As a business that’s trying to make money, you live and die by this evaluation: LTV > CAC.
For those that don’t know what the above means (aka me 6 months ago), it’s a more complex way of saying that in a real business, you make more from your customers than you paid to get them. Their lifetime value (LTV) must be greater than your cost of acquisition (CAC).
Let that sink in for a moment. As someone who (presumably) wants to make more money, there are two clear ways to get you closer to that Ferrari/Thailand trip/guitar studio: lower your CAC, or increase your LTV. Lowering your CAC involves things like pursuing virality, building referral engines and testing new marketing channels (which we cover extensively in Traction Book). I’ll cover that more in future posts.
For now, let’s take a look at how you can increase your LTV. Here’s a thought experiment for a bootstrapper running a SaaS software business. You hate paying for software and figure others do too, soo… you are thinking of pricing your app at $10/month. Let’s say the nearest comparable product sells for around $29/month. Where should you price it?
Let’s take a look at something completely obvious:
Yes, charging (roughly) 3x more per month means you have (roughly) 3x more revenue at the end of the year with one customer. Now before you hit the back button, let’s take a look at how this impacts your CAC.
We’ll assume for the purposes of this thought experiment that you’re somewhat of an Adwords guru and can buy clicks at $0.50. Let’s also assume that of those lucky individuals who click on your ad, 15% of them are blown away by your landing page and the value you’re offering that they sign up for a trial. Of those, 20% are so amazed with your product that they sign up for a paid account. That leaves you with a CAC of $16.67.
Not bad! In this (admittedly optimistic) scenario, you’re looking at about 1.5 months to recoup your investment in acquiring a $10/month customer, and about 2 weeks to recoup with the $29/month plan. Again, pretty intuitive.
What’s not intuitive is just how large an impact this can have on your ability to acquire more customers. Let’s say you are running your SaaS business as a bootstrapper, and don’t have oodles of VC money. In this case, you’re only reinvesting revenues into acquiring more customers. Where would this put you after a year?
Nice! After a year of work, you’re pulling in $1420 a month. Depending on your expenses, this might be enough to quit your day job – just stay away from San Francisco or New York.
Now, let’s compare the above to where you’d be if you charged $29/month and reinvested revenues into user acquisition. You know about things like compounding (you’re smart), so you take a tentative guess that charging 3x would probably result in something like 10x revenues. Let’s see how the two approaches stack up:
Um. What? That’s not a super useful comparison. Let’s try again at 6 months:
Finally, a useful graph! Who would have thought that after a year, charging 3x more would have resulted in 819x more monthly revenue than otherwise. That gets you to your financial goals a lot faster. After just 6 months, you’re pulling in nearly $36k per year!
Making real money as a business changes a lot of things. More revenue allows you to build a real business where you have the resources to invest in things like better support and new features. One of my mentors (a guy who’s built 5 successful software companies) told me that when a company would object to his prices being slightly higher, he’d respond along these lines:
“At $5/month I can’t build a real business. If I can build a real company, I can help you to blow up your business. I can provide support, product upgrades, and create more and more value for you. At $5/month, I can’t do anything real to help you build your business.”
Something to think about when pricing your next app.
Want access to the spreadsheet I used to calculate the above metrics (CAC, LTV, compounding revenue growth)? Sign up for my free mailing list – no spam, emails 1-2x per month, occasional goodies I don’t post to the blog.
Thanks to the guys at Lean Analytics for letting me get an early copy of their fantastic book, which inspired a lot of this post, as well as Kevin Espiritu and Nate Speller for edits.
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