Million Dollar Equations

these are seven investing Concepts that will make you money starting with number one lifetime gross profit compared to cost to acquire a customer which basically means how much money you make in profit from every person who comes into a business compared to how much it costs to get them to buy to begin with this is the fundamental economic unit of the business you buy attention you buy eyeballs to get customers and then you sell those eyeballs something that you're going to make a profit from all the profit that gets generated from the business comes from

this one ratio and so if someone has for example a 1:1 ratio of LTB to CAC they spend a dollar and they make a dollar back and so that's it you know let's say let's say a 20 to1 that means for every dollar they put in they get 20 back as profit this becomes a business that you can scale endlessly and becomes an incredibly attractive business getting really clear on what your lgp to CAC ratio is is core to Growing anything so let's define these terms lifetime gross profit has a couple of components there's Lifetime

and then there's the gross profit component so lifetime is like okay well how many times is someone going to pay me within a product's business how many times does someone Buy on average over the lifespan Shopify stores things like that will actually just give you this metric which is like the average customer buys 4.3 times if you have a Services business or a membership based business then it might be the average lifespan so how many months are they going to stick with you now if you don't know this because you might be a smaller business

that doesn't have a CRM that reports on this kind of stuff I'll give you the back of napkin way to actually calculate this how many customers did I have at the beginning of the month now of these people people that I had at the beginning 30 days later what's the number of those people that I have at the end not the number of customers in total cuz you might sell people in between but I want to know of the people at the beginning of the month how many of them are still there 30 days later

so if I had 100 people here at the beginning and I had 90 people at the end then I would have 10% turn and you're like okay wait is that the number no what we then do is we take one and we divided by this number which then means that our average lifespan in this example would be 10 months or or 10 intervals whatever interval you're measuring on cuz if I did this quarterly it would be the same thing or annually it'd be the same thing number of people at the beginning 100 number people the

end 90 I lost 10 meaning I have a 10% churn 1 divid by 10% equals 10 so the average number of months that someone stays is 10 months everything that I'm going to show you today is stuff that you can do addition subtraction multiplication or division there's nothing else you don't have to be a genius to learn how to invest or build a business so now that we just covered lifetime now we need to figure out gross profit which is how much extra cash do we have left over from each customer after we do a

transaction the simplest example I can give you is if this cost me a dollar and I sell it for $2 then I have a dollar of gross profit now I still have to take that dollar and pay other costs I have to pay rent I have to pay other fees that go along and then my margin is now squeezing from that 50% that was left over until what my net margin becomes at the end of the day with widgets or physical products it's really that simple it's just price minus cost of good sold and so

cost of good sold are going to be all the costs that you have to incur specifically related to delivering the product all you're trying to figure out is that the basic transaction how much money you have left over now with physical products it's typically much simpler than with service-based businesses but I'm going to give you a service-based example so you can still understand it because you need to you need to if I sell customers for $11,000 a month and I have an employee who cost me $4,000 per month and each employee can handle 10 customers

that means each employee handles $10,000 per month for 10 customers so now all we have to do is say what is our gross margin we're going to take the $10,000 we're going to subtract $4,000 from it and that gives us $6,000 per month gross profit which you'll sometimes hear expressed as a percentage which would be 60% gross margins both of these are the same thing one is an absolute number the other percentage you see seeing how $4,000 is my cost this is how much I make subtract the two that gives you the margin and that

gives you the percentage now remember we figured out what our lifetime was and we figure out how much we make per customer or how many months they stayed in that instance now we combine those two metrics to get the one lifetime gross profit earlier we did the 10% chur example and so let's say that these customers stay on average for 10 months because this is for 10 customers we can divide this by 10 which gets us $600 per month per customer so I just div ided the $6,000 bu the 10 customers to get my how

much do I make per customer per month so that's $600 per month per customer in gross profit now we said earlier that they're staying for 10 months which means that my lifetime gross profit per customer is $6,000 of LT GP so now I know that customers are worth $6,000 so this is important because now this is all the money I have to go spend to acquire them and run the rest of the business this is probably one of the biggest mistakes that business owners make because what they do is they look at their lifetime Revenue

per customer and say oh as long as it cost me less than that in advertising I'm making money but I'll give you an extreme example to point out why that doesn't work let's say I sell these for $10 this pen for $10 but it cost me $9 and the average person buys 10 pens so it's $100 in Revenue but it costs me $90 to sell the 100 but if my team comes to me and says dude we're killing it we're spending $50 to get a $100 sale we should do this all day but what's really

happening I'm actually spending $50 to make $10 in gross profit lifetime not a good equation and so you don't want Revenue to confuse you and this is like one of the biggest misunderstandings I see business owners make which is why sometimes because they don't know this they don't know why they can't grow the reason lifetime value and lifetime gross profit get conflated or confused is because many of the most formal businesses that are out there come from Silicon Valley which almost exclusively is Tech and software and the gross profits on software are almost always close

to 100% the two can flate but for everyday business owners who have people we have manufacturing we have inventory we have to pay for stuff to happen that isn't 100% And so we're not doing it off Revenue we have to calculate what our gross profit is because that's what we run our business off of so far we got our $6,000 lifetime gross profit cool so we've got one part of this equation this video is incredibly in depth and tactical because I break down every concept to its absolute base units so my recommendation to get the

most out of this is to watch all of the concepts understand them so you see how they all work together to ultimately help you invest better and then come back through and then do each of the concepts individually so that you can apply them so now we're going to talk about how to how much it cost to acquire a customer this is another one that people mess up so what a lot of people do is they just look at how much it cost them to advertise to figure out how much it cost them to get

a customer that's partially true but not completely for two reasons the advertising budget of you're running paid ads for example is only one of the many costs that go into a cry and customer the other issue is that you're not including the labor so let's say that we have five employees that cost in total $50,000 a month that's the labor and then let's say we're spending $50,000 a month in software and advertising like Facebook ads or Instagram ads that means that our total cost for as a company is $100,000 per month for all the customers

that we acquired that month and so then all we do is you look back and say okay how many do we acquire over the last 30 days let's say this $100,000 bought us 83 customers so our cost to acquire customer would be 100,000 divid 83 survey says $1,224 so this divided by that equals $1,224 cost to acquire a customer let's look at our math if if we have cost us $1,224 to acquire our customer and that customer makes us $6,000 in lifetime gross profit we're killing it so that means that we have a 5:1 ltp

to CAC ratio and if you're like is that good or is that bad 5 to1 is great you want to make sure that you're always at least greater than 3 to one meanings your lifetime gross profit compared to how much it cost you to make that money is at least three times greater otherwise you'll be too constrained to scale if this is bad I'm just not I don't need to look at anything else I can just automatically toss the business out and if this is exceptional I might be willing to overlook or forgive some other

metrics that are coming down the line that aren't as strong but if you don't know these numbers in a business that you're buying or investing or business that you own find them out so I told you earlier that I was going to give you seven well it turns out that uh that was three of them because the ratio is one gross profit is another and CAC is another so we covered three we're already almost halfway there so number four is return on invested Capital all right what we're looking at is how much money does it

cost us to expand the business there are some businesses like an accounting firm for example that the way that they expand the business is that they just hire more accountants there really isn't a lot of what they call Capital expenses which is why I tend to like service businesses now on the flip side if I was in manufacturing i' would have to factor in all the machines a new location another buildout that would go into expanding our capacity to make more stuff whatever business you have and I do a lot of brick-and-mortar stuff I want

to know first what's the LT GP to CAC ratio at the customer level but then how much does it cost me to make a location and scale it so for example let's say I have to put $100,000 in to open each new location now underneath of that $100,000 is going to be the marketing budget to launch the location the cost to do the buildout hiring staff recruiters if we need that ads for Craigslist to you know get new people in everything is included because once you do this enough times you do have a pretty good

idea of what that number is and you say cool it cost us $100,000 to open each new location and at month 6 we're here at 12 months we're here and at X months we're at capacity the question is first how quickly do I make my money back which is the payback period Then what is my one-year return and then what am I making once it's at capacity cuz I want to know how much cash flow this thing kicks off and so in this example I love to see at least 3:1 ideally 5 to1 meaning if

I put $100,000 in once we're at capacity we're at 500,000 per year in profit I put $1 in I get $5 out and so this is the same concept as what we're doing here but just at scale so I'm not buying one customer I'm buying a custom printing machine how much does it cost me to build another machine that creates profit every single year and so from a returns perspective if I can pay my investment back for example in 6 months after that everything's gravy the part that people don't want to to talk about is

that all of this stuff cost headspace right which is that you have an opportunity cost associated with any investment meaning what could you have done with the same level of effort and money in the same period of time but if at month 6 I'm breaking even and at month 12 I'm at let's say pacing 250,000 a year and by the second year I'm at 500,000 a year in profit then great this is now a node that just kicks off cash flow year after year after year and then I think okay well I have $500,000 what

am I going to do open five more locations if something costs very little and makes me a lot good now you might be like well the stock market gets 10% returns that would be putting $100,000 in and getting $10,000 back I actually really like to see at least I mean really 3 to one which means a 300% return per year kind of at minimum which sounds ridiculous but I'm putting time and effort in so these are not passive Investments for me it's different if I give someone cash and they do all the work and then

I just get dividends then that's different but if I'm actively working then I have to account for all the time that I'm putting into this and so for me I want to make sure that I have a really strong return profile to justify the cost of time so there's two big variables that come into fast or slow payback period one is how much is this build out right if you have a massive buildout sometimes it going to be hard to pay that back quickly the second is how good they are at launching somebody might have

five locations but not really have a new location strategy for a new city so this happens a lot in brick and mortar chains where they've got five locations in one city and they can they can drive to all of them but then really want to expand and going from 5 to 20 is a totally different game now mind you that's what we specialize in but you now have to go to a new market where no one knows you and actually have a launch strategy that ideally and this is what we like to do fill up

the facility so I want to get to this capacity as fast as humanly possible and sometimes that means hey you guys have a a $10,000 budget for opening let's put 40 into opening so that we're opening full and then we're already at 500,000 a year run rate by month 6 so if you're a brick and Mort business by the way and you would like to scale go to acquisition. comom and to be clear this is for businesses that are doing at least a million dollar a year in profit ideally 3 to five so let's go

through number five which is payback period simply put how quickly are you paid back for getting a new customer so we talked about return on invested Capital at the business level but now I'm going all the way back down to the unit of how long does it take me to recover the cost you acquire a customer remember said CAC was $600 if I spend $600 how quickly do I get it back and so if you had two scenarios one scenario where it takes you 3 months to get your $600 back versus another uh scenario where

you put $600 in and get $66,000 in the first 30 days which one would you rather have well if both of them have the same lifetime gross profit you'd rather get the money sooner that number of how long it takes me to get paid back is G indicator of how cash flow positive the business is for the big fancy investors they don't care about as much because they're working with these massive companies and long payback cycles and all this stuff but small business owners that's how you live and that's how you expand what we try

and do when we're looking at a business is okay what is the payback period and are there some easy levers that we can do to drive it Forward I'll give you a couple easy ones so number one is I could say hey with that example we gave it was $11,000 a month could we just get them to pay first and last month up front that' be an easy way to drive drag some of that cash flow forward and I could break even and make my payback period 1 month a second way to do that would

be some sort of fee which is I say hey I have an onboarding fee enrollment fee an Initiation fee a setup fee but the point is that you charge a fee of some sort in addition to whatever the recurring revenue is third way to do it is you could have an upsell of some sort this is structured as a fee the other is an upsell this one is optional this one is mandatory functionally they're the same thing we're trying to drag more Revenue up front a fourth way you could do this is that you could

get financing in place right so you get a third-party bank or financing partner who says I would like to make interest on some of these payments that you have with your business I will front you the whole amount that this person owes you but I'm going to take a piece for taking on the risk and so you basically give your risk away to somebody else they take a fee for that and then you get cash up front four easy ways that you can think about to try and decrease your payback period and in other words

get more cash faster if we're looking at this from a timeline perspective so $1,200 was the cost to acquire if we spread that out the first month I get 600 so I'm still at negative 600 and then I have another 600 that comes at month two so now I'm at zero so it took me two months to break even in the second scenario I add a fee let's say another $600 and it's just processing fee I cost me nothing to do this all right so now my first transaction I make $1,200 back and I'm already

at breaking even at zero and then here I get my 600 but I'm plus 600 now and so this business is a healthier business that will be more adaptable more resilient in a downturn than this one let's do number six six and seven are real short and then I'll give you a bonus one number eight so these are all about predictions so up to this point we've gotten a steady state of okay this is what the business is is 6 7even and 8 are all about what it can do in the future okay so number

one that I love this one is sales velocity times lifetime gross profit which means how many units are we selling per month times what are these people going to be worth to me over the lifetime now you can also do this as LTV as well because that's also a good metric to at least understand especially if sometimes margins can improve with scale so that can be helpful to just know both let's say that I sell 100 customers a month times $6,000 in in lifetime gross profit and it was $10,000 in lifetime value right which is

how much revenue they're going to generate remember because we still had all the cost Associated the nice thing with this is that we can see especially with this one where the revenue of the business is going to be at scale because especially if you have a recurring Revenue business it might take time for them for the business to actually get to its hypothetical Max and so the Assumption here is that if nothing else changes in the business they don't sell more customers and the customers don't become worth any more than they already are where will

this business even out and so in this example $1 million a month now this is why this is so important if someone comes to me and they're doing 500,000 a month and they have these metrics then I know that the business is going to double without doing anything which is great on the flip side if a company comes to me and has these metrics which it still could and is doing $2 million a month then I know that it's going to shrink means that they were either selling more units earlier on in the past and

think something happened their Facebook ads got shut down uh they got a bad rap on their content or and this is probably the more common one their delivery started to drop and so their turn started to increase and so their lifetime values actually dropped per customer because they couldn't scale well and so I can say even though you're at 2 million a month right now if things keep going the way they are it's actually going to go drop down to a million a month all right and so this gives you a really good idea of

a snapshot of where someone's going to be versus where they are so you might be wondering how can the lifetime value of a customer change for a business will if turn goes from 5% to 10% then it means you cut your lifetime Revenue in half tough but that's why turn numbers in retaining customers are so important because if you go from 10% turn to 5% you also double the lifetime revenue of a customer and so this is why the health of the business based on what its hypothetical Max is can change and so the longer

period of time you take the average over realistically the more accurate it'll be if you did this on a daily basis it would be really volatile in smaller businesses smaller businesses are volatile and so it's good to have snapshots of okay well what was it trailing 90 trailing 6 months trailing 12 months to get a much better idea and you can calculate this at each of those and then you can look at all three and say okay well this is what I think it really is and all of this helps you ask better questions as

an investor so I'm going to give you the next one which is very similar to this one which is sales velocity divided by churn so churn remember we defined this earlier at the beginning number of customers and let's say it's 10% per month okay is the number of customers who leave and let's say again we've got 100 customers in terms of sales velocity this means that our hypothetical Max in terms of logos or number of customers that the that the business is going to have to sustain or maintain is going to be a th000 customers

now remember we have 1,000 customers remember was paying $1,000 a month million doll a month these calculations work together this tells me how much money are we going to be making when we're at our hypothetical Max and this tells me how many customers are we going to have to be servicing at our hypothetical Max we're coming down and I say well dude right now you have the infrastructure to maintain 2,000 customers but we're going to be at 1,000 you're going to have to be looking at headcount which sucks on the flip side if we've got

500 customers we're doing 500,000 a month and I know we're going to get to 1,000 I might say hey how could we scale and make sure that we don't break on our way to a th000 because we're going to get there in X months that's six and seven and now we'll go to bonus number eight the secret bonus which wraps all of this stuff together this equation is really in relation to how big the opportunity is so Tam is just a fancy word for total adjustable Market which is how many people could I potentially sell

and so when I'm analyzing an opportunity it's number of potential units times lifetime gross profit divided by risk and so this ultimately gets at how big of a company do I think this could ultimately be if we're servicing you know vegan moms with three kids who like powerlifting then there might only be 50,000 of them and so I'm going to have 50,000 potential units sold that's assuming we get 100% of the market to buy now that might not be true but that would be here is what's what how many could we potentially sell the lifetime

gross profit is well how much do we make on all of these people this would give us an idea of how big the opportunity is this is all the good stuff the big question is How likely is that going to happen risk has a zillion categories so that's beyond the scope of this video but do I think that there's a trend are there going to be more vegan powerlifting moms in the future are there going be less vegan powerlifting moms in the future so for example right now I am looking at fertility stuff tons of

people are having fertility issues I think it's going to be a booming Market in the future so something that Services anything related to fertility will probably have big Tailwinds behind it you can apply risk to each of these so from selling potential units is okay is the way that we're acquiring customers something that's really risky are there going to be platforms that are going to change do we expect that this method of getting customers is sustainable is there key man risk is there's somebody who's in charge of that department that if they left would' be

screwed right all of these are factors of risk of How likely it is to happen in the future from the lifetime gross Prosper perspective are there other competitors that could come in and undercut us how strong is our position in the marketplace do we have a better product that can sustain a premium are there economies of scale that we can have or there is there shrinking margins which sometimes can happen at scale and so these are all risks that could affect our gross profit per customer over the long haul some people might think okay well

how how important is Tam it is extremely important but the ability to assess it is very limited this is one of those uh important and unknown uh which Charlie merer and Warren Buffett talk about a lot which is like you've got things that are knowable and unknowable and unimportant and important and we just want to focus on the knowable and important the economy and interest rates very important is it knowable no so they don't try to predict it with Tam I see it kind of in that very important but not knowable and here's why the

amount of companies that start with a niche and then expand and expand and redefine their customer redefine their Avatar most businesses have especially the biggest ones Amazon started as a bookstore now it's an everything store Facebook started as a social network for college kids and then became the everything social network and so many huge examples start small because they want to narrowly to find a problem for a specific Avatar and they expand over time but the main point for this one is how much risk am I exposed to that is knowable that I think could

potentially break this equation from working in the future when you take the first seven and you plug that into this framework for assessing value or how big this could potentially be then you have a very good framework to analyze a business yourself or others to potentially invest in or say I'm a no on this one dog and by the way if you don't have something like this I'd recommend just put one s sheet together that tracks your numbers automatically every month because you'll get a much better idea of how your business is doing from a

health perspective again if you're a brick and mortar chain doing a million dollars in profit per year or more and you've got a sound model and you want to expand we're looking for you right now we've done super well with brick and mortar chains expanded really really big and we're just looking for awesome businesses that we can get involved in so specifically service based businesses million plus ideally 3 to 5 million in profit so if that's you reach out to us we can make it rain together