The Dangers of LTV

Alex: What's up everyone? Welcome back to another episode of Founder’s Journal. I'm Alex Lieberman, co-founder and executive chairman of Morning Brew. On Founder’s Journal, I act as your startup sherpa, curating the best content for entrepreneurs, summarizing it so you don't have to read it yourself, and analyzing it so you have actionable takeaways to apply to your business. Before we hop into it, I have one ask of you: Please share Founder’s Journal on social media. Podcasting is a super competitive game these days and the only way to grow is through word of mouth and promotion on social. A minute of posting on your end will make the dozens of hours that my team and I spend each week creating the show completely worth it. You can either give the show a shout-out or share the single most interesting thing that you learned from today's episode, and make sure to tag me so that I can give you the proper props once you post.

Now let's talk about today's episode. LTV, or lifetime value has become the gold standard for startups, and specifically how they measure the effectiveness of their various marketing channels. Very simply, LTV is the cumulative contribution dollars, also known as cumulative net profit, over the course of an entire relationship with a customer. There are different methodologies to calculate LTV, but they all involve a few of the same variables: the average value of a customer during a period of time, and the average lifespan of a customer before they churn. There is a great deep dive on growth metrics like this by the founder of Ro or Roman that I will include in the show notes if you want to get into the weeds of these calculations.

Now, investors in Silicon Valley will often ask you about your customer lifetime value at the beginning of a pitch, and then have you dig deeper to understand how your LTV looks relative to the cost of acquiring your customers. In a lot of ways, I believe LTV and the obsession with marketing metrics like this is what has given the rise to more quantitatively focused growth marketers, a role that has replaced creative, more qualitative marketing manager roles at Silicon Valley startups. Now, LTV does have merit and it is a helpful proxy to prioritize your marketing and understand the economics of each customer that you acquire, but if relied on entirely, it can be misleading at best and extremely harmful to your business at worst.

I just wanna say that I do not at all claim to be an expert in growth marketing metrics or building out marketing programs using LTV and CAC, but I do think it is really important to understand for any entrepreneur in any business, and I have found what I believe to be one of the best pieces on the internet about the challenges of the LTV methodology. It is a 12-year-old essay by investing legend Bill Gurley, but it is as relevant today as it was then. Now I just wanna give you a heads up. I won't have much commentary on this specific episode because it is definitely not within my zone of genius, but there is a ton of value that you will get from this episode just by listening to Bill's words. So let's hop into it.

“The Dangerous Seduction of the Lifetime Value LTV Formula” by Bill Gurley, September 4, 2012. Many consumer internet business executives are loyalists of the lifetime value model, often referred to as the LTV model or formula. Lifetime value is the net present value of the profit stream of a customer. This concept, which appears on the surface to be quite benign, is typically used to compare the cost of acquiring a customer, often referred to as SAC, which stands for subscriber acquisition costs. With the discounted positive cash flows that will come from that customer over time, as long as the sum of the discounted future cash flows are significantly higher than the SAC, then people will argue it is warranted to push the accelerator, which typically means burning capital by aggressively spending on marketing. The LTV formula, when used correctly, can be a good tactical tool for monitoring and comparing like-minded variable market programs, especially across channels. But like any model, its proper use is entirely dependent on the assumptions used in that model. Also, people who have a hidden agenda or who confuse a model with reality can misuse it. For many companies that subscribe to its wisdom, the formula slowly takes on more importance than it should. Seduced by the model, its practitioners often lose sight of the more important elements of corporate strategy and become narrowly fixated on the dogmatic execution of the formula. In these cases, the formula can be confused, misused, and abused much to the detriment of the business, and in many cases the customer as well. Here are 10 reasons to avoid worshiping at the LTV altar.” I love that line, by the way. 

“Number one, it is a tool, not a strategy. Heavy LTV companies forget that the LTV model does not create sustainable competitive advantage. You shouldn't confuse output with input. The LTV formula is a measurement tool to be used by marketing to test the effectiveness of their marketing spend, nothing more and nothing less. If one asserts that buying customers below what they charge them is a corporate strategy, this is in essence an arbitrage game and arbitrage games rarely last.” That is such an important line that he just shared there. 

“Too many of the variables, specifically ARPU and SAC, ARPU is average revenue per user and SAC is subscriber acquisition costs, are outside of your control, and nothing would prevent another player from executing the exact same strategy. It's not rocket science, it's a formula that any business school graduate can calculate. Do not fool yourself into believing it creates a proprietary advantage.” 

So just my big learning here is LTV and calculating LTV is not a business strategy. It is a way of optimizing your marketing channels, and at the end of the day, LTV to CAC, lifetime value to acquisition cost, is simply just an arbitrage game. It is an arbitrage between what you can pay to acquire a customer through Facebook, Google, paid YouTube sponsorships, et cetera, and ultimately what that customer you acquire can end up generating for you as a business. 

“Number two, the LTV model is used to rationalize marketing spending. Marketing executives like big budgets, as big budgets make it easier to grow the top line. The LTV formula relaxes the need for near term profitability and justifies the ability to play it forward to spend today for benefits that are postponed into the future. It is no coincidence that companies that put a heavy emphasis on LTV are also the ones that have massive losses as they scale, frequently, even through an IPO. Consider that most companies limit any affiliate fee they would be willing to spend to 5% to 10% of sales. Yet when they're marketing, they use different math, they use LTV math, and all of a sudden it's acceptable to spend 30% to 50% of revenue on customer acquisition. Find the most boisterous executive recommending excessive spending, and you will usually find a loyal servant of the LTV religion.” 

What he's basically saying here is if you're a business and you have an affiliate program, so you pay people who will refer business to you, typical affiliate programs only pay out 5% to 10% of the sale that they generate. Whereas when people get hooked on this LTV model, somehow all of a sudden businesses are willing to spend 50% of their revenue on marketing, and so he's just giving you a sense of how blown out of proportion marketing as a cost, as a percentage of revenue, has gotten to by using this formula. 

“Number three, the model is confused and misused. Frequently the same group that is arguing for more spending is the same one that owns the LTV calculation. This is a mistake. Finance should monitor LTV. As a result, it is not uncommon for one to see shortcuts taken that allow for greater freedom. As an example, marketers often divide spend by total customers to calculate SAC, rather than just those customers that were quote unquote “purchased.” If you have organic customers, they shouldn't be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount revenues rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution. 

As an example of the sloppiness that exists around the formula, consider this blog post from Kiss Metrics, a company whose aim is to quote unquote “help you make smarter business decisions.” Not only do they include a version of the model that specifically ignores future costs, but also they recommend taking an average of three different results, two of which are clearly flawed. This voodoo math has no place as part of a multimillion-dollar marketing exercise.” 

Okay, so this is a kind of dense reason, but just to simplify things, there's a few things I get from this. Basically what Bill is saying is oftentimes when companies will calculate their average cost of acquiring a customer, they will include in that calculation all of their customers that they acquired, both the customers that they paid for as well as the customers they did not pay for, that they got organically. And what this does is it artificially lowers the average cost that it took to acquire a paid customer, because when you include in that calculation customers who you didn't pay for, who would've joined your business regardless, it just divides by a larger number, and so it's gonna artificially make it seem like you're getting customers cheaper than you actually were. The other thing that he was just basically talking about is it's so important to focus on cash contribution versus revenues. So you don't wanna just be focusing on discounting the revenue that customers are driving for you. You wanna actually focus on the contribution, meaning what is the actual profit that customers that you acquire are generating for you over time? 

“Number four, business isn't physics. The formula is not absolute. LTV zealots often hold an overly confident view of the predictive nature of the formula. It's not hard science, like say, predicting gravity. It's at best a good guess about how the future will unfold. Businesses are complex adaptive systems that cannot be modeled with certainty. The future LTV results are simply predictions based on many assumptions that may or may not hold yet. The LTV practitioner often moves forward with a brazen naivete, evocative of the first-time stock buyer who has just found out about the price to earnings ratio, or the newcomer to Vegas who has just been taught the basics of 21. LTV models win arguments because executives perceive them to be grounded in science. Just because it's math doesn't mean it's good math.” 

What Bill's basically just saying here is at the end of the day, when you calculate LTV, it is just a number of inputs or assumptions that you're plugging in that spits out the lifetime value of your customer. But that lifetime value calculation is only as accurate as your assumptions, and your assumptions can only be so accurate because you are making predictions about the future, right? You're making predictions about on average how much revenue a customer will drive for you, on average how much it will cost for you to acquire that customer, on average, how long a customer will be with you before they churn. But that is information. Those are assumptions you're making based on what has happened in the past with your business. But as time goes on, three, six, nine months from now, those assumptions could prove to be not true. And actually in a lot of cases, as companies spend more and more on marketing, the quality of your customer, meaning the average lifetime of them, the revenue they drive for you, that goes down, and oftentimes the cost of acquiring customers goes up as you spend more and more on marketing, because you've basically blown through the low-hanging fruit customers that were already looking for your product.

“Number five, the LTV variables tug at one another. This may be the single most important issue, and it lies at the heart of why the LTV model eventually breaks down and fails to scale ad infinitum. Trent Griffin, a close friend that has worked for both Craig McCaw and Bill Gates, refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all and they're all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Trent’s view is that the variables of the LTV formula are interdependent and not independent and are an overly simplified abstraction of reality. If you try to raise ARPU, average revenue per user or price, you will naturally increase churn. Basically saying if you increase price, people are gonna churn more quickly. If you try to grow faster by spending more on marketing, your SAC, subscriber acquisition cost, will rise, assuming a finite amount of opportunities to buy customers, which is true. Churn may also rise as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs and therefore deteriorate the potential cashflow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.” So said simply, as you change certain variables of the lifetime value equation, other valuables will change as well, and they won't necessarily change in your favor. But a lot of companies will evolve their LTV formula to be the most optimistic view of the future, and oftentimes it is not realistic. 

“Number six, growing becomes a grind. Let's say you have a company that estimates it will do a hundred million dollars in revenue this year, $200 million the next, and $400 million the year after that. In order to accomplish these goals, it is going to invest heavily in marketing, say 50% of revenue. So the budget for the next three years is $50 million, a hundred million and $200 million. How realistic is it to assume that your SAC will drop as you 4x your spend? Supply and demand analysis suggests the exact opposite outcome.” 

We were talking about this before. As you try to buy more and more of a limited good, that limited good is customers, the price will inherently increase. The number one place on the planet for marketing spend is Google AdWords. And make no mistake about it, this is an increasingly finite resource. Click outs are not growing at a meaningful pace.” What he's talking about is the click-through rate of a sponsored link on Google, and keyword purchases are highly contested. Assuming you will get better at buying while trying to buy more is a daunting assumption; the game will likely get tougher, not easier. All of this to say that marketing channels over time become less efficient, and they become more costly, as customers are a finite resource, but people competing for those customers increases. And as you spend more and more money to acquire customers, you are going to exhaust the best quality customers, which means you're gonna either have to pay more to find good quality customers or you're gonna acquire lower quality customers who are gonna churn faster or contribute less revenue to your business, et cetera. 

Number seven, purchased customers underperform organic on almost every metric. This is a really important one. Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend. LTV heavy companies are in denial about this point. In fact, many of them will argue until they are blue in the face that the customer dynamics are the same while this is rarely the case. A customer that chooses your firm's services will be much more satisfied than one that is persuaded to buy your product through spend. Find any high marketing spend consumer subscription company, and I will show you a company with numerous complaints at the Better Business Bureau. These are companies that make it almost impossible to terminate your subscription. When you are scheming on how to trap the customer from finding the exit, you are not building a long-term brand.” Just a quick anecdote here is, for the entirety of Morning Brew’s history, our highest quality customers have been people who were referred by other Morning Brew subscribers. So it's always been people that hear about our business through word of mouth. And then from there, paid acquisition is by definition a lower quality subscriber or customer. And within that, you know, we have many channels we've done for paid acquisition over the years, and it's always been the highest quality channel for paid acquisition has been spending on ads in other email newsletters, because at least it is a behavior that someone already has. Meaning if we acquire someone from another email newsletter, they already are reading email newsletters so we don't have to reprogram that behavior. So that has always been a higher quality paid customer than say, someone we acquire through a paid Facebook ad that sits on kind of the side rail of your Facebook feed.

“Number eight, the money could go to the customer. Think about this if you are a company that spends millions and millions of dollars on marketing. Wouldn't you be better off handing that money to the customer versus handing it to a third party who has nothing to do with the future lifetime value of the customer? Providing a better value proposition to the customer is much more likely to endure goodwill than spending on marketing. A heavy marketing spend necessitates a higher margin to cover the spend and therefore a higher end user price to the customer. So the customer is negatively impacted by the presence or need of the marketing program. Plus a margin umbrella now exists for competition that chooses to undercut your margin model with a more efficient customer acquisition strategy, such as giving the customer the money,” and then he shares a Jeff Bezos quote. “More and more money will go into making a great customer experience and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people will find out.” 

And so to me, what I take away from this point is that every dollar you spend on marketing is a dollar that you're not using to either give back to the customer to put in their pocket or to improve the experience for the customer. And also because when you spend a lot on marketing, you have to charge more for your product to account for having enough margins such that you're able to spend on marketing while having a, you know, good, profitable product. And so that means when you spend a lot of marketing, you hurt the customer 'cause you're gonna have to charge them more. Whereas if a competitor comes into the market and they don't spend a lot on marketing and they're able to acquire customers through word of mouth, they can just undercut you because they don't need as much margin for their business to be profitable. Okay, two more issues that Gurley talks about. 

“Number nine, LTV obsession creates blinders. Many companies that obsess over LTV become overwhelmed by LTV. In essence, the formula becomes a blinder that restricts creativity and open-mindedness. Some of the most efficient forms of marketing are viral, social, and effective PR. Most companies that obsess about LTV are less skilled at these more leveraged techniques. Ironically, it's the scrappy and capital-starved startup with absolutely no marketing budget that typically finds a clever way to scale growth organically.

I love this historic slide from Skype comparing their SAC with that of Vonage, an iconic disciple of LTV analysis. And in this picture that Gurley shows, it shows that Skype's cost of adding a new user was a 10th of a penny, whereas Vonage's was $400. And that's because Skype had a peer-to-peer technology where they were acquiring customers through word of mouth, whereas Vonage had to pay for their customers. And I just think this ninth point is such a good one by Gurley, which basically says, one, that the art and the creativity of marketing is lost when you become so obsessed with LTV. And also a focus on LTV leads to excessive spending on marketing, which leads to kind of like this abundance mindset. And generally the best way to think of creative ideas for acquiring customers is when you feel like your ass is against the wall, when you feel like there's scarcity, and you have to do clever scrappy things to acquire customers. And so to me, the LTV mindset can be a really dangerous mindset for not thinking in a scrappy way when you're building your business. 

“And now the 10th and final issue with focusing on the LTV calculation: Tomorrow never arrives. The utopian destination imagined by the LTV formula is a mirage. It almost never works out as planned in the long run. Either growth begins to slow or you run out of capital to continue to fund losses, or Wall Street cries uncle and asks to see profitability. When this happens, the frailty of the model begins to appear. SAC, subscriber acquisition cost, is a little higher than expected. You met your growth target, but the projected loss was bigger than expected. Wall Street is hounding you for churn numbers, but you are reluctant to give them out. The lack of transparency then leads to cynicism and everyone assumes the worst. It turns out that the excessive marketing spend was also propping up repeat purchase, and pulling back to achieve profitability is increasing churn. Moreover, a negative PR cycle has ensued as a result of your stock decline and the press's new doubts about your model. This also impacts results and customer perception of your brand. The bottom line is that the one day we can stop spending and be remarkably profitable rarely comes to fruition.

It is not impossible to create permanent equity value with the LTV approach, but it's a dangerous game of timing. You don't want to be the peak investor. Let's say a new business starts with an early market capitalization of A. Through aggressive marketing techniques and aggressive fundraising, the company is able to achieve amazing revenue growth and corresponding losses, but nonetheless creates a rather sizable organization. At this point, the company's valued at point B. Eventually, however, gravity ensues and the constraints outlined herein raise their head, resulting in a collapsed point C. For early founders and investors at point A, they may do okay, but it will be accomplished on the backs of later stage investors that helped fund the unsustainable push to point B. This is the story of many a telecom and cable provider expansion history, as well as a few recent internet companies.” By the way, this essay was written before the DTC boom, but this is the story of so many direct to consumer companies, whether it's Away luggage, Casper, Warby, et cetera. Ton of money was given to these brands early on to spend a ton on paid marketing. The early investors like the seed investors probably made a lot of money, but then in later rounds that these direct to consumer businesses raised to continue spending on marketing, those investors got screwed over, because at some point when the public markets or later stage investors were looking for profitability, these companies realized that if they pulled back on marketing that they couldn't just get profitable, that they started to churn through their customers, that they didn't have kind of the creative marketing strategies to actually acquire customers organically through word of mouth. And they realized that they had to keep spending. They were hooked on the drug of paid marketing and this relentless obsessiveness with LTV versus CAC. 

“This should not be misconstrued as a eulogy for the LTV formula.” I love this conclusion. “It has a very important place in business as a way to contrast and compare alternative marketing programs and channels. It is a tactical marketing tool that requires candor and thoroughness in its implementation. The fundamental reason that it is so amazingly dangerous and seductive is its simplicity and certainty. Generic marketing is conceptual. LTV marketing is specific. Building a plan to grow to a million users organically is an order of magnitude more difficult than doing it. With the aid of the LTV formula, there is comfort in its determinism, and it is simply easier to do.” Basically saying that because LTV marketing is specific, it's clear you have an idea of if I put a hundred thousand dollars into Facebook today, this is how many customers I'll get. It is easier right now to do than to drive an organic flywheel. But long term it is not how you build true brand equity. “Some people wield the LTV model as if they were Yoda with a light  saber.” That is a hell of a line. “Look at this amazing weapon I know how to use. Unfortunately, it is not that amazing. It's not that unique to understand, and it is not a weapon. It is a tool. Companies need a sustainable competitive advantage that is independent of their variable marketing campaigns. You can't win a fight with a measuring tape.” 

So that is Bill Gurley's essay on the dangers of lifetime value, and the 10 issues that ensue when you're obsessed with it. If you wanna go deeper into this topic, I highly recommend that you reread his full essay, which I'll include in the show notes, as well as the DTC Metrics Explained essay by the founder of Ro that I mentioned in the intro and include in the show notes as well. Before we go, just a quick reminder to give Founder’s Journal a shout-out on social and tag me so that I can thank you personally. As always, thank you so much for listening and I'll catch you next episode.