Jan 02, 2022

Payback period, why LTV is lying to you?

Did you ever wonder what is the optimal acquisition cost for your product? Or, have you tried to analyze your customer lifetime value, but resigned due to its high volatility? Today I’d like to introduce to you one of the tools we use while assessing performance of portfolio companies and analyzing potential investments – the payback period analysis.

When the payback period makes a difference?

Imagine having a choice of 2 startups competing in the same niche with a similar product (Tidal vs Spotify, Zendesk vs Freshdesk).

Company A:

LTV (Customer Lifetime Value) = $ 400

CAC (cost of customer acquisition) = $ 100

LTV: CAC = 4: 1

 

Company B:

LTV = $ 500

CAC = $ 100

LTV: CAC = 5: 1

Which one would you prefer to have in your investment portfolio?

Most people would indicate Company B -> with a higher LTV:CAC ratio.

But now let’s add one more variable: the Payback Period.

 

Company A:

Payback period: 6 months

LTV: CAC = 4: 1

 

Company B:

Payback period: 12 months

LTV: CAC = 5: 1

 

Okay, now the situation is completely different. Although Company A has a lower LTV:CAC ratio, its investment in sales returns 2 times faster than in Company B. The faster possibility of reinvesting the funds held will allow for much faster growth.

Why is this happening?

The shorter the payback period the more customers we may acquire in the same period (assuming constant CAC). The acquisition itself could be compared to a growing Uroboros – a snake swallowing its own tail:

  1. The company spends $$$ on acquisition
  2. New users increase MRR
  3. Due to a higher MRR/income, the company’s cash pool increases and allows for an even greater investment in acquisition.

The shorter the payback period, the faster the Uroboros will turn and grow.

How the payback period analysis can enhance your business?

Let’s take a look at the dataset below, which present the following data based on an example company for a 3,5 year period:

  • cohorts of monthly income/customer
  • # of conversions and its costs
  • customer acquisition cost
  • accumulated income/customer
  • cohorts aggregated income

Picture 1: Cohorts break-even points for certain CACs. Source: Payback period calculations

Picture 2: Cohorts cumulated income (last 2 columns) and a marked row with the highest income/cohort and the most optimal CAC.

Source: Payback period calculations

Optimizing the cost of your conversions is just one of the applications. Personally, I used this tool a lot when managing the advertising budget on international campaigns. Google Ads gives a lot of possibilities in maneuvering the height of positions in individual countries – and thus the cost of conversions and their number.

Conclusion

The payback period analysis can act as a make-up removal for CAC management.

Also it’s a vital tool for CEOs, allowing for:

  • determining whether or not we are passing the break-even point of the campaigns
  • proper management of working capital, allowing to increase the budget wherever it pays off the fastest
  • better prioritization of the market/product development roadmap
  • company-wide communication on the profitability and results

 

If you are interested in utilizing this tool in your business, please drop us a line. At BValue we are truly passionate about accelerating startup growth and always willing to consult your idea. We invest from EUR 250K to EUR 1M, mainly in SaaS and marketplace with global potential.

Author:

Mateusz Szczepaniak

Investment Manager at bValue VC