ve made this product, you need this product, we swap product for money and everyone is happy. With software as a service, it isn’t that easy. The money and product don’t change hands up front. Instead, we provide a service in exchange for a recurring fee. We know someone buying SQL Compare will pay us $X, but we don’t know how long service customers will stay with us, or how much they will spend. How do we find this out? We use lifetime value analysis.
What is lifetime value?
Lifetime value, or LTV, is how much a customer is worth to the business. For Entrepreneurs has a brilliant write up that we followed to conduct our analysis. Basically, it all boils down to this equation:
LTV = ARPU x ALC
To make it a bit less of an alphabet-soup and a bit more understandable, we can write it out in full:
The lifetime value of a customer equals the average revenue per customer per month, times the average time a customer spends with the service
Simple, right? A customer is worth the average spend times the average stay. If customers pay on average $50/month, and stay on average for ten months, then a new customer will, on average, bring in $500 over the time they are a customer! Average spend is easy to work out; it’s revenue divided by customers. The problem comes when we realise that we don’t know exactly how long a customer will stay with us. How can we figure out the average lifetime of a customer, if we only have six months’ worth of data? The answer lies in the fact that:
Average Lifetime of a Customer = 1 / Churn Rate
The churn rate is the percentage of customers that cancel in a month. If half of your customers cancel each month, then your average customer lifetime is two months. The problem we faced was that we didn’t have enough data to make an estimate of one month’s cancellations reliable (because barely anybody cancels)!
To deal with this data problem, we can take data from the last three months instead. This means we have more data to play with. We can still use the equation above, we just need to multiply the final result by three (as we worked out how many three month periods customers stay for, and we want our answer to be in months).
Now these estimates are likely to be fairly unreliable; when there’s not a lot of data it pays to be cautious with inference. That said, the numbers we have look fairly consistent, and it’s super easy to revise our estimates when new data comes in. At the very least, these numbers give us a vague idea of whether a subscription business is viable. As far as Cloud Services goes, the business looks very viable indeed, and the low cancellation rates are much more than just data points in LTV equations; they show that the product is working out great for our customers, which is exactly what we’re looking for!
