Understanding Your Economic Model

Your economic model is a lot more than just your simple accounting statements. When companies are scaling, things become more complex. You must understand the difference between creating economic value despite the losses and when you are just losing money.

Transcript

You’ve got to understand your economic model when you’re scaling, and your economic model is a lot more than just your simple financial accounting statements. Accounting was invented 500 years ago, and most of the time it works pretty well. For those companies we referred to earlier on who are in the steady state, the Fortune 500, your accounting statements, income statement, balance sheet, cash flow, it’s usually all you need to know about a company. When corporate America reports, all everyone wants to know is what was the EPS, the earnings per share. Equally, at the other end of the spectrum, a raw startup with no revenue, the accounts are pretty simple. You have a pile of cash, and you’re burning so much per quarter, and that’s all you really need to know until such time as you start shipping.

When companies are scaling however, it’s a lot more complex, and it gets complex really quickly. A typical scenario is a company grows from one million dollars in revenue, losing say two million year one, to ten million dollars in revenue losing five million dollars in year two. Is this good or bad? Well, revenue has gone up a lot, but operating expenses have gone up and you ended up with a bigger loss than before. If all you look at is your accounting statements, and if the purpose of business is to increase profits and minimize losses, you could credibly argue that you’ve actually destroyed value. However, if you understand your economic model, you can make an argument, maybe you haven’t. Raises another question. If it’s okay because you’re building value to go from one million to ten million by losing five, is it okay to go from one to ten million losing ten or twenty? The question we’re trying to answer is, when are we creating economic value despite the losses, and when are we just simply losing money? The job of accounting is to be able to answer that question and to be able to explain it to the rest of the management team.

Sometimes a very simple way to answer this question is just to talk about the revenue growth. A typical business has substantial fixed costs, but provided it has a high growth margin product, then logically at some point, revenue growth will produce enough margin to cover the operating losses and become profitable. Equally, a company that has low revenue growth, and is losing money, is almost certainly doomed. So it’s not unreasonable to say that a first pass proxy for how well are you doing despite the losses is to cite the revenue growth. However, it’s not enough. The metric of revenue growth doesn’t answer the question, how much extra can you spend in terms of increased operating expenses for that extra revenue growth? To answer that question, you have to dive deeper into the economic model.

There are all sorts of measures used to calculate this concept of the economic model for your business around customer costs. A lot of them go by the names of CAC to LTV, which is cost to acquire a customer, versus LTV where LTV stands for life time value. Let me give you a very simple example. A consumer business like a dating site, they have to acquire customers. The cost to acquire a customer which is CAC, let’s assume it’s $20 which means it costs this company $20 to get one new potential dating customer. Then, the revenue from that customer, say it’s $10 a month, it’s a subscription revenue business. And the typical customer stays with the company for six months before either opting out or hopefully getting married. So the lifetime value of that customer is six times ten, which is $60, so the ratio of LTV to CAC is three to one. This is a very good business. This is a very good healthy ratio. So the economic model of this company is very strong. It can invest more capital at $20 a unit to attract more customers and ultimately generate $40 of profit per customer which can then cover the fixed costs associated with the business. This is a very typical example of this CAC to LTV concept.

If you’re running a restaurant for example might be very different than if you’re running a subscription business like a dating site, or if you’re running a product company selling cars. What you’ve got to do is understand the bigger picture which is first of all you’re trying to encapsulate the relationship between sales and marketing spend, the cost to acquire a new customer, and the overall dollars or gross margin you get from that customer, over the lifetime of that customer’s relationship with you. There are lots of varieties of that. Just make sure you have the right one for your business.

Suggested Readings

Founders School || Scaling Your Company || Understanding Your Economic Model || Impact Guide (PDF).

Scott Maxwell. “Startup Growth Isn’t Rocket Science: The Key to Understanding and Boosting Your Growth Rate.” Open View Labs. Blog post. April 26, 2013.

To get a more thorough understanding of the basic financials of creating a startup, see Bill Reichert’s The Art of Startup Finance series.

The Lean Approach: Customer Acquisition and Archetypes with Steve Blank. Learn the value of keeping and growing a customer, understanding lifetime value (5:30).

Questions for You

How much revenue do I need to cover my fixed costs, such as rent, equipment, utilities, payroll, etc.?

How much does it cost me to acquire one new customer? For example, if I give away 1,000 free samples of my soft drink at a cost to me of 20-cents per sample and, in turn, sell 100 bottles at full price, then my cost per customer is ($0.20 x 1000)/100 or  $2 each. What is my customer acquisition cost (CAC)?

Calculating my LTV: How much revenue does a typical customer generate for me during the full amount of time they are a customer?

When I divide my LTV by the CAC, is the answer one or less? If so, this isn’t a profitable economic model. If it is greater than one, how many customers do I need each month to cover my fixed costs?

How much can the company afford to lose in profits in order to ramp up our scaling efforts?

How high does my gross margin have to be in order to offset losses and become profitable?

How much extra can I afford to spend in order to reach the revenue growth?

What steps can I take to make my model profitable? Reduce acquisition costs, production costs or fixed costs? Increase prices? How will a higher price affect our competitive position in the marketplace?

Tools and exercises

Calculate your CAC and your LTV for the current business model. Decipher what your LTV/CAC ratio needs to be for your growth plans to be worthwhile.

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