LTV vs CAC: The Ratio That Runs Everything | Ep 889

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 going to 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, We're $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. And to be very clear, this is not a tactic. It's not a funnel. It's actually a ratio. And once you understand it, you 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 will 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 want to build from day one. So taken 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. Than $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 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 very 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 6-week challenge. And so what ended up happening is that we came in and I was getting leads for, you know, $5 or $10 and I would convert about 1 out of 5 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 1 out of 5 leads, meaning my CAC was $25. So cost to acquire a customer was $25. 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 had $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 very good business. Because what are you going to do next month? You're going to take that $400 and you're going to plug it into the same exact formula and you're going to make $8,000. And what are you going to do with that $8,000? Boom. You're going to 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 one where you pay $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 playing with here? So if 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 wanna 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 spend 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, but once we get our $400 back, now we're up $375. Well, what are we going to do with that? Well, inside of that $375, we've got $25 times 4 is $100. So that's 4 customers, but there's 3 of those. That's 12. Plus 3 more. So we got 15. This $375 divided by $25 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 bring? Right? And so every cycle, every spin of the wheel, we can basically 13x 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 3 distinct levels of leverage that are associated with your LTV to CAC ratio. So to illustrate the concept, I'm going to kind of tell you the tale of 2 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 because in the M&A world, LBO is a leveraged buyout, but in the gym owner 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'd get $21 for 21 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 6-week challenges and with our 6-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 3, 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 can outspend who? This guy by 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. Handle it. 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 off your customers, that 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 effect or I'm pricing people out. It 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 because for them it would still cost them about $100 to get a customer. So 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 1 out of 3 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 6 months. Not a very good business, but this is what the industry standard was. But for us, we're making $1,000 plus. And for us, if we had $300 and it costs 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, you know, $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 the next month, but we have to budget it. Now, in scenario 2 here, what is our marketing budget for this business? Well, if it costs you $100 to make $1,000, 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 going to close 2 of those leads. From those 2 leads, I knew that I was going to get, let's call it, $600 each. So I was getting $1,200 immediately from the $100 that I spent earlier that day. Now, what's going to 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 again tomorrow. Now, if I did this every day, then I would make an extra, call it, $30,000 in profit month 1. 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 lead costs went up, etc., 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, 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 6 weeks after that, we would roll those customers into a recurring membership. And then at that point, 6 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 6 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 putting together our scaling roadmap. It's breaking scaling into 10 stages and across all 8 functions of the business. So you've got marketing, you've got sales, you've got product, you got customer success, you've got IT, you've got recruiting, 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 1 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, as in like you're willing to pay money, wait 30 days to get it back. That's also because that's the interest-free time period where people will give you money for no interest. Credit cards are interest-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 3 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 going to 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 math, 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, 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 $1 billion 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 you, they pay you $100, it costs you $20 to deliver a sandwich. $80 is your gross profit. They do that 10 times, $800 is the lifetime gross profit. All right. Now what's the 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 of 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. What'd you spend in advertising? What'd you spend in labor that's associated with it? So you might have 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 costs, you add them together and then you look at how many new customers did I get last year? Maybe you got 100 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 simplest way to do it, which is revenue divided by number of total customers. Now I want to 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 is going to be. And so the end result here is that you're going to have an LTV number or 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 going to give you 3 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 3 to 1, which is you want to make sure that you're making at least $3 in gross profit per customer for every dollar it costs to get them. Okay. Now, having done business for a while now, That is only true under the conditions where you have all 3 elements of business that are automated. And you're like, what are the, what are the components of business? Basically, lead generation has to be automated. Conversion has to be automated. So sales, how are you going to get people to, to, to give you money? All right. And then you have delivery or fulfillment. These are the 3 components. They have to be automated. If all 3 are automated, yes, 3-to-1 works. Now, if 2 of the 3 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 6 to 1. Now, if 2 of them are not automated and only 1 of them is, I think you change that to 9 to 1. That's at minimum. And then finally, if all 3 are not automated, meaning you have people at every one of these steps in the process, you need to be over 12 to 1. 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? This like the checks and the Xs. 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, but there's nothing wrong with doing that, to be clear. But if you do a manual process, then you're going to have an X here. So it's going to mean you're going to have to increase your altitude to calculation. 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 think that the, 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 customer, believe it or not, always goes up over time. So you might, whatever you have today, believe it or not, is likely going to be the best cost per acquire customer you're ever gonna get. All right? Because CPMs go up over time. This is a fact of life. More competitors into the marketplace. This is a fact 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 gross 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 5 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 6th person in or 7th person in, but that new sales guy's not gonna be as good as the first 5. It's gonna take time for them to get good, for them to get on ramped. 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, he's gonna make in— he's gonna have to get reps. Same thing on delivery. You might have some star account reps on the backend that do some level of service delivery and you're gonna have to bring somebody else up to speed. But the thing is, is the business has to incur that cost immediately day 1 and doesn't always get the return on that for a few months. And so if you're at 3 to 1 and then you have these, all of a sudden, imagine this, you're at 3 to 1, 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 this, 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, you can stay in business as long as you got money. That's the rule. And so we have to make sure economics of 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 conversion rates 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 on, 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 1 is you can raise the price. Number 2 is that you can decrease costs. Number 3 is that you can have upsells. Number 4 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've bought an expensive thing, a cheap thing, you make less money. So you gotta be very careful with downsells. You could 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 a 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 ebook 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 different— and if I have a— the downsell 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 can increase the price of my table. I can decrease the cost of manufacturing this table. I can upsell a higher quality table. So I can 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 could 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 want to always double down on the model, and obviously you want to 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 want to 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 sort of put out more ads? How do I have better hooks? How do I remake my winners? We can also increase CRO. So conversion optimization in terms of our pages. So are 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, because 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 5 to 1. Wouldn't you rather put $500 in and get $5,000 back? Because now you're getting 10 to 1. And so obviously this business number 1 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? Because 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 going to get way more and you're going to 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 $1 million 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 got to be willing to pay to play.