Defining A Sustainable Business Model
A sustainable business model is pretty easy to define… you need to make enough money from your customers to cover the costs of delivering your product or service, overhead, and profit. There are two measures you can easily calculate to see if your business will make enough money to be sustainable.
- Cost to acquire a customer
- Lifetime value of a customer
If you Google these terms you’ll see that the formulas can get somewhat complex for larger enterprises. For high-growth companies, we recommend a simpler formula to get started. You can add more depth and complexity as your business grows.
Calculating the Cost to Acquire A Customer (CAC)
The cost to acquire a customer includes all the capture costs of a customer during a period of time, divided by the number of new customers acquired. Capture costs are sales and marketing expenses. We assume that the sole purpose of high-growth companies is to expand their customer base, so all their sales and marketing expenses are dedicated to capturing new customers. Over time, you can adjust this formula by some percentage to say that a portion of those funds are dedicated to maintaining current customers.
The Cost to Acquire a Customer formula is:
Total Sales & Marketing Costs for a Period
# of New Customers Acquired During that Period
A period may be a month, quarter or year. Quarters and years tend to provide “smoother” data since it aggregates multiple periods. Months can get more volatile based upon marketing activities.
A software company sells a monthly subscription for $29 per month. It spent $50,000 in one quarter and signed up 250 new customers.
= $200 Cost to Acquire New Customer
Calculating the Lifetime Value of a Customer (LTV)
The lifetime value of a customer is the profit delivered by a customer while they remain a customer of your company. We need to define what that profit is and how long they remain a customer
The Lifetime Value of a Customer is:
(Total Gross Margin for a Period) x (Number of Periods A Customer is Retained)
We use gross margin because that is cash left over from a sale that covers overheads and profit. It is important to make sure your gross profit number is correct. Gross profit is your net selling price less any direct costs of selling a product. A direct cost is a cost that is incurred every time you sell that product. For example, if you sell a software license through a third party that charges you 25% of the app’s cost, you must deduct that amount from your selling price to determine your gross margin.
Let’s use the info from our Cost to Acquire a Customer to figure out the Lifetime Value of a Customer
The software company selling the monthly subscription for $29 per month pays out a $2 per month commission on all its subscriptions. The Gross Margin on each subscription is $27 per month. On average, each subscription lasts 3 years.
(Gross Margin is $27 per month) x (36 months) = $972
If you are just starting out and have no idea how long each subscription will last, do a Google search. Seek out terms for competitive or substitute products and just add keywords such as “how long is a customer retained” to it. You may get some results you can refine and inform your assumptions.
The Proper Ratio of CAC to LTV
The rule of thumb is that your LTV should exceed your CAC by at least a 3-to-1 ratio. Using the example above:
LTV = $927
CAC = $250
Another way to think about it is that for every dollar you spend acquiring a customer, you get two dollars to cover overhead and profit.
Why are These Calculations Important?
These calculations are important because they quantify the sustainability of your business. It is why every investor wants to know them and why the best companies track and measure them regularly.
If you are not generating sufficient margins from your sales, or your sales and marketing efforts are inefficient, you will be chronically strapped for cash. Of course, in a company’s early stage you will be spending far more to acquire customers as you build awareness of your company. But you should see a reduction of customer acquisition costs and increases in lifetime value as you retain customers for longer periods – and deploy them to help you bring in new customers.