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Guest Blog

Avoid This Leading Cause of Startup Death

I’ve taught CAC<LTV to my students at Stanford and to social entrepreneurs at Miller Center for more than a decade. In that time, it’s gone from being a little-known concept to being an often-misunderstood concept. So here are a few updated thoughts.

A quick review of the concept:

A business is an engine that attracts customers, delivers something of value to them, and then extracts that value in the form of profits. That’s what a business is. And so it logically follows that the cost of attracting a new customer needs to be less than the value we can extract from that customer. If it costs us $15 in advertising to get a customer, and we can only make $7 from them, then Houston, we have a problem. But if it costs $15 to get them, and then once they are a customer, they make a bunch of repeat purchases that yield $75 in profit, then we are happy. Ultimately every venture of every kind has to have a Customer Acquisition Cost (CAC) that is less than the Lifetime Value (LTV) of a customer. It’s a simple, self-evident concept.

Yet it’s a leading cause of startup death.

A high percentage of startups die because their cost of getting customers turns out to be higher than they can make from them. Partly this is just because we’re all optimists — we all think our startup is so awesome that people will flock to become customers and they will remain customers forever. But eventually, that optimism fades as we realize that marketing is expensive and no customer stays forever. The immutable laws of economics set in, and at some point, many startup founders find that their LTV/CAC ratio is slowly draining the bank account. To paraphrase Ernest Hemingway, Startups go broke two ways: gradually, and then suddenly.

Investors tend to obsess on the LTV/CAC ratio.

Obviously, investors care about your LTV/CAC ratio because it’s the essence of a successful business. But it’s also a proxy for the potential ROI of their investment. If you have proof that you can spend $1 on customer acquisition activities and get $5 in value back (a LTV/CAC ratio of 5.0), investors will want to shovel as much money as possible into that engine. As a VC friend of mine says, “What I’m looking for is a just-add-money opportunity.” Having a business with a LTV/CAC ratio of over 5.0 looks like a “just-add-money opportunity” to investors.

But it’s a blunt tool that is better if sharpened.

Let’s say that during the quarter we spent $10,000 on sales and marketing and got 1,000 new customers — a CAC of $10. But probably some of those customers came through word-of-mouth, some came as referrals, some came from our PR efforts, and some came from paid advertising. So we had a blended CAC of $10, but that doesn’t tell us anything about the relative effectiveness of each of our different customer acquisition efforts. Which leads me to the next point:

Not all customers are created equal.

With every business I’ve ever run, I’ve realized at some point that 80% of our profits were coming from 20% of our customers. It’s amazing how this tends to be true with almost all businesses. So if we look at LTV (Lifetime Value) of our entire universe of customers, we’ll probably see that 20% of them have a much higher individual LTV than the rest. Wouldn’t we want to focus our CAC efforts on getting more of the high-LTV customers? Yes, we would.

Therefore, cohorts matter.

The two points above would indicate we really want to track LTV/CAC ratio by customer cohort. For example, what’s the ratio for customers acquired through Facebook advertising vs those acquired through Google advertising? Knowing that would tell us a lot about how we should allocate advertising dollars. What’s the LTV/CAC ratio for customers acquired through our referral program? Knowing that would tell us how much we can afford to offer in a referral fee. Knowing your company’s blended LTV/CAC tells you the health of the overall engine, but it doesn’t tell you how to optimize the engine’s performance for next quarter. Tracking customer cohorts tells you that.

Also, velocity matters.

One afternoon recently, I sat in the backyard of longtime Silicon Valley venture capitalist Tim Connors as he drew graphs for me on his whiteboard (only VCs have whiteboards in their back yards). He explained that he doesn’t care about the LTV/CAC ratio, per se. What he cares about is the velocity with which invested CAC comes back in the form of LTV. So he’s developed a metric he calls CACD — the D is for “doubled”. CACD answers the question, “If we spend $12 in customer acquisition activities, how long does it take for us to get $24 back?” As an investor, he wants to see a business with a CACD of less than eight months. Tim’s formula gets to the heart of an inherent flaw in the LTV/CAC ratio: it doesn’t include a time factor. A business with an LTV/CAC ratio over 5.0 might seem good at first, but if you have to service a customer for 10 years before you make back the money you spent getting him, then it doesn’t seem so good, right? Velocity matters. So think about how you can measure CACD for your business. Putting $12 somewhere where it returns with a high velocity will accelerate your engine of growth (and make Tim happy).

Summary

The CAC<LTV concept applies to every business of every kind. Every venture must have a sustainable way to get customers at a cost less than the venture can make from them. It’s an immutable law of economics. Ignoring the formula (or misunderstanding it) remains a leading cause of startup death. As legendary venture capitalist Bill Gurley once wrote in “The Dangerous Seduction of the LTV Formula”, “The formula can be confused, misused, and abused, much to the detriment of the business.” So don’t do any of those things, or it will make Bill mad.

Sharpen the tool by tracking customer cohorts, improve the formula by adding a time factor, and remember that not all customers are created equal. If you do those three things, you will have an engine of growth that makes you happy, and investors eager.

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Bret writes a weekly newsletter for entrepreneurs and innovators. You can subscribe here (and unsubscribe at any time).

Photo by Antoine Dautry on Unsplash

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Guest Blog

Here’s to keeping the magic alive. 

The last couple years have been tough on everyone as we navigated a pandemic as best we could. For nearly 3 years Miller Center went without having a physical in-residence program, and honestly, I was sort of wondering how much longer I would stay engaged. Miller Center just became yet another set of Zoom calls on my schedule that already had too many Zoom calls on it. For me, it just didn’t have the feel that it once did.

And then Monday night happened. Brigit invited us upstairs for Thai food, I walked into the room and could immediately feel the magic – it was back again! Louis was talking wine. Jose was holding court talking about ops. Steve A. was in the corner helping an entrepreneur with his spreadsheet. Ed was talking strategy. The brainpower and passion in the room was giving off the unmistakable smell of magic being forged.

For me, this has always been the essence of Miller Center. Silicon Valley’s smartest women and men, huddled in a corner, investing themselves unconditionally in social entrepreneurs from around the world. Innovation has always been the result of moments of serendipity. And those moments of serendipity happen when a group of ridiculously smart people are immersed together on campus.

Monday night was it. Thank you for reminding me that the Magic of Miller Center is still alive.

Finally, I know that putting together a program like this takes so much more work than anyone realizes. You all labored hard to make the past week happen. Karen had a thousand details to organize, Lynne and Sharon had to wrangle recalcitrant mentors, Alex had to play money matchmaker, and probably a thousand other things that we never actually saw.

You all worked very hard to make the past week happen, and I want you to know how much we appreciated it. Truly.

So thank you. Here’s to keeping the magic alive.

-Bret

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Guest Blog

Become a Master Storyteller

If you walk into Warren Buffett’s office, you might think you’d see his framed diploma from Columbia Business School. But you won’t. Instead, you’ll see proudly displayed on his wall a 1952 certificate for completing a $100 course on public speaking. It was while he was a 22-year-old at Columbia that he saw an ad in the paper for a Dale Carnegie public speaking course. “I went to Midtown, signed up, and gave them a check. But after I left, I swiftly stopped payment. I just couldn’t do it. I was that terrified,” he recounts now.

Warren Buffett says that learning how to be a good public speaker changed his life.

Fortunately, he went back, overcame his fear, and today he credits that $100 course with having changed his life. “In graduate school, you learn all this complicated stuff, but what’s really essential is being able to get others to follow your ideas,” he says.

And so it is for entrepreneurs. Every great entrepreneur has the ability to tell a crisp, clear, and compelling story about what she’s working on, and why it matters.

“In the modern world of business, it is useless to be a creative, original thinker unless you can also sell what you create.” —David Ogilvy, founder of Ogilvy & Mather and “Father of Advertising”

In the world of startups, one often hears of “pitch decks” — a set of slides used for a pitch. And while most people think of this in the context of fundraising, the fact is that successful entrepreneurs are pitching all the time for all sorts of reasons. Entrepreneurs are pitching customers, recruiting employees, convincing partners, telling the landlord why he should give them a discount on the rent. Pitching skills matter.

At Stanford, I make my students give a 3-minute pitch on their startup idea. I do the same with social entrepreneurs at Miller Center. They usually grumble about being given so little time, and tell me that their idea is so amazing they need more time to properly explain it! I respond by telling them that if they can’t sell it in 3 minutes they won’t be able to sell it in 30.

Telling a short story is hard. But it is so important. It’s important because it’s a powerful tool for an entrepreneur to have, but it’s also important because figuring out how to say it short helps you to develop clarity yourself on what it is you’re working on.

“If you can’t explain it simply, you don’t yet fully understand it.” —Albert Einstein

I once met an entrepreneur at a social event and asked him what he was working on. “Well,” he said, “there are a lot of grocery stores in the country,” and then he took a long sip from his glass of wine. “Their biggest facilities expense is cold storage,” he continued before having another sip of Zinfandel. Now I was intrigued. “We make a device that cuts that cost in half.”

Boom! I wanted to invest! In three short sentences, he told me the size of the market, the problem to be solved, and that he had a solution!

An inexperienced entrepreneur might have described the exact same startup this way: “We’ve developed a cloud-powered IoT device that uses proprietary algorithms to analyze operational data for mercantile customers, generating paradigm-changing results…..” I would have walked away from that guy.

Learn to tell the story crisply and clearly. Watch videos of Warren Buffett, or of Steve Jobs, or of Elon Musk. Take a public speaking course. As an entrepreneur, the ability to tell a crisp, clear, and compelling story is a skill that will serve you well.

Originally published on Medium.