There has been a lot of public debate over the past several weeks about whether it’s a good thing to be “gross margin positive” or not and commentary always reminds me that some people at startups don’t quite understand financial metrics or even how to think about which ones are healthy.
When I publicly Tweeted that all companies should be gross margin positive many people pointed out that Amazon wasn’t profitable for many years. Gross margin positive != profitable and companies like Amazon who chose to focus on growth > profitability were not losing money on each book sale (ie they were gross margin positive).
The key to being able to run a business that isn’t yet profitable (on operating margin) is availability of capital to finance losses and preferably at a cost that isn’t too punitive to the founders and employees. The reason one would accept losses is when they are investments in fueling faster growth.
There are good reasons why one would raise capital and make investments that lead you to be unprofitable (hiring more sales people in an organization that has found product/market fit or hiring engineering to expand product lines to have more products to sell to existing customers) and bad reasons (having bad unit economics but raising money to “figure it out”).
In general I find that raising large amounts of money when you haven’t figured it out ends up papering over problems more then helping solve fundamental issues in the business. It’s funny how scarcity of capital can focus one’s mind.
I’ve written about the trade-offs between growth and profitability before and if you don’t fully grok the topic I suggest you click through to that post.
Perhaps the most misused terms I see these days from entrepreneurs involve CAC (customer acquisition costs) and LTV (life time value) and a lack of understanding these critical components is driving many companies to premature failure.
The tl;dr version is this: Many have been taught to focus on LTV/CAC ratio and if that number is substantively > 1 said entrepreneur feels great. That can be a trap for three primary reasons:
- Payback period may be long even if LTV/CAC is large, and having a long payback period requires you to be able to raise capital to fund this deficit period. So if you’re able to raise easily no problem. If you can’t raise — you’re dead. End of story. No matter what you were taught about this fucking ratio. So I spend an inordinate amount of time with entrepreneurs focused on payback.
- LTV is imprecise. In product business it is often measured over multiple purchases and assumptions are made about the repeat rates, and in the enterprise or services world LTV can be based on churn rates, which are notoriously hard to predict in an early-stage business. Poorly calculated LTVs can become BVs (bankruptcy values).
- CAC is often measured incorrectly and often doesn’t capture the true costs of acquisition. And even when calculated correctly often CAC’s are assumed to be constant but of course they’re not. If you acquire 10 customers a month at $100 per customer and this scales to 100 customers at the same price you may make assumptions about 1,000 customers that don’t hold. The reality of CAC is both that when you scale your acquisition “channel,” costs usually go up plus when you find a great channel others notice it and drive up the costs as they compete with you in that channel.
So here are some more details ….
Let me start with the easy stuff and graduate to the punch line in the final section.
The first input is CAC. Customer acquisition cost. This is how much you spend to get a new customer. That bit is easy. In an eCommerce or Internet Services business it is often the marketing costs (if purchased online) and in an enterprise software company it is often marketing plus enterprise sales reps.
The first mistake that mostly only rookies make is to measure the CAC by looking at the attributable marketing costs of acquiring a user. So if you paid $100 for a customer who converted via a Facebook ad or Google search ad (SEM) that is not your CAC.
Let’s say you had a budget of $1,000 to spend on Facebook Ads and they cost you $100 each and you got 5 customers. If you had no other spend in your company to acquire the customers then your CAC is $200 / customer, not $100. That’s because CAC needs to take into account all of your marketing spend to truly understand how much each customer costs you.
If you’re spending $200 to acquire a customer and you want to spend less you can either test out other channels to see whether you can acquire customers more cheaply or you can try to optimize your funnel through your Facebook Ads to convert better. This is often called “funnel optimization.”
If you converted one more customer (6 in stead of 5) your CAC just went down to $167.67 ($1,000 / 6). So it might actually be more productive for you to improve your conversion than to improve your ad buying, for example.
But often this doesn’t tell the whole story because often companies are also spending money on PR and other marketing activities in order to support the sales process. Generally you should take your full marketing spend including PR divided by your customers acquired to get your “fully loaded CAC.”
Of course this is an imprecise science which is why you measure both methods. PR and non programmatic marketing often have a lagging effect so if you ran a big out-of-home marketing campaign that created brand awareness you may find that conversion actually takes place 60–90 days later.
In many senses the KPIs of a business should be driven by the finance / ops team more than the sales & marketing teams because the latter is wont to use the most liberal definitions of CAC to justify spend where the former has to make sure you don’t run out of cash. Of course it’s a collaborative effort — I’m just saying to involve bean counters in the discussion!
Enterprise software companies also should measure CAC even though it, too, is an imprecise science. SaaS companies need to estimate the amount of sales resources spent on clients (can be measured by activities like visits, sales calls, etc) / the clients who convert to look at sales productivity.
Equally you’ll want to measure the total sales costs / clients converted to get a fully loaded sales rep cost / acquisition. And then of course you need to layer in marketing to understand the true SaaS customer acquisition costs.
I’m sure there are way more detailed blogs than this one that can help you with a deep dive on CAC methodologies — my point is the bring the issue to the attention of more early-stage founders who probably aren’t developing enough cycles to thinking about metrics.
The second TLA (three letter acronym) all entrepreneurs are now taught to measure is LTV or “life time value.”
In eCommerce it’s easy to measure the first time purchase value (AOV, average order value) but that doesn’t tell you the “life time” value. To understand that you need to understand repeat purchase rates and of course that is harder to know in a startup company. Estimating your assumptions and testing how cohorts perform over time is critical to perfecting your LTV calculations over time.
In SaaS (or any recurring revenue business) this is also a very difficult task. What you need to figure out is “churn” or the number of customers (and dollar of customers) that leave your business every month. So measuring LTV requires that you look at cohorts of data over time to see how they perform and then make assumptions for the rest of the data set.
The problem with LTV is that many SaaS companies assume customer lifetimes of 5+ years and of course you can’t reasonably predict that because it doesn’t take into effect technology or competitor disruptions that may have profound impacts on churn or pricing.
One big, beginner’s mistake people make in LTV is to measure revenue. The correct way to think about LTV is to measure the profits gained by the customer. The reason is that you’re trying to understand whether you’re cost effectively acquiring customers.
So in the case above if you are spending $200 to acquire a customer who buys 3 times from you at $100 each time ($300) this may seem like a great idea. But if your profit margin is 50% then you’re only making $150 in profits. So you actually lost $50 acquiring that customer. This is a simple example but I promise you as businesses layer on complexity they often make simple accounting mistakes that can lead to disastrous results.
Now. The thing about LTV is that you may rationally make assumptions that would persuade you it’s a good idea to lose money on acquiring customers. An example is that you may assume you’re going to launch a second product line that you can market to existing customers and if you had strong penetration rates that might layer on profitability.
If your economic case is built on increasing LTV over time or on retaining recurring revenue streams please remember to layer on “re-marketing or retention” costs into your equation. In this case, CAC isn’t sufficient to look at long-term profitability.
I’m guessing much of this was 101 to many readers. You were taught diligently to look at LTV / CAC ratios and somebody told you a magic number (maybe 2 or 3, preferably 4 or 5) that they asserted was the magic number to know whether you had a healthy business. Some even suggestion and LTV/CAC ratio of 1 while you’re growing to capture market share.
But LTV / CAC is just one measure. There is another that is critical and that surprisingly few have paid attention to in the past few years. I have been shouting it from mountaintops to companies I’ve invested in for years.
In eCommerce it may be a perfectly reasonable assumption to wait for the second or third purchase to make a profit. In enterprise software it likely makes a ton of sense to sell to customers who don’t churn and who yield recurring revenues for 5 years and hugely positive LTV/CAC ratios.
But none of this matters if you run out of money. Sustaining short-term losses is all predicated on ability to finance the losses through venture capital or other means. The dreaded trade-off between profitability and growth!
What I talk with entrepreneurs I like to focus on:
- What is the fully burdened CAC?
- What are the re-marketing or retention cost assumptions?
- What is the LTV? And …
- What is the payback period?
The payback period is when you have paid off your CAC. I am on the board of some companies with multi-million dollar LTVs calculated over a 7-year period (with proof over time that they do retain these customer) but where the payback is longer than 18 months. This can be a spectacular situation IF there is freely available capital to fund the company at good valuations. That is what finances rapid growth.
But when the venture markets slow down, when capital is less freely available, when prices start to decline — the balance shifts from growth-at-all-costs to profitability. And this isn’t theoretical and it isn’t just about your company. It’s also about how much you pay to acquire customers and how long it takes you to recoup this investment.
I would say that the obsession with LTV/CAC and the laissez-faire attitude to Payback Period is amongst the chief reasons you have a lot of companies that have raised a lot of capital and are now struggling.
In a market less focused on hard metrics, sales growth feels amazing and validating. In a market that discovers sobriety, investors start asking the tougher questions about acquisition costs. In a market where capital is no longer freely available and always increasing prices, people start to focus on payback on spend. And of course ultimately on profitability.
It’s probably worth boning up on these metrics in your business.