Million Dollar Equations

These are seven investing concepts that'll make you money. Starting with number one, lifetime gross profit compared to cost to acquire a customer. Which basically means how much money you make in profit from every person who comes into a business compared to how much it costs to get them to buy to begin with. This is the fundamental economic unit of the business. You buy attention, you buy eyeballs to get customers, and then you sell those eyeballs something that you're going to make a profit from. All the profit that gets generated from the business comes from this one ratio. And so if someone has, for example, a one to one ratio of LTG to cac, they spend a dollar and they make a dollar back. And so that's it, you know, let's say, let's say a 20 to 1. That means for every dollar they put in, they get 20 back as profit. This becomes a business that you can scale endlessly and becomes an incredibly attractive business. Getting really clear on what your LGP to cap ratio is is core to growing anything. So let's define these terms. Lifetime gross profit has a couple of components. There's lifetime and then there's the gross profit component. So lifetime is like, okay, well how many times is someone going to pay me within a products does someone buy on average over the lifespan? Shopify stores, things like that will actually just give you this metric which is like the average customer buys 4.3 times. If you have a services business or a membership based business, then it might be the average lifespan. So how many months are they going to stick with you? Now if you don't know this because you might be a smaller business that doesn't have a CRM that reports on this kind of stuff, I'll give you the back of napkin way to actually calculate this. How many customers that I have at the beginning of the month now, of these people that I had at the beginning 30 days later, what's the number of those people that I have at the end? Not the number of customers in total, because you might sell people in between. But I want to know of the people at the beginning of the month, how many of them are still there 30 days later? So if I had 100 people here at the beginning and I had 90 people at the end, then I would have 10% churn. And you're like, okay, wait, is that the number? No. What we then do is we take one and we divide it by this number, which then means that our average lifespan in this example would be 10 months or 10 intervals. Whatever interval you're measuring on because If I did this quarterly, it would be the same thing. Or annually it'd be the same thing. Number of people at the beginning, 100. Number the end, 90. I lost 10, meaning I have a 10% churn. One divided by 10% equals 10. So the average number of months that someone stays is 10 months. Everything that I'm going to show you today is stuff that you can do. Addition, subtraction, multiplication or division. There's nothing else. You don't have to be a genius to learn how to invest or build a business. So now that we just covered lifetime, now we need to figure out gross profit, which is how much extra cash do we have left over from each customer after we do a transaction. Transaction. The simplest example I can give you is if this cost me a dollar and I sell it for $2, then I have a dollar of gross profit. Now I still have to take that dollar and pay other costs. I have to pay rent, I have to pay other fees that go along. And then my margin is now squeezing from that 50% that was left over until my net margin becomes at the end of the day with widgets or physical products, it's really that simple. It's just price minus cost of goods sold. And so cost of goods sold are going to be all the costs that you have to incur specifically related to delivering the product. All you're trying to figure out is that the basic transaction, how much money you have left over. Now, with physical products, it's typically much simpler than with service based businesses. But I'm going to give you a service based example so you can still understand it, because you need to. You need to. If I sell customers for $1,000 a month, and I have a employee who cost me $4,000 per month, and each employee can handle 10 customers, that means each employee handles $10,000 per month for 10 customers. So now all we have to do is say, what is our gross margin? We're going to take the $10,000, we're going to subtract $4,000 from it, and that gives us $6,000 per month gross profit, which you'll sometimes hear expressed as a percentage, which would be 60% gross margins. Both of these are the same thing. One is an absolute number. The other percentage. You're seeing how $4,000 is my cost, this is how much I make. Subtract the two, that gives you the margin and that gives you the percentage. Now remember, we figured out what our lifetime was and we figure out how much we make per customer or how many months they stayed in that instance. Now we combine those two metrics to get the 1 lifetime gross profit. Earlier we did the 10% churn example. And so let's say that these customers stay on average for 10 months. Because this is for 10 customers. We can divide this by 10, which gets us $600 per month per customer. So I just divided the $6,000 by the 10 customers to get my. How much do I make per customer per month? So that's $600 per month per customer in gross profit. Now we said earlier that they're staying for 10 months, which means that my lifetime gross profit per customer is $6,000 of LTGP. So now I know that customers are worth $6,000. So this is important because now this is all the money I have to go spend to acquire them and run the rest of the business. This is probably one of the biggest mistakes that business owners make because what they do is they look at their lifetime revenue per customer and say, oh, as long as it cost me less than that in advertising, I'm making money. But I'll give you an extreme example to point out why that doesn't work. Let's say I sell these for $10, this pen for $10, but it cost me $9. And the average person buys 10 pence. So it's $100 in revenue, but it cost me $90 to sell the hundred. But if my team comes to me and says, dude, we're killing it, we're spending $50 to get a hundred dollar sale, we should do this all day. But what's really happening, I'm actually spending $50 to make $10 in gross profit lifetime. Not a good equation. And so you don't want revenue to confuse you. And this is like one of the biggest misunderstandings I see business owners make, which is why sometimes people, because they don't know this, they don't know why they can't grow. The reason lifetime value and lifetime gross profit get conflated or confused is because many of the most formal businesses that are out there come from Silicon Valley, which almost exclusively is tech and software. And the gross profits on software are almost always close to 100%. The two conflate. But for everyday business owners who have people, we have manufacturing, we have inventory, we have to pay for stuff to happen that isn't 100%. And so we're not doing it off revenue. We have to calculate what our gross profit is to, because that's what we run our business off of. So far we got our $6,000 lifetime gross profit. Cool. So we've got one part of this equation. This video is incredibly in depth and tactical because I break down every concept to its absolute base units. So my recommendation to get the most out of this is to watch all of the concepts, understand them, so you see how they all work together to ultimately help you invest better. And then come back through and then do each of the concepts individually so that you can apply them. So now we're going to talk about how to how much it costs to acquire a customer. This is another one that mess up. So what a lot of people do is they just look at how much it costs them to advertise to figure out how much it costs them to get a customer. That's partially true, but not completely for two reasons. The advertising budget, if you're running paid ads, for example, is only one of the many costs that go into acquiring customer. The other issue is that you're not including the labor. So let's say that we have five employees that cost in total $50,000 a month. That's the labor. And then let's say we're spending $50,000 a month in software and advertising, like Facebook ads or Instagram ads. That means that our total cost as a company is $100,000 per month for all the customers that we acquired that month. And so then all we do is you look back and say, okay, how many do we acquire over the last 30 days? Let's say this $100,000 bought us 83 customers. So our cost to acquire customer would be 100,000 divided by 83. Survey says $1,204. So this divided by that equals twelve hundred and four dollars cost to acquire a customer. Let's look at our math. If we have cost us $1,204 to acquire a customer, and that customer makes us $6,000 in lifetime gross profit. We're killing it. So that means that we have a 5 to 1 LTGP to CAC ratio. And if you're like, is that good or is that bad? Five to one is great. You want to make sure that you're always at least greater than 3 to 1, meaning your lifetime gross profit compared to how much it costs you to make that money is at least three times greater. Otherwise you'll be too constrained to scale. If this is bad, I'm just not. I don't need to look at anything else. I can just automatically toss the business out. And if this is exceptional, I might be willing to overlook or forgive some other metrics that are coming down the line that aren't as strong. But if you don't know these numbers in a business that you're buying or investing or a business that you own, find them out. So I told you earlier that I was going to give you seven. Well, it turns out that that was three of them because the ratio is one, gross profit is another and CAC is another. So we covered three. We're already almost halfway there. So number four is return on invested capital. All right, what we're looking at is how much money does it cost us to expand the business? There are some businesses, like an accounting firm, for example, that the way that they expand the business is that they just hire more accountants. There really isn't a lot of what they call capital expenses, which is why I tend to like service businesses. Now, on the flip side, if I was in manufacturing, I'd have to factor in all the machines. A new location, another build out that would go into expanding our capacity to make more stuff. Whatever business you have, and I do a lot of brick and mortar stuff. I want to know first, what's the LTGP to CAC ratio at the customer level? But then how much does it cost me to make a location and scale it? So, for example, let's say I have to put $100,000 in to open each new location. Now, underneath that $100,000 is going to be the marketing budget to launch the location. The cost to do the build out, hiring staff, recruiters, if we need that, ads for Craigslist to, you know, get new people in, Everything is included. Because once you do this enough times, you do have a pretty good idea of what that number is. You say, cool, it cost us $100,000 to open each new location. And at month six, we're here. At 12 months we're here, and at X months, we're at capacity. The question is first, how quickly do I make my money back, which is the payback period. Then what is my one year return? And then what am I making once it's at capacity? Because I want to know how much cash flow this thing kicks off. And so in this example, I love to see at least 3 to 1, ideally 5 to 1, meaning if I put $100,000 in once we're at capacity, we're at 500,000 per year in profit. I put $1 in, I get $5 out. And so this is the same concept as what we're doing here, but just at scale. So I'm not buying one customer, I'm buying a custom printing machine, how much does it cost me to build another machine that creates profit every single year? And so from a returns perspective, if I can pay my investment back, for example, in six months, after that, everything's gravy. The part that people don't want to talk about is that all of this stuff cost headspace, right? Which is that you have an opportunity cost associated with any investment. Meaning what could you have done with the same level of effort and money in the same period of time? But if at month six, I'm breaking even, and at month 12, I'm at, let's say, pacing 250,000 a year, and by the second year I'm at 500,000 a year in profit, then great. This is now a node that just kicks off cash flow year after year after year. And then I think, okay, Well, I have $500,000. What am I going to do? Open five more locations if something costs very little and makes me a lot good. Now you might be like, well, the stock market gets 10% returns. That would be putting $100,000 in and getting $10,000 back. I actually really like to see at least, I mean, really three to one, which means a 300% return per year, kind of at minimum, which sounds ridiculous, but I'm putting time and effort in. So these are not passive investments. For me, it's different. If I give someone cash and they do all the work, and then I just get dividends, then that's different. But if I'm actively working, then I have to account for all the time that I'm putting into this. And so for me, I want to make sure that I have a really strong return profile to justify the cost of time. So there's two big variables that come into fast or slow payback period. One is how much is this build out? But if you have a massive build out, sometimes it can be hard to pay that back quickly. The second is how good they are at launching. Somebody might have five locations, but not really have a new location strategy for a new city. So this happens a lot in brick and mortar chains where they've got five locations in one city and they can drive to all of them, but then they really want to expand. And going from 5 to 20 is a totally different game. Now, mind you, that's what we specialize in. But you now have to go to a new market where no one knows you and actually have a launch strategy that ideally, and this is what we like to do, fill up the facility. So I want to get to this capacity as fast as humanly possible. And sometimes that means, hey, you guys have a $10,000 budget for opening, let's put 40 into opening so that we're opening full, and then we're already at 500,000 a year run rate by month six. So if you're a brick and mortar business, by the way, and you like to scale, go to acquisition.com. and to be clear, this is for businesses that are doing at least $1 million a year in profit, ideally 3 to 5. So let's go through number five, which is payback period. Simply put, how quickly are you paid back for getting a new customer? So we talked about return on invested capital at the business level, but now I'm going all the way back down to the unit of how long does it take me to recover? The cost to acquire customer versus the CAC was $600. Well, I spent 600. How quickly do I get it back? And so if you had two scenarios, one scenario where it takes you three months to get your $600 back, versus another scenario where you put $600 in and get $6,000 in the first 30 days, which one would you rather have? Well, if both of them have the same lifetime gross profit, you'd rather get the money sooner. That number of how long it takes me to get paid back is an indicator of how cash flow positive the business is for the big fancy investors. They don't care about as much because they're working with these massive companies and long payback cycles and all this stuff. But small business owners, that's how you live and that's how you expand. What we try and do when we're looking at a business is, okay, what is the payback period? And are there some easy levers that we can do to drive it forward? I'll give you a couple easy ones. So number one is I could say, hey, with that example we gave, it was $1,000 a month. Can we just get them to pay first and last month upfront? That'd be an easy way to drive drag some of that cash flow forward, and I could break even and make my payback period one month. A second way to do that would be some sort of fee, which is I say, hey, I have an onboarding fee, an enrollment fee, initiation fee, a setup fee. But the point is that you charge a fee of some sort in addition to whatever the recurring revenue is. Third way to do it is you could have an upsell of some sort. This is structured as a fee. The other is an upsell. This one is optional this one is mandatory. Functionally, they're the same thing. We're trying to drag more revenue up front. A fourth way you could do this is that you could get financing in place, right? So you get a third party bank or financing partner who says, I would like to make interest on some of these payments that you have with your business. I will front you the whole amount that this person owes you, but I'm going to take a piece for taking on the risk. And so you basically give your risk away to somebody else. They take a fee for that, and then you get cash up front. Four easy ways that you can think about to try and decrease your payback period and in other words, get more cash faster. If we're looking at this from a timeline perspective. So $1,200 was the cost to acquire. If we spread that out the first month, I get 600, so I'm still at negative 600. And then I have another 600 that comes at month two. So now I'm at zero. So it took me two months to break even. In the second scenario, I add a fee, let's say another $600, and it's just processing fee. It cost me nothing to do this. All right? So now my first transaction, I make $1,200 back and I'm already at breaking even at zero. And then here I get my 600, but I'm plus 600 now. And so this business is a healthier business that will be more adaptable, more resilient in a downturn than this one. Let's do number six. Six and seven are real short. And then I'll give you a bonus one, number eight. So these are all about predictions. So up to this point, we've gotten a steady state of, okay, this is what the business is. 6, 7, and 8 are all about what it can do in the future. Okay, so number one that I love this one is sales velocity times lifetime gross profit, which means how many units are we selling per month? Times what are these people going to be worth to me over the lifetime? Now, you can also do this as LTV as well, because that's also a good metric to at least understand, especially if sometimes margins can improve with scale. So that can be helpful to just know both. Let's say that I sell 100 customers a month times $6,000 in lifetime gross profit. And it was $10,000 in lifetime value, right? Which is how much revenue they're going to generate, remember, because we still had all the costs associated. The nice thing with this is that we can see, especially with this one, where the revenue of the business is going to be at scale, because especially if you have a recurring revenue business, it might take time for them, for the business to actually get to its hypothetical max. And so the assumption here is that if nothing else changed in the business, they don't sell more customers and the customers don't become worth any more than they already are. Where will this business even out? And so in this example, $1 million a month. Now this is why this is so important. If someone comes to me and they're doing 500,000amonth and they have these metrics, then I know that the business is going to double without doing anything, which is great. On the flip side, if a company comes to me and has these metrics, which it still could, and it's doing $2 million a month, then I know that it's going to shrink. Means that they were either selling more units earlier on in the past and think something happened, their Facebook ads got shut down, they got a bad rap on their content, or, and this is probably the more common one, their delivery started to drop and so their churn started to increase. And so their lifetime values actually dropped per customer because they couldn't scale well. And so I can say, Even though you're at 2 million a month right now, if things keep going the way they are, it's actually gonna go drop down to a million a month. Alright. And so this gives you a really good idea of a snapshot of where someone's going to be versus where they are. So you might be wondering, how can the lifetime value of a customer change for a business? Well, if churn goes from 5% to 10%, then it means you cut your lifetime revenue in half. Tough. But that's why churn numbers in retaining customers so important, because if you go from 10% churn to 5%, you also double the lifetime revenue of a customer. And so this is why the health of the business, based on what its hypothetical max is, can change. And so the longer period of time you take the average over realistically, the more accurate will be. If you did this on a daily basis, it would be really volatile in smaller businesses. Smaller businesses are volatile. And so it's good to have snapshots of, okay, well, what was it? Trailing 90, trailing six months, trailing 12 months to get a much better idea. And you can calculate this at each of those and then you can look at all three and say, okay, well, this is what I think it really is. And all of this helps you ask Better questions as an investor. So I'm going to give you the next one, which is very similar to this one, which is sales velocity divided by churn. So churn, remember we defined this earlier at the beginning. Number of customers. And let's say it's 10% per month, okay? It's the number of customers who leave. And let's say again, we've got 100 customers. In terms of sales velocity, this means that our hypothetical max in terms of logos or number of customers that the business is going to have to sustain or maintain is going to be 1,000 customers. Now remember, we have a thousand customers. Remember it's paying $1,000 a month. Million dollars a month. These calculations work together. This tells me how much money are we going to be making when we're at our hypothetical max. And this tells me how many customers are going to have to be servicing at our hypothetical max. We're coming down and I'd say, well, dude, right now you have the infrastructure to maintain 2,000 customers, but we're going to be at a thousand. You're going to have to be looking at headcount, which sucks. On the flip side, if we've got 500 customers, we're doing 500,000amonth. And I know we're going to get to 1,000. I might say, hey, how could we scale and make sure that we don't break on our way to a thousand? Because we're going to get there in X months. That's six and seven. And now we'll go to bonus number eight. The secret bonus which wraps all of this stuff together. This equation is really in relation to how big the opportunity is. So TAM is just a fancy word for total addressable market, which is how many people could I potentially sell? And so when I'm analyzing an opportunity, its number of potential units times lifetime gross profit divided by risk. And so this ultimately gets at. How big of a company do I think this could ultimately be? If we're servicing, you know, vegan moms with three kids who like powerlifting, then there might only be 50,000 of them and someone have 50,000 potential units sold. That's assuming we get 100% of the market to buy. Now, that might not be true, but that would be. Here is what's happening. What? How many units could we potentially sell? The lifetime gross profit is, well, how much do we make on all of these people? This would give us an idea of how big the opportunity is. This is all the good stuff. The big question is, how likely is that going to Happen risk has a zillion categories, so that's beyond the scope of this video. But do I think that there is a trend? Are there going to be more vegan powerlifting moms in the future? Are they mean less vegan powerlifting moms in the future? So for example, right now I am looking at fertility stuff. Tons of people are having fertility issues. I think it's going to be a booming market in the future. So something that services anything related to fertility will probably have big tailwinds behind it. You can apply risk to each of these. So from selling potential units is okay. Is the way that we're acquiring customers something that's really risky? Are there going to be platforms that are going to change? Do we expect that this method of getting customers is sustainable? Is there key man risk? Is there somebody who's in charge of that department that if they left would be screwed? Right. All of these are factors of risk of how likely it is to happen in the future. From the lifetime gross prosper perspective, are there other competitors that could come in and undercut us? How strong is our position in the marketplace? Do we have a better product that can sustain a premium? Are there economies of scale that we can have? Or is there shrinking margins which sometimes can happen at scale? And so these are all risks that could affect our gross profit per customer over the long haul. Some people might think, okay, well, how important is tam? It is extremely important, but the ability to assess it is very limited. This is one of those important and unknown which Charlie Munger and Warren Buffett talk about a lot, which is like you've got things that are knowable and unknowable and unimportant and important. And we just want to focus on the knowable and important. The economy and interest rates, very important. Is it knowable? No. So they don't try to predict it. With tam, I see it kind of in that very important but not knowable. And here's why. The amount of companies that start with a niche and then expand and expand and redefine their customer, redefine their avatar. Most businesses have, especially the biggest ones. Amazon started as a bookstore, now it's an everything store. Facebook started as a social network for college kids and then became the everything social network. And so many huge examples start small because they want to narrowly define a problem for a specific avatar. And they expand over time. But the main point for this one is how much risk am I exposed to that is knowable? That I think could potentially break this equation from working in the future when you take the first seven and you plug that into this framework for assessing value or how big this could potentially be, then you have a very good framework to analyze a business yourself or others to potentially invest in or say I'm a no on this one dog. And by the way if you don't have something like this I'd recommend just put one Excel sheet together that tracks your numbers automatically every month because you'll get a much better idea of how your business is doing from a health perspective. Again, if you're a brick and mortar chain doing a million dollars in profit per year or more and you've got a sound model and you want to expand, we're looking for you right now. We've done super well with brick and mortar chains expanded really really big and we're just looking for awesome businesses that we can get involved in. So specifically service based businesses, million plus ideally 3 to 5 million in profit. So if that's you reach out to us we can make it rain.