For most companies seeking series-A or -B financing, the most important set of questions that VC's will ask are around CAC, LTV, Payback Period and Cashflow.
Whilst these measures are widely discussed, they lack clear and precise definitions; their meaning is ambiguous and vague; and they are often misunderstood by both the VC's asking and the entrepreneurs answering those questions.
This is the first in a series of articles, co-authored with a number of prominent Toronto entrepreneurs and investors, that discuss these metrics, their importance, definitions, and why they are vital in understanding the health and future performance of a company.
Jack and the Beanstalk - A Brief Interlude
I'm sure that we all remember the fairytale of "Jack and the Beanstalk". Jack trades his family's only cow for magic beans, those beans grow into a giant beanstalk, Jack climbs the beanstalk, and finds treasure plus a giant.
I'm going to use this fairytale as an analogy for CAC, LTV, Payback Period and Cashflow as it highlights many of the arguments and misconceptions that occur
(Here's the original story on Project Gutenberg)
To jog your memory, Jack lives in poverty with his widowed Mother and their one old dairy cow. The dairy cow stops producing milk, and facing a desperate financial situation the family is forced to sell the dairy cow. Jack is entrusted with this deed, but on the way to market he meets a funny-looking old man who offers him five magic beans in exchange for the cow. Returning home, Jack is delighted with this trade; his Mother is absolutely distraught.
So how is this fairytale even vaguely related to entrepreneurs, VC's, and financial measures?
Jack's Mother has entrusted Jack with an investment (the cow) and expects some form of future return from this investment, perhaps money, grain or some other source of sustenance — let's assume that she expects to sow a field with grain and reap future harvests that she can bake into bread. So Jack's Mother has a clear concept of what asset she'll receive from this investment (a field of grain), what she expects to receive from that asset (grain each harvest, resulting in bread) and how much it should cost (a cow).
Jack, conversely, has a different idea. He purchased the magic beans because the funny-looking old man told him they'll grow overnight. Wonderful! He's expecting to get many more beans tomorrow morning.
Here's a simple summary of the issue: -
Both parties have the same cost, but his Mother thinks that trading a cow for 5 beans is a dreadful trade — so bad that she actually throws them away because she perceives them as being worthless — whereas Jack's expectations of value are high for many reasons: -
- Jack expects the beans to grow overnight so he will yield a return tomorrow
- The beanstalks will yield future dividends of subsequent crops
- Those future dividends will probably occur frequently because they're magic beans that grow rapidly
- Magic beans are potentially pest resilient, so the beanstalks may last long into the future
What matters to Jack is the immediacy and size of future benefits, their frequency, and their repetition long into the future. This is exactly what matters for LTV. Customers are more valuable if they bring in large revenues, on a frequent basis, for a long time into the future (ie they are retained and Customer churn is low).
Conversely, Jack's Mother has the opposite perception. She thinks that five beans will grow into a few modest beanstalks that might yield a few beans each harvest time.
We can visualise these two perspectives and easily see the differences: -
So we now understand part of the reason Jack's Mother was so angry —both parties in this example have the same cost but different perceptions of value. Jack believes he has traded a cow for an enormous bounty of future magic beans, whereas his Mother believes he has traded a cow for a few measly beanstalks. So the return on investment for Jack is very high (a great investment), whereas for his Mother it is very low (a very poor investment).
In order to understand this in relation to startups though, we need to make some abstractions about Customers.
Customers as Assets
In general, more Customers is good, because we expect that Customers will do something with our product — whether it's buying more takeout on Foodora, viewing more ads on Facebook, or paying their monthly Netflix subscription.
These actions all bring value to our business, through direct purchases, indirect views, or subscription payments. We want our Customers to keep doing these in the future so that we gain future value from these actions. That makes Customers a lot like assets:
- You buy shares in Coca-Cola because you expect they'll pay you quarterly cash dividends
- You buy Bitcoin because you think you can sell it for more in the future as the price goes up
- Or you buy land in New Zealand because you're a survivalist and are prepping for the apocalypse
These are all assets that have expected future incomes or values that we benefit from— and we can regard Customers in the same way by quantifying their Cost via Customer Acquisition Cost (CAC) and their Value via Lifetime Value (LTV).
It takes time to convince people to use your product, buy your services, or interact with your app. These routes to acquire users all have a cost and this is quantified in the CAC. Customer‘s interactions with your product then create value, and by estimating the timing, frequency and value of these interactions, you can quantify the LTV
Just as you wouldn't buy Bitcoin for $1000 if you expect it will be worth $500, similarly you wouldn't expect to acquire a new Customer for $1000 when they'll only ever pay you $500 — this is quantified in the LTV to CAC ratio
CAC and LTV are simply two measures of how much each Customer asset costs to purchase and how much they will be worth over their lifetime, whilst the ratio of LTV to CAC is a measure of the relative value of the investment.
A Return to Poverty
Unfortunately I must remind the reader that our protagonists in "Jack and the Beanstalk" were in dire financial straits, and that the cow that Jack traded was their only dairy cow. Hence the family now has nothing but the 5 magic beans. This is where Payback Period and Cashflow become important for Jack and his Mother.
We can take our previous graph of perceived returns and use this to understand each party's perspective on timing. Let's consider the cumulative wealth that each believes they will have over time: -
It becomes clear that Jack's Mother's perception is that it's not just a lousy investment, but that it's a lousy investment that will take a long time to show any benefit, and that means that they will run out of food and starve whilst waiting for that benefit.
Conversely, Jack is confident in his investment because he perceives a high LTV to CAC, expects that the beanstalks will have grown by tomorrow, and will be yielding beans tomorrow. In other words, Jack expects the payback period of his investment to be very short and that they won't starve.
Just as it is important to Jack and his Mother that they understand the cost of an asset (CAC) and its future value (LTV), it is also critical that they consider the timing of that future value (payback period) and how that will affect their livelihood (cashflow estimations) and likelihood of starvation.
How's this Relevant to Startups?
Whilst lighthearted, this fairytale illustrates a number of issues that occur for startups when planning for rapid growth.
A startup has finite resources to dedicate to growth, and needs to clearly understand the trade-offs being made between CAC, LTV, Payback Period and Cashflow.
Like Jack, it is clear that when a startup is entrusted with an investment by a VC (or Jack's Mother), they are expected to use that investment wisely. Time, money and assets spent on growth purely to acquire Customers is wasteful if that growth is a poor investment, ie if the LTV to CAC ratio is low. We'll talk about ideal LTV to CAC ratio in a future article.
Similarly, in most cases the LTV is an estimation or assumed value, and in the same way that Jack and his Mother differed in their belief of the value of the magic beans, it's common for entrepreneurs and VC's to see very different futures with wildly different LTVs. We will also cover the subjects of CAC estimation, LTV estimation (and various different methodologies) in future articles.
Furthermore, startups are substantially asset constrained, and like Jack they may be facing starvation with only a single cow to spend on their project. It may make sense to overlook a valuable project if it absorbs all free assets and doesn't yield value for a long time, or it may make sense to pursue low value options if they yield more immediate returns. This means that startups must consider when they will receive returns, and how this will affect their cashflow.
I am working with a number of Toronto entrepreneurs and investors on articles that expand upon each of these subjects, and have developed a simple CAC, LTV, Payback Period, Cashflow calculator that illustrates these trade-offs.
We will go into the details of each of these measures; how they are defined; how they are calculated; what affects each; then discuss the strategic trade-offs that a startup must make when considering growth.
In the meantime I look forward to hearing your thoughts and comments on these topics