Generally, business revenue models fall into two categories… recurring revenue models and non-recurring revenue models.
A business with a recurring revenue model can be looked at like they generate an annuity revenue stream. Because of that you can use financial industry concepts to predict the Life Time Value (“LTV”) of a customer.
First you have to make the following assumptions:
- Estimate your COA in $s. This is how much you must invest in marketing to generate the LTV.
- Calculate your Margin in $s. This is the Price times the Margin %.
- Decide what your Cost of Money is. This is typically what you pay as an APR to borrow money from your bank.
Insert the variables into this formula:
PVofA = Present Value of an Annuity = P * [ {1 – (1+r)^(-n)} / r ]
Where:
- P = Periodic Payment and
- r = Rate per Period and
- n = # of periods.
Note: the ^ symbol indicates “raised to the power of”.
An example of how to calculate Rate per Period is as follows: Your bank lends money at the rate of 12% APR. Your Customer Purchase Frequency Cycle = monthly. Your R per Month = 12%/12 months = 1% per month. If your Customer Purchase Frequency Cycle = Quarterly your R per Quarter = 12%/4 quarters = 3% per quarter.
EXAMPLE: Let’s assume the following:
- COA = $200, and your
- Sale Price = $100 and your
- Margin % = 70% and your
- Customer Purchase Frequency Cycle = monthly, and your
- Bank APR = 8% adjusted for the monthly period rate by dividing by 12, and the
- # of Months for the average Customer to remain a Customer where (t = ) 50 months.
Here is the calculation:
- PVoA = P * [ {1 – (1+r)^(-n)} / r ]
- PVoA = Cash Flow per Period * [ {1 – (1 + (0.08/12)) ^(-50) } / (0.08/12) ]
- PVoA =(Sale Price $ x Margin %) * [ { 1 – (1 + (0.00667))^(-50)} / 0.00667]
- PVoA = ($100 x 70%) * [ 1 – (1 + .00667)^50) / .00667]
- PVoA = $70 * [ 1 – 0.7161 / 0.00667]
- PVoA = $70 * [ 0.2839 / 0.00667]
- PVoA = $70 * 42.56
- PVoA = $2,979.46
Now, subtract the original investment required to generate the annuity stream… ie: subtract the Cost of Acquisition of the customer from the PVoA… $2,979.46 – $200 = $2,797.46 which is an ROI of 13.99 X or 1,399%.
There you have it… a customer in the above example is worth almost $3,000 over 50 months and generates a Marketing ROI of almost 14 times your investment. This is a “no brainer”… you should ramp up as fast as you can to generate as many customers as you can get if the COA is only $200.
Now, lets consider the following question: What would you pay today for a cash flow stream that would generate almost $3,000 over the next 50 months? Keep in mind that you only get $70 per month… so an investment of $210 will take 3 months to recoup your cash outlay. What would you pay?
The answer partly depends on how much free cash you have available to invest in marketing. If you have $2,000 you can generate almost $700 per month in positive cash flow. If you were to reinvest $600 each month your monthly positive cash flow would increase by $210 per month. After 5 additional months your cash flow would have increased by a total of $1,750.
Personally, given that the LTV = almost $3,000 I would probably be willing to invest $500 to $700 to get a new customer. At $700 you are recovering your investment in 10 months and everything after that is positive cash flow.
Of course, since it takes a few months for each new customer to generate enough cash to cover the COA related to their revenue you can absorb a significant amount of cash while you are ramping up your marketing. Once you have proven that you have the right message and audience and media then you can focus on raising capital to ramp up your marketing. Balancing the cash reserves needed against the cash flow stream to be created is a constant and demanding task. Markets never stay static… things change… and what works one month may not work as well the next month and may not work at all 3 to 6 months in the future. Monitoring and modifying your market and audience and media mix to maintain an optimal ROI is challenging.
To make computing the Present Value of an Annuity (PVoA) easier you will find this online calculator a big help: https://www.calculatorsoup.com/calculators/financial/present-value-annuity-calculator.php