Avoiding Business Model Failure
The #1 reason most companies fail, even more than running out of cash, is that their business model was not viable.
We have good ideas, but bad businesses.
After spending time with hundreds of early stage CEOs companies over the years I’ve noticed that CEOs and Founders are too optimistic about how easy it will be to acquire customers. They assume that because they will build an interesting web site, product, or service, that customers will beat a path to their door. That may happen with the first few customers, but after that, it rapidly becomes an expensive task to attract and win customers, and in many cases the cost of acquiring the customer (CAC) is actually higher than the lifetime value of that customer (LTV).
The observation that you have to be able to acquire your customers for less money than they will generate in value of the lifetime of your relationship with them is stunningly obvious. Yet despite that, I see the vast majority of CEOs failing to focus on figuring out a realistic cost of customer acquisition.
A very large number of the business plans that I’ve looked at have no thought given to this critical number, and as I work through the topic with the CEO, they often begin to realize that their business model may not work because CAC will be greater than LTV.
The Crux of a Business Model
A simple way to focus on what matters in your business model is to look at these two questions:
Can you find a scalable way to acquire customers?
Can you then monetize those customers at a significantly higher level than your cost of acquisition?
David Skok has developed two “rules” around the business model, which are less hard and fast “rules” and more like guidelines.
The CAC / LTV “Rule”
This rule is extremely simple:
CAC must be less than LTV
To compute CAC, you should take the entire cost of your sales and marketing functions, (including salaries, marketing programs, lead generation, travel, etc.) and divide it by the number of customers that you closed during that period of time. So for example, if your total sales and marketing spend in Q1 was $1m, and you closed 1000 customers, then your average cost to acquire a customer (CAC) is $1,000.
To compute LTV, you will want to look at the gross margin associated with the customer (net of all installation, support, and operational expenses) over their lifetime. For businesses with one time fees, this is pretty simple. For businesses that have recurring subscription revenue, this is computed by taking the monthly recurring revenue, and dividing that by the monthly churn rate.
Because most businesses have a series of other functions such as G&A, and Product Development that are additional expenses beyond sales and marketing, and delivering the product, for a profitable business, you will want CAC to be less than LTV by some significant multiple.
For SaaS businesses, it seems that to break even, that multiple is around three, and that to be really profitable and generate the cash needed to grow, the number may need to be closer to five.
The Capital Efficiency “Rule”
If you would like to have a capital efficient business, I believe it is also important to recover the cost of acquiring your customers in under 12 months. Wireless carriers and banks break this rule, but they have the luxury of access to cheap capital. So stated simply, the “rule” is:
Recover CAC in less than 12 months
Most CEOs mistake a business plan to be a cost revenue projection. It is much more than that. It is the blueprint of your vision.
It is a blueprint of how will you progress, make money, run the company and grow it. It is also a voice to tell yourself and stakeholders that these are the pitstops that will lead to our final goal.
And that final goal has to be defined and put into as a milestone. It has to cover both short term and long term objectives. You just don’t make the business plan for the investors, you make it for yourself. Period.
For help with your business model, contact me at firstname.lastname@example.org
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