The Formula for a Winning Startup Business Model


 

Know your customer lifetime value

 

Do you know what each additional new customer is worth to your business? A customer’s lifetime value is one of the most essential metrics for startups because it influences what you can afford to spend to acquire customers.

Startups with successful business models get this formula correct: Customer lifetime value (LTV) is greater than the cost to acquire that customer (CAC).

It sounds so simple, right? Yet startups still burn through cash on acquisition and sales costs that aren’t sustainable. Even at scale, many are unlikely to recoup enough revenue from customers to make the business model work.

Thankfully, sometimes it just works out – the startup pivots and they hit on a formula that’s in balance.  But more often than not, these are potentially fatal mistakes, because once you’re selling your product to real customers, there will be surprises. Your churn rate might be higher than you expect. Or each sale might take longer to close than you thought. Or your lead conversion rate turns out to be half of your projections.

In defense of startups, understanding LTV is one of the trickiest concepts to validate early. Startups simply don’t have the benefit of data gained by selling in volume to customers over several years. And often your acquisition cost per customer may be higher in the early years until there is traction in the market. So it’s challenging to make educated decisions.

But even though many of the factors that go into calculating LTV and CAC are assumptions, the successful startups experiment, learn, and iterate to get their numbers in their favor.

And the more the numbers are in your favor, the more you can be flexible as you adjust your business model. For many web startups, expecting LTV that is at least three times CAC is in the right comfort zone.

There are lots of ways to calculate LTV, but for startups, this is an art, not a science. I recommend keeping it a simple back-of-the-envelope calculation at the beginning using these factors:

A. Revenue per period

B. Less the cost of delivering the service to the customer each period

(this gives you your rough gross margin)

C. Multiplied by how long you expect to retain an average customer

(A-B)*C

If you are selling software at $25 per month, spend $5 a month delivering and supporting the service, and keep an average customer for 18 months, your rough LTV is: (25-5)*18 = $360. So if the cost to acquire that customer is less than $100, you are in good shape.

At some point you’ll want your calculation to be more sophisticated by adding retention rate, Net Present Value of the revenue, and other factors. But too many complications will keep you from thinking about the big picture.

Once you have your calculations, set out to validate your assumptions.

If you haven’t already done so, start by writing down your revenue model hypothesis. Use the Business Model Canvas to document your assumptions. If your LTV calculations simply won’t get the value high enough, you can adjust your model to include items that will bring LTV up. For example, adding additional services, changing monthly plans to annual plans, or adjusting pricing.

Look at industry standards and competitors for retention and churn rates to make sure you are in the ballpark. For example,  if you are selling software to small businesses it’s reasonable to have an expected retention of three or four years. What you are looking to avoid is missing the mark by a huge margin.

You can also benchmark that against public companies and others in your market. For example, mature SaaS companies with a recurring revenue stream like Salesforce.com have LTV multiples that are 3-5 times CAC.

As soon as you can, begin talking with prospects and customers. Call customers using competitive products to determine what the sales process looked like, when they switched from their prior solution, how long they had the prior solution, and how often they switch.

Stepping on the gas before nailing your business model can burn through cash and potentially lead to failure. But by making a few educated calculations about LTV and CAC, you can get closer to finding the the right business model – before any heavy investment of capital.