The three key things you need to know to build a great startup

The three key things you need to know to build a great startup

Tl;dr: The three things that matter for a startup is CAC, LTV and Payback time. Nothing matters if these things don’t work.

What’s a great startup? It’s one that makes money. You like to get featured in TechCrunch, you want to make money.

I’ve been studying startup for ten years and I’ve figured out that there are only three things that matter when figuring out if a startup is viable. I’m going to share it with you. You need to get it in your head.

And wait… yes, there are a lot of other things that matter (market size, solving a problem, capability of team etc.), but when I’m thinking about a new business these are the things I focus on to triage.

So what are the three things:

  • How much you acquire people for = CAC
  • How much you make from them = LTV
  • How long it takes to cover the cost of the CAC and recycle the money = Payback time

So the secret revealed. Let’s dig into them a bit.

Now, just to be clear, this involves some metrics and some nerdy stuff. I am NOT going to go on a math rant. This blog is just going to highlight what matters. This ain’t going to be a math class. If you are interested in that sort of thing, read this and other stuff on my blog: LTV/CAC: Credit Suisse approach to SaaS Customer Unit Economics

CAC

CAC is Customer Acquisition Cost. It’s what you acquire customers for in $ (I always use dollars: Use Dollars in your startup, especially for your financial model).

Now there are two ways you want to think about CAC:

  • Basic CAC: This is the direct marketing spend. You spend money on SEM and Display, you divide that amount by the number of say, paying customers, and you have the CAC
  • Fully Loaded CAC: Now things get a bit more complicated. Knowing how much you blow on Google on FB is easy as you get an invoice. To acquire customers you are going to have consultants, full-time managers, those that execute on marketing and even software costs. You pay them to get you customers. If you really want to understand your true CAC, you need to bake in all the costs. No one can really agree on the real calculation, but chuck in your staff that is focused on acquiring customers to the paid marketing cost to get a better idea of the real cost of acquiring a customer.

Do not be delusional when approximating your acquisition cost. It matters a lot. Trying to deflate the number will screw you. It’s much better to round up, than round down.

Yes, your CAC will be higher once you start hiring people as their cost needs to be amortized over customers. Think carefully about your direct marketing budget to headcount. Headcount is an enabler or marketing spend and effectively dead wood. But your efficacy of spend is crap if you have crap people. Balance your budget.

A low CAC is good

A low CAC is seriously cool. There are lots of ways to make it lower. Here are a few:

  • SEO:  You ‘earn’ these through backlinks, content marketing and the like. You really do want to build this ‘engine of growth’, but invest early as it takes a long time to get going
  • Virality: Ok, the viral thing. True virality is rare as balls. Do not think it will just happen. It won’t. If you can get any element of virality, cherish it. A tiny viral element can decrease your aggregate CAC. That is awesome. (I’ve done a lot of advanced research on virality. Check this out: How to model viral growth at your startup)
  • Email/Social/etc: Yeah, there is a load of things you can do to decrease paid spend. Do it.

A CAC will only get larger over time

It’s really important to understand that your CAC will get bigger over time.  A lot of founders think that it will get smaller.

Nope. It won’t.

You target keywords, whatever, and you tap out the search volume. So you start picking less relevant words which will have lower CPCs and conversion. This means higher CAC.

As you grow more you need to increase your margins to compensate for higher CACs. You need to be able to find economies of scale… everywhere.

I did a fab interview with a founder that struggled with just this fact. He tapped out his market and his CAC.

High CAC is bad

A high CAC is rarely if ever a good thing. Startups which have the highest CAC are going to be when you have an enterprise sales cycle (meaning long as balls). Gosh, can you imagine having a 13-month sales cycle? Like, it takes over a year to close a deal! A lot of people do. I know because I’ve done this kind of sales before.

One downside of a high CAC is that you need to have a bankroll to keep the lights on whilst you are waiting for the cash to come in. You’re going to be paying salespeople, support systems and all your other costs. Until you have the cash rolling you are going to struggle.

The upside of a high CAC is you might have a huge ROI in your LTV. Say you blog $150K in CAC to close a deal, but they pay you license fees of $3.5m, that’s pretty awesome. But good luck making that happen and getting the funding in the short term. I have no idea how people build enterprise companies. My hat off to those that do. I’m not kidding.

LTV

The next big thing that matters is how much money you make from your customers. LTV is short for Life Time Value. Both CAC and LTV can be calculated in complicated ways, but let’s skip that. Ultimately what you want to know is are people paying you and how much.

Are you making $50 or $5000? That’s tough to answer as you probably don’t know what your churn rate is going to be, just to get started. Don’t be ambitious here in the absence of empirical data.

LTV matters because it’s how you get rich. A big LTV means more Bentleys. It also lets you know how much of a CAC you can afford. You might be happy, for various reasons, to have a CAC the same as your LTV to grow market share. Under no circumstance do you want your CAC to be more than your LTV as you are flat out losing money. That’s only the sort of thing you might temporarily do whilst blowing VC money and figuring out your market channels… but only for so long.

Payback time

Now, the final thing that really matters is how long it takes to cover your CAC. Does that take one month or three years?

If you are able to cover the cost of your marketing to acquire customers the cool thing is that you can recycle the money to keep acquiring more customers.

Let me explain so you really get it.

Let’s say a customer pays you $50 per month. You figured out how to acquire customers cheaply as you have a really high NPS and your customers are making referrals. Let’s say your CAC is $50. This means it took you one month to cover your marketing cost. Let’s forget about the costs of keeping the lights on and your COGS. This means if you keep a customer for 3 months (not great, but who cares) you make $150. So one month covers your cost to get the customer and you get $100 to get 2 more customers. If you keep that going then the new two customers get you two more, then each gets you two more and so on. Your business starts getting large pretty fast.

Now let’s say that things are not quite so peachy. You are still making $50 per month from a customer but your CAC is $600 = 12 months payback. It now takes 12 months before you can start recycling the money from a customer and another year before that customer pays money to cover the cost of a new customer. This is clearly far less productive in attaining your goal of getting rich, and fast.

Your payback time is an output of the ratio between your CAC and LTV.

What’s good on the menu?

Now you know what matters, you are probably wondering what numbers are good for these three key factors.

The flippant answer is: low CAC, high LTV and short payback time. Duh…

If you are starting out then a CAC of $1000 is likely to bankrupt a lot of people. If you are rich, then maybe you don’t care. You need to fund your initial CAC out of your savings, so personally, I would like a CAC lower than $100.

You want your LTV to be large. I think about 1-year LTV and use that when thinking about the CAC I want to spend because, let’s face it, a lot of startups are dead in a year. I don’t want a CAC more than my one-year LTV, max. Ideally, I would be able to cover it with say 3 months of a SaaS-like payment. For ecom I want to be profitable on the first purchase as I’ve no idea if there will be a second (depending on what you are selling). If you are running a little Shopify site, then this applies, if you are running something like an Amazon-like site like I have before, then you are going to have to assume repeat purchases.

The general rule for a SaaS company is a payback time of 12 months is fundable. Clearly, a shorter one is better for marketing recycling purposes. For a side hustle business, I would want it to be a few months.

A word of caution

Your CAC and LTV calculations are rarely easy to calculate and neither are they accurate. You, therefore, need to be ballpark right with a degree of inaccuracy. Don’t think your numbers work and start hiring a tonne of sales guys.

LTV:CAC ratios are to be used, not believed.

You will have a much better handle on your numbers as you get larger and have numbers nerds to do calculations (AKA business intelligence). You will start getting experience by reviewing cohorts and that’s the best way to know. But, it takes time.

There are three stages in a scalable company:

  1. Figuring out product / market (/founder) fit
  2. Figuring out a scalable business model
  3. Scaling that business model

It’s only going to be at the end of phase two that you will ever have a strong command of the numbers.

I have written a few blogs about the fact you can know before you start if a business is going to work. I never start a company before I have an idea of those numbers.

Here is the logic for a potentially large startup I’m going to start.

  • LTV: My target niche has a high propensity to buy things. I reckon I can get maybe 18 months out of them (I know similar businesses in a related sector failed as they have a 3-month LTV) by offering targeted services that they need. There are a lot of people in the niche. I’m betting I can get a solid LTV in months purchased, even before I know what my margins are
  • CAC: My partner is a marketer. He knows how to target the hell out of these people. There are very particular things we are targeting for. Targeted means low CAC. I don’t know what the CAC might be yet, but the fact we can be super targeted is all I know to make it worth the time to dig into this industry.
  • Payback time: If my CAC is reasonable and I have a long LTV I know I will make money on customers. I don’t know what the payback time will be exactly, my guess is 6 months at a reasonable scale of marketing (once we are a little less efficient)

I don’t know anything about the industry and I’m not ideally suited to it. But I’m interested solely because I know it solves a real problem for a lot of people, AND my unit economics sound really compelling from what I theorize; the three things.

Conclusion

I don’t write stuff that I don’t do myself. These are the three key things I care about financially before I am willing to spend any time on a business myself. They are the things I want to know from my clients. They are the things you should care about too. They are all that matter at the end of the day.

Read this blog on being dispassionate about how you allocate your time to get an RoI on your time: Passion is over-rated. Build a better mousetrap instead

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