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Keeping it simple, one equation at a time

13 October, 2015

It is lonely at the top as a startup CEO. Moreover, as an entrepreneur, one has to wear multiple hats (or turbans as the case may be) – from strategist to marketer to employer to investee to IT administrator, office manager and the janitor. Given the complexity within a startup, I often encourage entrepreneurs to simplify, focus and prioritize, which is often easier said than done, by the way.

But there is one metric that every startup should blow up and hang in their office. This is the one metric that encompasses so much of the challenge and opportunity that defines a startup. That metric is LTV/CAC; LTV being the Life Time Value of a customer and CAC being the acquisition cost of that customer.

I thought of writing this article specifically because that is the metric that either gets me really excited or discouraged about startups as I advise them, or think about investing in them. Let us dissect further.

Embedded in the very notion of LTV is the fact that the customer is a customer for life, or a proxy for a “very long time”. Another way to think about that notion is simply “retention”. Once the customer is hooked, how long does he/she continue to use the product or service. If the customer sticks around for a long time, then one could make the argument that the product/service is of real value. And on the “must have to nice to have” spectrum, the value proposition is closer to the “must have” end of the range.

If, on the other hand, the customer churns relatively quickly, then one could deduce that either the customer came on board due to a pricing discount or freebie that was offered to entice, and/or the product/service did not deliver the value that was promised. The customer in that case was really interested in the “free” and not the “mium” portion of the freemium model.

Embedded still in the LTV is the notion of perceived value. In other words, does the combination of pricing for the product and the value delivered to the customer justify sticking with the product/service. The LTV, therefore, could also provide the startup real insight into product/service pricing. The churn or low LTV could be due to high pricing (compared with perceived value), low quality (or un-compelling value proposition) or both.

The hardest thing often for a startup to do is to say “no” to a prospective customer. But it may actually be the right thing.

I am also a big fan of a concept called “negative churn”, which is a terminology often used for SaaS companies with a recurring business model. Negative churn should be a mission that every SaaS company should take to heart. It’s a measure of how many dollars churned out of the company as measured on a monthly, quarterly or annual basis. Ideally, one would want that churn to be zero from a customer standpoint. In other words, the value proposition should be so compelling that no customer should voluntarily leave the platform once they join. But even if some do chose to depart the company, there should be enough additional business from existing/go-forward customers to more than make up the reduction in revenue.

To drive the point home, assume there is Cust X who is worth $10,000 a year to a SaaS company, MJ Inc. There is also Cust Y who is worth $5,000 a year to MJ Inc. Then assume that Cust Y decides not to renew its contract with MJ Inc at the end of the year (therefore, MJ Inc loses $5,000 in ARR, or annual recurring revenue). But Cust X buys additional modules of MJ’s product and increases its annual spend with MJ to $20,000 a year. In that case, there is a net negative churn of $5,000 a year, from $15,000/year (Cust X and Y) to $20,000/year (upsell to Cust X, even though Cust Y churned out).

By the way, often the hardest thing for a startup to do is to say “no” to a prospective customer. But it may actually be the right thing. For example, if the product is sold through feet on the street sales force, the LTV of the customer has to be high enough to justify spending time and resource trying to close that sale via a relatively highly compensated sales force. So, if the customer is small and is not really going to grow into an interesting LTV customer, it may not make sense spending time with them.

At the same time, customers with very unique requirement who continuously have startups modify or customize their product, may also be time and resource sinks, even though the customer logo might look great. Do take these statements with a grain of salt. Having logos of marquis customers, more often than not, is extremely beneficial for a startup looking for street cred. But the combination of long sales cycles, as well as extremely stringent modification and integration requirements can send a startup down an unending rat hole.

Let me now focus on the denominator of the seemingly simple ratio. The CAC is an incredible indicator of everything that either resonates or does not with a potential customer before they walk in the door (literally or digitally). It’s about the marketing P’s and C’s. Is the product positioned and priced correctly? How does it compare with alternatives? And so on. But the bottom line is where in the Vitamin vs. Cancer Drug spectrum does the product reside. Does it solve a significant pain point for the customer for which he/she is willing to pay a lot for, and that too for a long time to come?

The CAC is often an indicator of the price sensitivity of the target customer. Does the discount lure them in, or the inherent value of the product does so without discounts or promotions? (Promotion obviously is necessary sometimes to simply expose the prospect to the product, even for some of the best products.) Additionally, CAC is an indicator of what I call the “virality quotient” of a product or service. In other words, how well does word of mouth works as a catalyst. Some products, like messaging or social apps, are inherently viral in nature. Other companies that don’t have an inherent viral component aim to create evangelists or ambassadors with each customer to get the word of mouth affect going.

The two terms, LTV and CAC, should not be considered in isolation. Think about it as a party, where you want everyone to show up (because it’s the place to be and be seen), and where everyone stays for as long as possible. While seemingly obvious that companies should aim for LTV/CAC to be as high as possible, it’s very hard to actually execute against that mission. I have seen companies across the globe focus much more on customer acquisition and growth, than retention (or the LTV). It’s a leaky bucket, or a hamster-on-a-wheel syndrome. No matter how many customers one adds, the same number churn out of the system every year. Plug that hole by focusing on the customer. Your mantra should be: Deliver real “pain killer” value. If you do that, not only will customers trip over each other to get to you, but they also will be customers for life and become evangelical ambassadors for your company.

(Mohanjit Jolly is a partner at Draper Fisher Jurvetson.)


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Keeping it simple, one equation at a time

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