You Will Stay Poor If You Don't Understand These Equations Ep 527

Summary Notes


In a discussion on the importance of high-quality data for successful entrepreneurship, the host emphasizes the need to understand fundamental business equations to make prudent decisions. He introduces two key equations vital for analyzing business growth and profitability: the first equation involves variables such as the number of new sales, lifetime gross profit per customer, and hypothetical max revenue to determine business growth potential. The second equation calculates lifetime gross profit per customer using price, margin, and churn (or number of purchases for non-recurring businesses). Through examples, including a marketing agency case study, the host demonstrates how these equations help in assessing customer acquisition costs (CAC), lifetime value (LTV), and growth strategies. He concludes by stressing the necessity of mastering these equations for any entrepreneur aiming to make informed business decisions and achieve financial success.

Summary Notes

Importance of High-Quality Data for Decision Making

  • High-quality data is essential for making good decisions in entrepreneurship.
  • Poor quality data leads to poor decisions and undesirable life outcomes.
  • Entrepreneurs must understand the basic equations of business to succeed.

"In order to make good decisions, you need to have high quality data. And if you don't have high quality data, then you will have poor decisions and you will not like the life that you end up leading."

This quote emphasizes the direct correlation between the quality of data and the quality of decisions made by entrepreneurs. It suggests that good data is foundational to a successful entrepreneurial journey and life satisfaction.

Understanding Basic Business Equations

  • Understanding business equations helps entrepreneurs identify key levers for profitability.
  • Knowledge of equations makes business owners more prudent in decision-making.
  • Two fundamental equations are often used to analyze and guide business decisions.

"And so one of the important skills or attributes that I believe successful entrepreneurs have is in understanding the basic equations of business."

Speaker A indicates that a critical skill for entrepreneurs is the understanding of fundamental business equations, which are instrumental in evaluating and steering business operations.

Fundamental Equation of Business

  • The equation includes sales velocity, lifetime gross profit per customer, and hypothetical max revenue.
  • Knowing these variables allows prediction of business growth or shrinkage.
  • Awareness of current status versus potential allows for strategic planning.

"So this equation has three variables in it. One is the number of new sales per month, which most people know. The second is the lifetime gross profit per customer, which most people have no idea. And then the third is hypothetical max revenue, which most people also have no idea about."

Speaker A introduces a fundamental business equation that incorporates three critical variables: new sales per month, lifetime gross profit per customer, and hypothetical max revenue, noting that most people are unaware of the latter two.

Scenarios of Business Growth and Equilibrium

  • Businesses may be shrinking, growing, or at equilibrium based on the fundamental equation.
  • Shrinking businesses are making more than their hypothetical max revenue.
  • Growing businesses are making less than their hypothetical max revenue but have the potential to double.
  • Businesses at equilibrium provide a stable platform for accurate future projections.

"The flip side is, if I have a company that has a million dollars a month and they're currently doing $500,000 a month, then I know that they're going to be growing, and then they will cap at a million."

This quote describes a scenario where a business is currently underperforming relative to its hypothetical max revenue, indicating potential for growth up to that maximum threshold.

Calculating Lifetime Gross Profit Per Customer

  • The lifetime gross profit per customer is a key metric for understanding business profitability.
  • For recurring businesses, the formula is price times margin divided by churn.
  • For non-recurring businesses, the formula is price times margin times number of purchases.

"Now, the second is, how do we actually figure out what the lifetime gross profit is per customer? All right, so you've got price times margin divided by Churn."

Speaker A introduces the formula for calculating lifetime gross profit per customer in recurring revenue business models, which is essential for assessing the long-term profitability of each customer.

Understanding LTV to CAC Ratio

  • LTV (Lifetime Value) to CAC (Customer Acquisition Cost) ratio is a critical metric for businesses to understand the profitability of acquiring new customers.
  • A high LTV to CAC ratio indicates a strong return on investment for customer acquisition efforts.
  • Knowing the LTV to CAC ratio allows businesses to make informed decisions about marketing and sales strategies.

"If you know that it costs you $10 to acquire a customer, then you have a 15 to one LTV to CAC ratio, which is awesome, right? Which is high five."

This quote highlights the significance of knowing the cost to acquire a customer and the resulting LTV to CAC ratio, which in this case is very favorable at 15 to 1.

Importance of Knowing Business Numbers

  • Many businesses lack knowledge of their key financial metrics, which hampers decision-making.
  • Understanding these metrics is essential to evaluate the effectiveness of marketing and operational strategies.
  • Businesses need to be aware of whether their performance numbers are considered good or bad to make informed decisions without relying on external judgment.

"But a lot of times, people don't know what these numbers are. And so then they can't make decisions."

This quote emphasizes the problem of businesses not knowing their key financial metrics, which leads to uncertainty in decision-making processes.

Calculating Gross Margins and Churn Rate

  • Gross margin is calculated by understanding the cost versus the selling price of a service or product.
  • Knowing the churn rate, which is the percentage of customers who stop using a business's service over a certain period, is crucial for projecting growth and customer retention.
  • The churn rate is calculated by dividing the number of churned customers by the total number of customers.

"Based on their new units per month, we know that we can go 120 divided by churn, but we don't have the churn percentage. But we do, because 50 over 380 is your churn percentage, which I'm guessing is going to be like 13 or something like that."

This quote illustrates the process of calculating the churn rate, which is necessary to forecast the maximum number of clients a business can maintain.

Projecting Business Growth and Equilibrium Point

  • The equilibrium point is when the number of new customers equals the number of customers leaving, indicating stable business growth.
  • Projecting the maximum number of clients and revenue is possible by understanding the churn rate and new customer acquisition rate.
  • A clear picture of current and potential growth helps in strategizing for business scalability.

"So if nothing changes about the business, their churn stays the same, their number of new customers stays the same. That's where they're going to cap out, which means that this business will do $923,000 per month."

This quote explains how to project the maximum potential monthly revenue for a business by taking into account the churn rate and the rate of acquiring new customers.

"Because this point right here is the point of equilibrium. It means that the number of new sales they make compared to the number of people that exit the business are the same."

The quote defines the equilibrium point in the context of business growth, highlighting its importance in understanding the balance between customer acquisition and churn.

Business Growth and Scaling

  • Discusses the challenge of scaling a business from a substantial size to an even larger operation, specifically targeting businesses aiming to grow to over $100 million.
  • Emphasizes the importance of understanding churn rate and sales velocity in achieving business growth.
  • Highlights the need to find new channels for growth when a business reaches an equilibrium point where new sales equal lost customers, resulting in zero growth.
  • Provides a simplified example to illustrate the concept of business equilibrium and how to calculate churn and Lifetime Value (LTV) of a customer.
  • Suggests that businesses often overlook the simplicity of scaling by increasing successful customer acquisition strategies.
  • Points out that businesses need to consider the cost of customer acquisition versus the profit made per customer to make informed decisions about growth strategies.

If you are a business owner that has a big old business and wants to get to a much bigger business, going to 5100 million dollars.

This quote highlights the target audience for the discussion: business owners with substantial businesses aiming for significant growth.

Why is that? Well, we said the churn was 13%, right? So times zero is going to be equivalent to 120.

This quote explains how a churn rate of 13% can lead to a situation where the number of lost customers equals the number of new customers, resulting in no net growth.

That is a point of equilibrium. The reason the equilibrium point is so important is that that's where we know, that's where we're going to level out again.

The speaker emphasizes the concept of an equilibrium point in business, where the rate of acquiring new customers equals the rate of losing customers, resulting in no growth.

A lot of people are like, I don't know what my LTV is, right.

This quote reflects a common issue where business owners are not aware of their customer Lifetime Value, an essential metric for making informed business decisions.

So let's say you've got a business that's doing $100,000 a month, right? $100,000 a month. Let's say price point is. I'll use simple numbers here again. So let's say it's $1,000 a month for the services, which means that they have 100 customers.

The speaker sets up a hypothetical business scenario to illustrate the concepts being discussed, using simple numbers for clarity.

So your inflow is ten and you haven't grown, then it means your outflow is ten, and then it's simply ten over 100 is 10%.

This quote demonstrates how to calculate churn rate based on the number of new customers (inflow) and the stable customer base, leading to the conclusion that if a business is not growing, the churn rate equals the rate of new customer acquisition.

Which means that we're going to make $8,000 per customer, all right? In gross profit.

The calculation provided by the speaker shows how to determine the gross profit made per customer by considering the service price, margin percentage, and churn rate.

How much is it costing you to do acquire a customer? And this is where it gets funky. A lot of people are like, well, it costs about $1,000 to acquire a customer. And I'm like, great, why don't we do ten times more of that?

The speaker identifies a common gap in business owners' thinking, where they don't correlate the cost of acquiring a customer with the profit that customer brings, leading to missed opportunities for scaling up customer acquisition efforts.

But let's be real for a second. You don't want to run a nonprofit, even though a lot of people do. But if you're in the game to make money.

This quote underscores the ultimate goal of business—to make money—and the importance of not losing sight of profitability when considering customer acquisition costs and strategies for growth.

LTV to CAC Ratio

  • The LTV to CAC ratio is a metric used to determine the sustainability of a business.
  • A minimum ratio of three to one is necessary for growth.
  • The ratio is particularly relevant in the software industry where many aspects are quantifiable.
  • It is also connected to the concept of cash flow within a business.

It's called LTV to CAC ratio. Is that three to one LTV to CAC ratio or greater is what is necessary for growth, all right?

The LTV (Lifetime Value) to CAC (Customer Acquisition Cost) ratio is a fundamental metric for assessing the sustainability and growth potential of a business. A ratio of three to one or higher is typically necessary for a business to grow.

Cash Flow Challenges

  • Recouping the customer acquisition cost can affect cash flow negatively, even if the LTV is high.
  • The example given illustrates a scenario where a customer's lifetime value is $1,200 over ten years, but the initial acquisition cost and the time to recoup this cost can lead to poor cash flow.
  • This challenge is a reason why businesses may seek outside investment.

And so your cash flow is going to be horrible.

The example highlights the issue of cash flow when the time to recoup the customer acquisition cost is significant, despite a high lifetime value of the customer. This can result in a business experiencing poor cash flow.

Strategic Financial Models

  • The concept of "money models" is discussed, which involves strategies to improve cash flow and profitability.
  • Ideas include reducing the cost of acquisition and offering upfront payment discounts to improve immediate cash flow.
  • These strategies are seen as advanced and often come with experience in business.

It's called money models, which is how can we figure out a way to make money getting this customer?

The speaker introduces the idea of "money models," which are strategies to improve the financial aspects of acquiring customers, such as reducing acquisition costs and structuring payment terms to improve cash flow.

Importance of Fundamental Equations

  • Knowing how to calculate LTV and understanding the LTV to CAC ratio is crucial for analyzing a business.
  • These equations allow for a quick assessment of a business's potential on a simple level.
  • Mastery of these concepts is essential for those looking to acquire stakes in businesses.

These are the two fundamental equations you have to know like the back of your hand. You have to know this one. And you have to know how to calculate LTV.

The speaker emphasizes the importance of understanding the LTV to CAC ratio and how to calculate LTV as key equations for anyone involved in business acquisitions or analysis.

Conclusion and Call to Action

  • The speaker hopes the audience finds the information valuable.
  • A call to action is made to subscribe to the channel if the content is appreciated.
  • The speaker expresses a desire to help the audience avoid financial struggle.

So I hope you found this valuable. You keep being awesome, mosy Nation. A lot of people are broke. I don't want you to be one of. That's why I made this. Click. Subscribe if you dig it. Don't click if you don't. Either way, love you. Bye.

The conclusion wraps up the discussion on financial models and encourages the audience to subscribe to the channel, indicating the speaker's intent to provide helpful content to prevent financial hardship among the audience.

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