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.
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.