You Will Stay Poor If You Don't Understand These Equations | Ep 526

And if you don't have high quality data, then you will have poor decisions and you will not like the life that you end up leading. Welcome to the game where we talk about how to get more customers, how to make more customers, how to keep them longer in the many failures and lessons we have learned along the way. Hope you enjoy and subscribe. If you're an entrepreneur, then you need to be able to make decisions. In order to make good decisions, you need to have high quality data. And so one of the important skills or attributes that I believe successful entrepreneurs have is an understanding the basic equations of business. And so what I want to share with you today are probably two of the most used equations that I use when talking to the portfolio companies that we have when analyzing decisions about what we need to do with the business, where our bottlenecks are, etc. And so I also think that understanding the equations will make you a better business owner because you'll understand the things that move the levers within how much money you're going to make into business. And so if you understand that these are the most important levers in the business, then you'll be more prudent in terms of when you make decisions around them. All right. So there's the fundamental equation that I like as a simple understanding of business, which is just number of new sales or sales velocity, right? Number of new sales. So this equation has three variables in it. One is the number of new sales per month, which most people know. The second is the lifetime gross profit per customer, which most people have no idea. And then the third is hypothetical max revenue, which most people also have no idea about. And so then if this is the equation that I want to get to, right? Because from here I can tell if business is growing or shrinking, because let's say your hypothetical max revenue is a million dollars a month, and you're doing 1.5 right now. Well, it means that at your current sales velocity and current lifetime gross profit, you're actually going to be shrinking, right? So like, ah, that's probably a company that I don't want to deal with or I'm going to know that there's a problem, right? The flip side is if I have a company that's a million dollars a month and they're currently doing 500,000 dollars a month, then I know that they're going to be growing and then they will cap it a million. So I know that this thing if we change nothing will double, right? The third scenario, which is actually probably the most common, is when people or business owners have, they're at equilibrium. So they're pretty much maintaining the same sales month over month over month. And the revenue has remained more or less unchanged. That's actually pretty beautiful because there's other stats you can pull from that with very high degrees of certainty. The longer they've been maintaining that period of time. And so then you can actually make really good extrapolations about the future, all right? And so that is equation number one, which I would just call like fundamental to doing business. You have to know how much money you're going to be making and how many of those things are going to sell. Okay? Now, the second is, is how do we actually figure out what the lifetime gross profit is per customer, all right? So you've got price, times margin, divided by turn. The alternative to this, this is in recurring based businesses. The alternative to this is simply price margin, price times margin times number of purchases. So it's like if you sell a hundred dollar widget and the average person buys, you know, three of them. And you make a 50% margin, then it's 50 times 50, you know, 50 plus 50 plus 50, which is 50 times three. And so your lifetime gross profit per customer is 150 bucks. The reason that that's so important is that if you know that it costs you $10 to a car customer, then you have a 15 to 1 LTV to catch ratio, which is awesome, right? Which is high five. Keep going. Keep doing more of that thing. But a lot of times people don't know what these numbers are. And so then they can't make decisions. They're like, should we increase our marketing expense? We do more reach outs. Are these numbers good? Right? Because people want to understand like, is this good or bad? Right? Which is kind of funny because you want to have weight for someone else's judgment on whether or not a number is good or bad. But anyways, we'll get beyond that. So when I know this, right, when I'm dealing with a company that doesn't know, you know, what their numbers are, I will walk through these two equations with them. So let's walk through one together. All right. I actually had a recent conversation with a company that had a service-based business. They were marketing agency of sorts. Cool little niche. And so they were selling $1,000 a month service. It cost them $100 a month, right? In cost. So there's price. They were selling 120 new units per month. They had 40. So these are the numbers that we knew, right? That they knew as of right now. And so from these numbers, we're able to learn a lot about the business, right? So one of these is that they have 90% gross margins, right? Based on their new units per month, right? We know that we can go 120, divided by, churn, but we don't have the churn percentage. Ah, but we do. Because 50 over 380 is your churn percentage, which I'm guessing is going to be like 13 or something like that. Let's see here. It's 13, 13.1%. Right? So I'm going to buy this by 0.13, which is going to give me my hypothetical max. Ready? This is how business really works. My friends, most of the nation, most people don't want to do this math. But this is why most people don't make money. All right. So 923 is the max amount of clients that they're going to be able to have at this current juncture. So if nothing changes about the business, their churn stays the same, their number of new customers stays the same. That's where they're going to cap out, which means that this business will do $923,000 per month, right? That's where it, that's where it'll max out, right? Cool. Nothing wrong with that. And they have 90% gross margins, right? Now there's obviously other costs that have to go into doing the business, but they probably run this at, I probably have 40 to 50% net margin because if you run a 90, you can probably cover that. Right? Just a good business. Six million bucks a year. Good business, right? And so the idea here is if they're currently, because remember, we know what their current is, they're currently at 380,000 because we have 380 active customers per month, then this business is going to be a fast growing business, right? I mean, think about, they're going to do 120 right now and their turn is 13%. They're going to be, they're going to jump to, you know, 500 next month and, I mean, it's going to, they're going to jump pretty quickly here, right? But what it'll do because of the churn is the churn will start evening out their growth, right? Because this point right here is the point of equilibrium. It means that the number of new sales they make compared to the number of people that exit the business are the same. So let me actually spell it out because I think it might be useful. Most of the nation wrote quick, if you are a business owner that has a big old business and wants to get to a much bigger business, going to $50, $100,000 plus we would love to talk to you. And if you like that, we would like to hear more about it. Go to acquisition.com and you can plan anywhere on the page and talk to one of our team and see if we can help you get there. So I said, 923 is the max, right? That this thing can do. Why is that? Well, we said the churn was 13%, right? So times 0.13, right? It is going to be equivalent to, do, do, do, do. 120. All right? Now, if 923 is equal to 120, which is the number of new sales, then it means you're going to have 120 new sales every month and you're also going to be losing 120 every month, which means zero growth. All right? That is the point of equilibrium. The reason the equilibrium point is so important is that that's where we know we can, like that's where we're going to level out again. We have to find a new channel for growth, right? Now, right now, if you're a business is plateauing, then you can make, you can make these assumptions and you can do this math about your business. A lot of people are like, I don't know what my LTV is, right? And I'll give you a simple, a simple, another example of something like that of a business and equilibrium. So let's say you've got a business to do in a hundred thousand dollars a month, right? A hundred thousand dollars a month. Let's say, you know, the price point is, you know, I'll use simple numbers here again. So let's say it's a thousand bucks a month, right, for the services, right? Which means that they have a hundred customers. Simple business so far, right? So now the question is just going to be sales velocity and churn. So let's say that they've got 10% churn and they've get and they get 10 new customers per month, right? And the thing is a lot of people don't know this number, right? Which is silly to me, but a lot of people don't know that number. But the thing is is if you are in equilibrium and they're getting 10 new customers a month, then I can tell you the churn's 10%. I don't need to, I don't need them to calculate it for me. I know, like, so you haven't grown for six months. Yes, let's average out the number of sales that you get month over month over the last six months and then it'll tell me it's been around 10. I'm like, okay, well, if you have a hundred current, right? And your outflow is 10 and you haven't grown, sorry, so your inflow is 10 and you haven't grown, then it means your outflow is 10. And then it's simply 10 over 100. It's 10%. That's the game, right? And so now you're like, well, why do I want to do all that stuff? Well, now we know what the LTV is, because again, they're probably not going to know what that number is. So we say, okay, well, $1,000, remember, times our margin percentage, right? I didn't put the margin in here. Let's just say it's 80%, right? Times 80%. And we divide it by churn, which is 10%, right? Which means that we're going to make $8,000 per customer, right? In gross profit. The reason this is important is they might be like, I don't know how to grow. I'm like, we're going to make an 8 grand per customer. How much is the costing you do a car customer? And this is, this is where it gets funky. A lot of people are like, well, it costs about a thousand bucks to a car customer. I'm like, great. Why don't we do 10 times more of that? And sometimes it's really that simple. It's like, I just, we never saw like that. I'm like, right, you're spending 1,000 to make 8. Let's play that game as many times as we possibly possibly can. Right? And if it's like, well, we can't do, we've maxed out this channel. It's like, okay, well, we have $8,000 to work with in order to acquire customers, right? But let's be real for a second. You don't want to run a nonprofit, even though a lot of people do. But if you're in the game to make money, right? Then this $8,000, right? Realistically, in order to have a sustainable business, you need to have a 3 to 1 or higher, right? It's called the LTV to CAC ratio, all right? And so, for me, I personally really don't look at businesses that have less than this. 10 to 1. And that's just a choice. You can do that. But there's tons of research studies that have figured this out, especially in the software world. A lot of things are quantified or quantitized or whatever you want to say here. Right? Is that 3 to 1, LGBTQCAC ratio or greater is what is necessary for growth. All right. And a lot of this also has to do with cash flow. So imagine for a second that you had a $10 per month thing, right? Okay. And let's say you had someone and you know they're going to stay for 10 years. Something super long, right? 10 years. I'd say that's a very long LTV. But the total lifetime value of a customer like this for 10 years is 120 months is going to be 1200 bucks, right? And let's just assume it's a digital product so that there's almost virtually all growth marks, right? Well, the thing is, you might have a 3 to 1. So let's say I cost somebody, you know, let's say I cost you 200 bucks, right? To acquire this. You're like, "Woo, I'm going to be rich, right?" What the thing is is $200 is 18 months or 20 months, rather, excuse me, is 20 months. It's going to take you 20 months to recoup off of your $10 per month, right? And so your cash flow is going to be horrible, right? Even though the business fundamentally is good. And that's why people raise capital and they take outside investors and all that kind of stuff, right? But the game is then figuring out, which is actually the topic of my third book that will come out probably in a year or so. It's called Money Models, which is how can we figure out a way to make money getting this customer? How can we figure out a way that we can do a little bit of money kung fu and figure out a way to either decrease the cost of acquisition, right? If we can get this from 200 to let's say 50, right? It's like, "Okay, well, now I've got five months." It's like, "Okay, can we put some sort of like, you know, buy three months up front, you know, or buy five months up front, buy your first year's half off, right? If we know they're going to stick." So if we did first year at 50% off, right, then we're going to have $60, right, that we're going to make up front, right? And we know that it's going to cost us $50 to make this $60. So we actually have plus 10 in cash flow for the business on the first transaction and then we can keep spending our money around and we just know that 12 months from now, this guy is going to start recurring at $10 per month, right? And then we're good to go. So this way we cash for the acquisition. And so that's the kind of little stuff that I think it just sometimes takes experience having done this a lot of times to know. But anyway, this is definitely a more in the trenches, how we look at businesses that we're looking to acquire percentages of it in the portfolio. These are the two fundamental equations you have to know, like the back of your hand, right? You have to know this one and you have to know how to calculate LTV. If you have those two equations, you can pretty much learn everything you need to know about a business on the back of a napkin. All right, so hope you found this valuable. You keep being awesome, mousy nation. A lot of people are broke. I don't want you to be wonderful. That's why I made this click subscribe if you dig it. Don't click if you don't. Either way, love you. Bye.