The reason most small businesses are alive today is because the founder was willing to do anything to bring cash in the door. This is essential to get a business off the ground, but doesn’t scale and is why most small businesses stay small.
Chasing more revenue and customers feels like you’re building your business, but if you don’t know the inputs to the customers, you may be incurring hidden costs and wasting time and money. Particularly in a businesses with multiple products, services, and acquisition channels, not all dollars are worth the same.
Let’s look at the two vectors that influence the value of each new dollar in your business.
Every Customer Has a Cost
Think about how customers come to you: word of mouth, paid ads, founder hustle, partnerships, cold outbound. Each one has a different price tag both in dollars and time.
Word of mouth might cost nothing. Paid ads might cost $400 per lead. A founder grinding out 10 hours to close a deal may not spend cash, but is burning their most valuable resource (time).
This is Customer Acquisition Cost (CAC). What does it cost in dollars and time to acquire one new customer. Every channel will cost something different.
Every Customer Has a Lifetime Value
Some customers churn after a single project. Others stay on a contract for five years. Each of those customers is worth something different to your business with the obvious being that a customer that stays longer is both worth more and has higher lifetime value.
This is Lifetime Value (LTV) which is how much revenue a customer brings in over the course of their time with you.
LTV/CAC
If you divide the life time value by the customer acquisition cost, you get the ROI for customer acquisition. Said another way, do you make more money on a customer than it takes to get a new customer.
Where LTV/CAC gets really interesting is when apply it to each product you offer and each acquisition channel.
For example, what is the LTV/CAC of a customer who bought one module from you through a facebook ad vs a customer who was referred by an existing client and bought four modules?
You quickly start to see that there are different segments of your customers that are worth more than others.
From the trenches
An acquisition I was a part of at my last organization had this exact problem.
The owner spent his own time working with two customers that were “special”. I put this in quotes because the more you think certain customers are special, the more this whole framework will evade you.
These two customers were roughly 5% of the customer count and 15% of top line revenue. The owner spent 20+ hours a month doing custom work for these two clients who weren’t under a contract and essentially billing by the hour. The other 95% of the customers required no custom work and signed multi year contracts.
I asked why he didn’t get rid of them and the answer was always look at how much money they brought in.
Don’t just take my word for it though. This was a great thread on how this guy modeled out his entrance into a new advertising channel (cold mailers). With assumptions like this, you can go test and see what the results are. If LTV/CAC > 1, you can virtually spend infinite dollars there.
So What?
This is not sophisticated math nor is it difficult to do, but many business owners don’t think this way. They’re stuck in the mentality that the door is open for all new business.
Past startup mode, you don’t want to be open to all new business. You want to be open for business to the customers with the highest LTV/CAC number possible. This is your ICP (ideal customer profile).
If you’re an owner and haven’t considered this, this is an exercise you can do in an afternoon and will put you on a path towards better use of your time. I guarantee it.
As someone looking to buy a business, I’m doing this exercise with every opportunity in due diligence. While the first 6 months post acquisition are focused on doing no harm, understanding what customers drive the business both from an acquisition and profitability standpoint are worthwhile to know while you set a new long term vision for the company.
A few things I read this week
Hiring engineers is always a challenge particularly when you’re not technical. Next time I need to, I’m for sure doing this.
Personality tests are worthwhile to do in hiring. Its extremely well documented how certain archetypes fit different roles. The person should still screen well and have the basic prereqs, but if you need a tiebreaker, personality test is a good way to do it.
Books -
I recently read Double Your Profits by Bob Fifer. Literally a step by step walkthrough of everything you should do in your business to get better operating leverage and stop unnecessary expenses.
Also recently finished How I Raised Myself from Failure to Success in Selling by Frank Bettger. If you ever want to learn how to sell ANYTHING, this is a must. If someone were pursuing a search fund, this would be on my recommended reading list. It gives How to Win Friends and Influence People vibes, but applied to selling things specifically. Frank, coincidental or not, was friends with Andrew Carnegie.
Onward,
Brock