I just met with a company that wants to raise equity to invest in marketing. The B2B services company founder thought they were ready. I soon found out they are not.
The biggest issue for them is fundamental to any business that generates recurring monthly revenue, or other reasonably reliable repeat revenue from existing customers. Stated simply:
Is your marketing and sales model ready to scale?
Related: Scaling Your Company
Sophisticated investors in Software as a Service (SaaS) companies have developed a simple rule of thumb to measure whether or not a company’s sales and marketing is ready to scale. It’s expressed as a mathematical equation:
LTV > 3 x CAC
In words, the average LifeTime Value (LTV) of your customers must be greater than three times the average Customer Acquisition Cost (CAC).
Why is this so important to understand, whether or not you are looking for equity investment?
- Many companies fail, or are barely profitable, because they can’t figure out how to get new customers profitably
- Profitable marketing and sales is hard, continually changing, and only achieved through continuous testing, measurement and improvement
- It is not intuitive. You have to apply disciplined measurement and management attention to figure it out.
Sorry for that bad news. You may have seen a ton of blog posts promising that one magic technique – a marketing hack – will lead you to profitable marketing. But it’s almost never just one secret away.
What’s Your LTV?
I asked the B2B services company founder what their customer LifeTime Value was? Or their Customer Acquisition Cost?
Deer in the headlights look.
The founder tried to BS his way through the answer, then change the subject, but I’d have none of it. I turned to his junior partner, a young woman who he’d called the “brains of the business” and now a 25% shareholder, and explained the importance, as I just did for you readers.
The rest of this article is a follow up for her, but it should help you too if you have a recurring revenue business.
1. What is the LifeTime of A Customer?
Recurring revenue businesses don’t keep customers forever. Sometimes they go out of business, they move, their needs change, their budget changes, they switch to a competitor. Churn – losing customers – is normal and inevitable, but it can vary from 5% a year (great!) to 95% a year (disastrous).
It’s hard to be accurate about churn rate when your company is young and you haven’t had customers for very long. It’s also hard to be accurate if you have a relatively small number of customers, because individual random events can distort the long term picture.
But don’t let that keep you from making a first guess! You can get more accurate over time.
a. Good First Estimate of Churn
Count all of the customers you lost during a particular time frame, such as a month, or three months, or six months, or a year. Make sure you pick a time frame size that is both representative of your current business and has enough lost customers to be meaningful. For example, if you just have 100 customers and nobody has stopped being a customer in the last month, try looking at the last six months.
Let’s say that 5 customers stopped their service for one reason or another in the last 6 months.
Then, count the customers you had at the beginning of that time frame. Let’s say that six months ago, you had 85 customers, 5 of whom stopped service since then.
Divide Churn by the beginning number of customers:
In this example 5/85 = 5.9% churn for 6 months. As a first guess, you have annual churn of about 12% by multiplying the 5.9% rate for 6 months times two for a full year.
b. Better Estimates of Churn
When you have lots of customers, and you are growing rapidly, churn calculations can get pretty tricky. Here are some of the reasons why:
- Every month you’re adding new customers, but some of them might immediately churn
- Actual churn can vary month to month for random reasons
- Figuring out what that customer number is for the bottom of the equation can be tricky and yield different results if you are looking at daily, weekly, monthly and quarterly churn rates.
It’s enough to make your stomach churn with anxiety!
If you want to learn more, here is some suggested reading on other blogs:
- Profitwell has an extended description of an old Shopify blog post on churn that shows four different approaches, starting with the simple one above
- Evergage compares customer churn and revenue churn, which is relevant if your customers are growing their average revenue over time
- Lesschurn.io dives into subtleties like customers who quit then return, or customers who upgrade or downgrade when there are multiple pricing plans.
My advice: start with a simple estimate, then improve it over time. Don’t let perfect be the enemy of good enough and done for now.
c. Turning Churn Into Customer Lifetime
Here’s the simple equation for turning Churn into Lifetime, courtesy of VC David Skok:
Applying this to our example of about 12% annual churn, the lifetime is 8.5 years. That’s a long time!
2. Calculating LifeTime Value
We’re close to the LifeTime Value answer now! But first, you need to calculate the average gross margin (gross profit) per customer. Why?
The value of an added customer when you are growing is their contribution to gross profit: revenue minus cost of good sold (COGS). That’s because adding just one more customer doesn’t increase overhead. Importantly, it is NOT total revenue.
Let’s assume your accounting system is correctly measuring revenue and cost of goods sold. (Although, you know what they say about ASSUME – it makes an ASS out of U and ME.)
a. Good Gross Margin Estimate
For the period of time used to calculate churn rate, add up revenue, subtract your Cost Of Goods Sold (COGS), calculate average monthly gross profit, then divide by the average number of customers for the period.
To keep with this example:
Six months revenue = $53,802
Six months COGS = $26,331
Six months gross profit = $53,802 – $26,331 = $27,471
Average monthly gross profit = $27,471 / 6 = $4,578.50
Average number of customers = 91.5
Average monthly gross profit per customer = $50.04
b. Better Gross Margin Estimates
If you plan on increasing revenue per customer over time as you add products with different gross margins, this calculation is going to get trickier.
Also, if you are retaining customers over very long periods such as in this example, you may need to use Discounted Cash Flow analysis to satisfy your inner MBA.
But don’t worry about that now if you have never made a first pass at estimating LTV.
c. Finally! Calculating LifeTime Value
Now we just need to multiply the “Value” times the “Lifetime,” making sure that the time scales are the same. In other words, Value Per Month times Lifetime in months, or Annual Value times Lifetime in years. In this example:
Annual Customer Value = $50.04 per month x 12 months = $600.46
LifeTime Value = $600.46 per year x 8.5 years = $5,103.90
In this case, then, the average Lifetime Value of a customer is a bit over $5,000. It’s a current estimate, no more, no less. You can be sure of just one thing: it will change over time!
What’s Your CAC
Calculating your Customer Acquisition Cost (CAC) can also be a bit tricky, especially for small and young companies that aspire to be much larger through rapid growth. Here’s the simple formula, again courtesy of David Skok:
The reason it can be tricky is that when you add up all of your marketing costs, including the salaries of marketing and sales people, and one-time costs like initial web design and graphics design, it’s a much bigger number per customer than when you are bigger and growing rapidly.
Stepping back for a moment, what you’re trying to figure out is whether or not you are ready to invest lots of dollars in acquiring valuable new customers. So the marketing costs you should be measuring should include variable costs such as digital advertising and social media campaigns, as well as a piece of salaries that will have to increase as you grow and the marketing needs to be managed.
Let’s continue with our example here. For the past six months the company has been spending $1,500 per month on an outside marketing campaign. In addition, the company estimates $750 per month in salary plus overhead has been spent on marketing and sales. During that time, 15 new customers were acquired.
Sales and Marketing Expenses = ($1500+$750) x 6 = $13,500
New Customers = 15
CAC = $13,500/15 = $900
The initial guess here is that it costs about $900 to acquire a new customer.
Is LTV > 3 x CAC?
In this case, the first estimate initially looks positive. Even with a modest marketing budget, new customers are being acquired for $900, and LifeTime Value is about 5.6 times that number.
But there is a problem with a metric I haven’t yet talked about.
How many months does it take to recover that investment in customer acquisition?
The math is simple: divide CAC by monthly per customer Value. In this example,
Months To CAC Payback = $900 / $50.04 = 18 months
Ideally investors want 12 months or less to recover CAC. And so should you if you’re investing company resources into marketing. Why?
You are still operating a high risk business, in which the marketing environment and the competitive environment is going to change. Constantly.
So while you might want to believe that the average customer is going to be around for 8.5 years, in fact the world will change dramatically in that time so you really don’t know.
Think about it this way: would a bank lend your company money for 8.5 years? Probably not. And you might not either. Short term recovery of investment better aligns with your risk.
Invest In New Customers Now Or Marketing Improvements First?
Hopefully by following the detailed steps above, you’ve been able to take some initial steps towards figuring out if your marketing is ready to scale, or you still need to tweak it to profitability.
If you’re not quite ready to spend millions on your current marketing program because it isn’t yet profitable, don’t worry. That’s common.
But it’s important to be honest with yourself, and with potential investors, about where you are in the process. Because premature scaling after taking lots of investment is a major cause of post-funding failure.
Seed investors understand that companies are on a trajectory of learning about profitable marketing. And they will invest even if LTV < 3 x CAC today, knowing that you are disciplined in measuring and managing your marketing effectiveness.
But if you aren’t disciplined, and measuring, and managing, you won’t get investors on board.
And if you’re bootstrapping, shouldn’t you be as tough on yourself as investors are?
Be Your Own VC and analyze your numbers to make sure you aren’t pouring your marketing dollars down the drain.