LTV vs CAC: The Ratio That Runs Everything | Ep 928

Everything in business changes once you understand this. All you have to do to stay in business is you have to have cash. And in order to have cash, you need to increase what you make versus what you spend to make it. And managing that ratio and the payback period of when you get that money back is gonna be the lever on how quickly you can grow and reinvest the money back into your money-making machine. - I've been in business 14 years. I have a portfolio of companies that generate, at least last year, over $250 million in aggregate revenue. And if I had to start over from scratch today, this is the most important business concept to learn or that I would focus on. Gonna be very clear, this is not a tactic, it's not a funnel, it's actually a ratio. And once you understand it, you'll really never look at business the same. And so the way that I like to think about it is that the best model will win, not the best method. And so a lot of videos that you see, a lot of trainings, a lot of people talking online, we'll talk about specific methods. They'll talk about one, this little trick that they found out, this weird way to do DMs and get into someone's inbox. Those are all methods, but methods always expire. Models last forever. And so the most enduring model is the one that you wanna build from day one. So taking to the natural extreme, what is the one thing that must be true in order for you to stay in business? You must have cash, that's it. Like the only thing that has to happen for a business to stay in business is it has to have money to continue to operate, that's it. And so if that's true, then what we wanna do is optimize our cash flow so that we never go out of business. And so as much as we wanna talk about marketing, sales, branding, all of these other things, the thing that really matters is money in versus money out over what time period. And so fundamentally the question becomes, can you afford to get more customers than your competitors can? And so that's what separates real businesses from side hustles, right? So this concept is what turns a dollar into $5, then $5 into $50, and $50 into $5,000, right? And if you can do it consistently, you win. And so the reason that businesses get outsized returns from other investments, like if you would compare a business to real estate, you can compare business to anything. Businesses get outsized returns because they have fundamental unit arbitrage, which is basically the difference between what you buy and what you sell in two different places. But what you're buying is the attention of the customer and what you're selling is a product that has gross margins associated, meaning the price versus what it costs you. And so if you can buy attention for very cheap and then sell that attention something that you make more than it costs you to get it, fundamentally that is business. So I'm gonna give you a real-world brick and mortar example that I built my whole career on this. As much as I'd love to say that this was some brilliant thing that I devised since day one, it wasn't, I actually lucked into this, which is the first time I ran a paid ad, I ran a free six-week challenge. And so what ended up happening is that we came in and I was getting leads for $5 or $10, and I would convert about one out of five leads into a $500 sale. And so you can do the math there. I'm buying attention for $5 a lead. So I'm buying attention for $5 per lead, all right? So that's the name and numbers that people give me. And I would close one out of five leads, meaning my cat was $25. So cost to acquire a customer was 25 bucks, all right? So don't get overly complicated on this. Now, what I was able to sell was something for $500. Now, of course that $500 wasn't free. I had services that I had to render with that. But because I was paying, I was making at least 80% gross margins, basically it would cost me $100 to service the customer. And so I have $400 of lifetime gross profit left over. So if you can build a business where you put $25 in and then $400 of gross profit comes out, that is a very good business. 'Cause what are you gonna do next month? You're gonna take that $400 and you're gonna plug it into the same exact formula and you're going to make $8,000. And we're gonna do that $8,000. Boom, you're gonna do it again and again. And that rinse and repeat cycle is what every business seeks to build. And this line here basically represents the time period that it takes in order for you to recycle the cash. Now, this would be an amazing business, pretty much no matter what time period. But would you rather have a business where you pay $25 today and then you get $400 in 10 years? Or would you rather when we paid $25 today and you get $400 back today? Because that means that we can multiply that cycle 365 times in one year versus only doing it once in a 10 year period. And so those are dramatically different businesses and also get dramatically different returns because the investment cycle can be sped up so much. And so this is called the cash conversion cycle. Now, what are the numbers that we're actually applying with here? So this were your business. Let me ask you a question. What's your marketing budget? Basically say differently, how much money are you gonna limit yourself on spending to put into this machine where every dollar you put in, you get $10 back out. What's your limit for how much money you would have put in that machine? Of course it's ridiculous. There should never be a limit. And so only people who talk about marketing budgets are people who aren't good marketers. Like if you ever hear someone say, what's your marketing budget? There is no marketing budget. The marketing budget is spent as much as you possibly can and then wait till something else in your business breaks. Your marketing budget should be dictated by your operational constraint of the business and your ability to deliver on whatever you're selling. That's the real marketing budget. Think about it like this. Imagine that you get paid to get customers because that's functionally what this is. You pay 25 bucks, but once we get our $400 back, now we're up $375. Well, what are we gonna do with that? Well, inside of that 375, we've got 25 bucks times four is 100. So that's four customers, but there's three of those that's 12 plus three more. So we got 15. This 375 divided by 25 bucks equals 13 customers. So one customer then comes baked into it, 13 more customers for us to go get with the cash that they generate for us. But if we go get 13 more customers times 375, how much more money does that break, right? And so every cycle, every spin of the wheel, we can basically 13 X the amount of customers we have. Now again, this sounds crazy and I understand that, but the vast majority of the wealth that I've made in my business career has come from economics that look like this. And there's nothing wrong with having, hey, we spend $25 to make $100. That's amazing. That's awesome. But I have had the material amount of wealth in my life built on significantly larger numbers. But if you have that, is it required? And the answer is it depends. So this is getting to the meat of this video, which is what I really want to get to, which is that there are three distinct levels of leverage that are associated with your LTV to cash ratio. So to illustrate the concept, I'm going to kind of tell you the tale of two businesses. And this tale is actually what I built, you know, my, my wealth off of this idea. So like, I mean, it made me a multi-deca millionaire. So maybe worth paying attention to. So when I entered the gym industry, they were running things what they called LBOs, which is funny 'cause in the M&A world, LBOs are leveraged buyout. But in the gym motor world, it was a low barrier offer. That's what it meant. Sometimes now people call it a low ticket offer, but they would go out, they would run these $21, 21 day programs, right? And this was like kind of like industry standard. That's what everyone ran. So you get 21 bucks for 20 days. And then afterwards you try and convert them from $21 into a $99 per month membership, right? And this would take 21 days. Okay, what we came in to start doing is we ran six week challenges. And with our six week challenges, we would get $600 upfront, day one. And then we would sell another $200 of supplements within the next 48 hours. And then at week three, we would get them to prepay for the year. And so we would get another $2,000. Now, of course, not every single person took every one of these upsells, but blended. We'd be looking somewhere in the neighborhood at $1,000-ish within basically the first 30 days. Now, look at the difference in economics between $21 in the first 30 days and $1,000. So if these two people or these two businesses are competing in the same marketplace, which is an auction of attention, quite literally when you're running ads, who do you think an outspend who? This guy, buy a mile. And so when we entered the space, our gyms that ran our model, not method, our model, didn't matter what advertising platform we were advertising on, could outspend the competition handily. So fundamentally, the business that can make more money from its customer than its competitors wins. And so because you make more money than your competitors offer your customers, then it means you can spend more to acquire them. And if you can spend more, then it means you have a veritable monopoly over the attention. Because think about every one of these eyeballs has a little auction that's going on in real time every day. If I can outspend everybody in my market and I can actually have the ability to deliver on all of these customers, guess what I can do? I can buy up 100% of the advertising space and have a legal monopoly over that market because I can just outspend everybody. You know, it's not like I have some network of factor and pricing people out has nothing to do with that. If anything, I make more money from customers. I can pay more to get them. I'm not undercutting them and doing competitive practices. It's the opposite. I'm competing by having a better model. And so these guys would lose money 'cause for them it would still cost them about $100 to get a customer. So you're like, wait a second, why would they pay $100 to make 21? This actually happens all the time in business. And then they'd get one out of three of these people to buy the $99 thing. And so it's really closer to $300 for them to get a $99 membership, which on average would stay six months. Not a very good business, but this is what the industry standard was. But for us, we're making a thousand plus. And for us, if we had $300 and it cost us less 'cause our offer was actually better, we were able to acquire and then continue to profit this whole period of time. So if you have these two businesses, if you're in business one, do you have a marketing budget? Of course you do, because you have to limit how much you're burning to get customers 'cause you're losing money getting them. So you have to say, okay, we're willing to spend $4,000 and we're gonna get 40 people to buy our $21 thing. That's what we're willing to spend. And we're gonna wait until we get these people to add into our recurring revenue and then we might go to spend $5,000 next month. But we have to budget it. Now, in scenario two here, what is our marketing budget for this business? Well, if it costs you a hundred bucks to make a thousand, what's your budget? You spend as many dollars as you possibly can and keep those numbers. That's how you do it. And so this is what allowed me to bankroll the opening of each of my gym facilities when I had them beyond the first one and to open all of them at full capacity on the first day, which is not common. And so basically this is what it would look like. I would put $5,000 into a bank account and I would sign a lease. And then I would start running ads for $100 a day. From those $100 a day of ads, I would get 10 leads. From those 10 leads, I knew that I was gonna close two of those leads. From those two leads, I knew that I was gonna get, let's call it $600 each. So I was getting 1200 bucks immediately from the $100 that I spent earlier that day. Now, what's gonna happen to my bank account? Well, I was at 4,900, but now I have $1,200 more. So now my 4,900 becomes 6,100 and I repeat the cycle against tomorrow. Now, if I did this every day, then I would make an extra call $30,000 in profit month one. But I was a sneaky, sneaky guy. And so instead of spending $100, I would spend $500 every day. And then with that money, there were some inefficiencies that happened, sometimes Lee cost one up, et cetera. But I would usually be able to generate upwards of $100,000 in sales within that period of time from one gym. And so with that $100,000, guess what it cost to open a gym? A little bit less than $100,000. And so I was able to finance the opening of each of my gyms by putting $5,000 into the bank account, running through this black box and then getting $100,000 on the other side in that first month. And so that then allowed me to buy the equipment. It did the flooring, I bought the sign, I did the painting, I put the lobby in place, I got my weights, I got everything I needed, the sound system, right? Merch, all that stuff set up so that at the end of the 30 days of the presale, I could then kick the gym off, completely outfitted, completely paid for by the customers that now started. And then six weeks after that, we would roll those customers into a recurring membership. And then at that point, six weeks later, the business was cash flow positive. And this is how when I was in my very early 20s, I was able to open up six locations off of the cash flow that the business was able to generate. And in such a short period of time. And so the thing is, is that every single business can build a box like this with skill. Real quick guys, I have a special, special gift for you for being loyal listeners of the podcast. Layla and I spent probably an entire quarter of putting together our scaling roadmap. It's breaking scaling into 10 stages and across all eight functions of the business. So you've got marketing, you've got sales, you've got product, you've got customer success, you've got IT, you've got recruiting, you've got HR, you've got finance. And we show the problems that emerge at every level of scale and how to graduate to the next level. It's all free and you can get it personalized to you. So it's about 30-ish pages for each of the stages. Once you answer the questions, it will tell you exactly where you're at and what you need to do to grow. It's about 14 hours of stuff, but it's narrowed down so that you only have to watch the part that's relevant to you, which will probably be about 90 minutes. And so if that's at all interesting, you can go to acquisition.com/roadmap, R-O-A-D map, roadmap. So coming back to the number one most important business concept, this is what you need to know. Number one is what, what's a customer worth to you over 30 days? And the reason I limit it to 30 days is because that's typically as long as most small businesses can handle from a cash flow perspective. It's in like, you're willing to pay money, wait 30 days to get it back. That's also because that the interest-free time period where people will give you money for no interest, credit cards are just free for the first 30 days. And so you basically are limited by your ability to get credit if you actually had no money. But if you do have some money, then still you want to recover it back within the first 30 days. That's a rule of thumb. Now, the second thing is, okay, we know what a customer is worth to us. We know what gross profit, how much we're gonna make from them after we pay the cost of delivering whatever it is that we sell. The next is what's a customer cost me? Now, what I'll be clear here is, I'm not talking about cost me to deliver. I'm saying what does it cost me to get them? So what do I have to spend in marketing, in advertising, in content, in sales commissions to get a customer in the door? And you have to know these two numbers. Number one and number two. And ideally, number one is greater than number two, right? Like we want to make sure we're making more money from customers than it costs us to make it. And the thing is, is if you don't understand your business paths, you'll continue to blame other things, right? You'll continue to blame your methods. Oh, Facebook doesn't work for me. Oh, Outbound doesn't work for me. Oh, content doesn't work for me. Well, imagine you're in this scenario, right? Is it actually an issue with Facebook ads? Is it the ads that aren't working? Is it the method that's not working? Or is it the model? You have a model issue. If you could make hypothetically a billion dollars from a customer, you could spend 12 cents to reach every single person on earth and just try to get one customer. That would be a business that could probably spend a lot of money. Now, I've been hiding the real words for this, but thankfully, business actually has a term for this, which is the lifetime gross profit, which is LTGP. Sometimes people refer to this as LTV or CLV, customer lifetime value, lifetime value. All of these more or less mean the same thing. What's the amount of money you make after you spend whatever you gotta spend in delivering for the customer? What's the extra cash on top? If they pay you a hundred bucks, it costs you 20 to deliver a sandwich, 80 bucks is your gross profit. They do that 10 times, $800 is the lifetime gross profit. All right, now, what's a customer cost me? This is CAC, this is cost of acquiring a customer. That's what that stands for, all right? So, this is our ratio of LTV to CAC. Here we go. Now, if you can do this math for yourself, and I'll give you the back and napkin way of looking at this 'cause you're probably like, "I don't track this stuff," and that's okay. Look at what you spent in marketing for all of last year. Okay, so do a whole year, very simple. You can just look at the line item. Would you spend in advertising? Would you spend in labor that's associated with it? So you might have a videographer, your contractor. You might have spent some money on ads. You might have spent some money in commissions. Everything that it takes to cost to get a customer, okay? All of those cost you, add them together, and then you look at how many new customers did I get last year? Maybe you got a hundred customers and let's say it cost you $100,000. Okay, so that means it costs you $1,000 per customer, okay? This should make sense. That gives you how much your CAC is, and the nice thing is that CAC's the easiest one to calculate. You just literally look at your cost divided by customers, that's it. So it's total acquisition costs, number of new customers over that period equals CAC. That's it, very, very simple. Now, lifetime gross profit, a little bit tougher. I'll give you the back of napkin's simplest way to do it, which is revenue divided by a number of total customers. Now, I wanna be clear. This is going to give us our lifetime revenue. We still have to look at our gross profit here. So we would just multiply that number by gross profits. And if you're not sure what your gross profits are, if it costs you $20 to make a sandwich and you've charged $100, then your gross profit is 80, meaning 80%. All right, so you'd multiply that number by 80%, and that's what your lifetime gross profit's gonna be. And so the end result here is that you're going to have an LTV number, a lifetime gross profit number, whatever it is, and you're going to have a CAC number, on average for the last year. Now, ideally, you want the ratio between these numbers to be as big as possible. Now, I'm gonna give you three kind of considerations for this. Many of the people in the software world, the very smart Silicon Valley, people talk about a rule of thumb of three to one, which is you wanna make sure that you're making at least $3 in gross profit for a customer for every dollar cost to get them. Okay, now, having done business for a while now, that is only true under the conditions where you have all three elements of business that are automated, and you're like, what are the components of business? Basically, lead generation has to be automated. Conversion has to be automated, so sales, how are you gonna get people to give you money, all right? And then you have delivery or fulfillment. These are the three components that have to be automated. If all three are automated, yes, three to one works. Now, if two of the three are automated, right? So let's say this one isn't automated, this one is, and this one is, then I think you change that to about six to one. Now, if two of them are not automated and only one of them is, I think you change that to nine to one. That's that minimum. And then finally, if all three are not automated, meaning you have people at every one of these steps in the process, you need to be at over 12 to one. Now, you might be like, wow, that's a lot different than what I have. Right, and that's why we need to improve it. Now, you might hear this and then wonder like, wait, what degree is this like, the checks in the X's, what does that even mean? Okay. So, lead gen, something that's high leverage would be like making content. That's one to many. Running ads, one to many. Those are things that would qualify to me as being high leverage. It's not one person, you don't have manual labor that's really installed there in order, you're not limited by human. Now, if you're doing manual outreach in order to get customers, you would be limited there, right? If you have viral coefficient, it's all word of mouth and it's compounding, that has high leverage, right? So, if you were doing outreach as your primary way of getting customers, well, there's nothing wrong with doing that to be clear. But if you do a manual process, then you're gonna have an X here. So, it's gonna mean you're gonna have to increase your altitude to calculate. Now, if you're like, why do I have to do this? The reason that this ratio has to increase is because there's a number of costs that the business incurs as you scale. So, number one is the cost of getting new customers is actually gonna go up as you go to colder and colder markets. Cost of getting a customer, believe it or not, always goes up over time. So, whatever you have today, believe it or not, is likely going to be the best cost of power customer you're gonna get. All right, because CPMs go up over time, this is a fact of life. More competitors into the marketplace, this is a factor of life. And even if neither of those things are true, and you just went into colder and colder markets, as in you scaled up your advertising, you're gonna reach people that the algorithm thinks are slightly less likely than the first people that they displayed your ads to, which means it's gonna cost more because it's gonna have to show it to more eyeballs to get the same number of conversions. So, it's gonna cost you more per customer. You're going up the interest graph, right? You're going up kind of the normal curve of people who are less and less interested as you go colder and colder and spend more and more. That's number one. The second reason that this is important is that you're gonna put in layers of infrastructure in your business, you're gonna have levels of management, and these things, although they suck, still add cost to the business as it scales. And so, you're gonna need some padding in terms of your lifetime risk profit to be able to afford this level of scaling. And typically, customers that come in later are less sold on the idea and sometimes are worth less. So, they actually end up spending less money over time. And so, all of these reasons kind of compound together. And the last one, which is so important when it comes to this X mark, is that when you have people in every one of these processes, whenever you hit a point of kind of saturation, you've hit the capacity of, let's say, your sales team. Let's say you've got five guys that are proficient, they do well. Well, at some point, you're gonna have to scale your sales. And so, you're gonna bring a sixth person in or a seventh person in it. But that new sales guy's not gonna be as good as the first five. It's gonna take time for them to get good, for them to get on-ramp. Same thing when it comes to marketing. You're gonna have to have a new marketer who's gonna come in. It's not gonna be who's gonna be making concierge. You're gonna have to get reps. Same thing on delivery. You might have some star account reps on the back end that do some level of service delivery, and you're gonna bring somebody else up to speed. But the thing is that the business has to incur that cost immediately day one and doesn't always get the return on that for a few months. And so, if you're at three to one, and then you have these, all of a sudden, imagine this, you're at three to one, but then you have to bring in a new marketer. You have to bring in new salespeople, and you have to bring in new account reps. Well, all of your metrics are gonna suffer, which means all of a sudden, you're gonna go from barely being profitable to probably not being profitable at all. And so, we have to have these increases for each level of manual that enters the business in terms of manual labor, so that we have padding and cushion for cash flow in order to scale. Because the number one rule of business is, you have to stay in business as long as you got money. That's the rule. And so, we have to make sure our economics and the business support the fact that we're gonna have inefficiencies as we scale, and it's going to be lumpy, right? We have to bring in a whole bunch of new sales guys, our converts are gonna tank, but we have to have the business economics, the model to support that. Because if the only way your business works is that you're selling, you're never gonna scale. You have to fix the model. I could make 20 books and movies on what you do to increase this ratio. How do you improve it, all right? So, off the top of my head, all right? Some things that you can do to immediately make more money. Number one is you can raise the price. Number two is that you can decrease costs. Number three is that you can have upsells. Number four is that you can add downsells, which means that a higher percentage of customers who otherwise wouldn't have bought now do. So, you actually make more money per because you actually sell more people. If you start selling expensive people who would have bought an expensive thing, a cheap thing, you make less money. So, you gotta be very careful with downsells. You can add in financing, all right? This is something that pulls cash forward. Again, this is from a cash flow perspective. You can change the terms of how you collect payment. You can say, you know what? You can have payment plan, and you can pay as long as you want, but we don't start working until you pay off everything, right? There are different ways that we can structure these things that we can front load the cash in the business. You can also have cross-sells, which means that you sell them something different rather than higher quality or more of something. You actually sell something different. You sell a burger with fries rather than a bigger burger or a better burger, right? And as I'm going through these things, you should absolutely know how to be able to apply this to any business. So, if I wanted to run through this, I could raise the price of my book. I could buy in larger economies of scale to decrease the cost of the book, or I could figure out what I could do from a shipping perspective to negotiate better rates on my shipping. I could have maybe AI support so that I don't have to have as many people to manage kind of shipping issues. I could upsell a nicer version of this book. So, instead of being a digital book, I could upsell a hard version of this book, or I could give you audio and hard copy and e-book version of this book. If I wanted to cross-sell, I would sell a second book that was different than the original book. If I needed financing, which for the, you hope that people don't need financing for a book, but I could introduce financing so that people could pay for this book upfront. And so, all of these, and if I have the down-sell here, is the reverse of the upsell. People can't afford my hardback. Then I say, why don't you have one of my digital copies, which is cheaper? All right, and so, every business, you should be able to, on the top of your head, think of ways to apply this. I'm gonna do this again, 'cause I think it's worth doing. All right, what is this? This is a table, all right? So, I could increase the price of my table. I could decrease the cost of manufacturing this table. I could upsell a higher quality table, so I could say, hey, let's make this marble, right? Or I can downsell a wood or plastic version. I can cross-sell chairs or table covers that go with this thing. I can add a warranty on top of this that I can upsell or cross-sell, excuse me. I can add financing, or I can change the terms of collection. All of these things are things that can drive up the lifetime value. And if you can't go through that exercise with your business, you don't understand your business well enough. You could absolutely do this with any business. It's actually harder with physical products than it is with services. Now, of course, what every business owner wants is they want cheaper customers, because no one ever wants to admit that their business isn't that good, and the reality is most business owners want more leads, and it's usually the last thing they really need. They really need a better model so they can afford more expensive leads. And that gives you a competitive advantage. You wanting cheaper leads means that you're competing on methods, and that means that somebody else can copy your methods, and if they have a better model, they'll still outspend you. And so, the model is the competitive mode. A method is a one trick, right? And that will expire. So you wanna always double down on the model, and obviously, you wanna know what's up to date right now. Hey, if you can get customers for cheaper, let's do it. But the long-term thing is you wanna make sure you have a better model. Now, how do you decrease the cost of getting customers, all right? So, you can improve your offer, right? How do we make the thing that we have more compelling? We can improve our ad creatives, so this is better ads. So think about this in terms of volume and quality. How do I set up more ads? How do I better hooks? How do I remake my winners? We can also increase CROs, so the conversion optimization in terms of our pages, so we split testing our pages, split testing our follow-up, or split testing the scripting that we're using on the phone, are we training our team if we use phone sales? All of these things decrease your CAC. On top of this, we can go to cheaper CPMs, which is you're going to advertise in places that cost you less per eyeball. Now, again, lowering CAC is not necessarily the answer. You can lower CAC, but that assumes that you're, and again, CAC not cost per lead, 'cause you can get very cheap leads very easily. But you might not get good leads. You might not get customers if you do that. And so we really just want to maximize for our return between these two numbers. So I'll give you a hypothetical example. So let's say scenario one, LTV is $5,000 and CAC is $500. And let's say scenario two, LTV is $1,000 and CAC is $200. Which business would you rather have? Well, if you just said, "Hey, I want cheaper customers," then you'd say this, but does that make sense? No, because you're getting five to one. Wouldn't you rather put $500 in and get $5,000 back 'cause now you're getting 10 to one? And so obviously this, business number one, is the better business to own, even though it costs you more than twice as much to get a customer. And so we want to optimize for our returns, not for one specific number of, "I want the cheapest leads or I want the cheapest customers." You want the customers that are worth the most relative to what you pay. This concept, if you actually can internalize this, and actually choose to make decisions about your business like this, 'cause I'm telling you right now, most business owners optimize for this. They say, "Oh, this is getting us cheaper customers. "Let's advertise broader. "Let's make sure that we open up the top of the funnel." Well, guess what? You're gonna get way more and you're gonna get way more trash. And then all of a sudden you're like, "Man, all these customers suck." Well, that's because you're not willing to spend more to get a better quality customer. The thing is, is the higher the customer is, typically the more expanded this LTV to CAC ratio gets. So wouldn't you be willing to spend a million dollars to get a customer that pays you 20 million? Yes, and sometimes that's what it is. It costs a ton of money, but then you make so much more. But you've gotta be willing to pay to play.