Posted: September 13, 2009
How to make your business worth more
Calculate the lifetime value of your customersBy Kevin Custer
The top two questions we get from business owners: What's my business worth? How do I make it worth more?
The answers are: 1) Your business is worth what someone will pay for it and 2) what someone will pay for it depends on the lifetime value of your customers.
Most people overlook the value of their customer base. Here's a simple calculation to find out what that value is: Take the total number of customers and multiply that by the average amount of revenue per customer. That's the total value of the entity.
Do this calculation at several different time periods, say, over the past three years. Are you trending up or down in terms of how much your customers are spending with you? Say you have 100 customers who spend $100 with you. The next period, there are only 90 customers but each is spending $120 with you. You've still increased the value of the business.
Having more customers isn't always better. If you have 120 customers spending only $40 with you, your business is worth less than half of the 90 who are spending $120.
So I've figured out the value of my customer base. How do I improve?
So how do you increase your revenue per customer? Figure out what they're buying and then analyze how your business can be more valuable to your existing customers. This is a critical analysis. If you can bump them from $100 to $150, that's worth spending time and marketing money on. If you are already selling $200 worth to a customer and the potential is $225, then you are better off acquiring new customers.
We are a private equity fund that buys businesses and we do this analysis all the time. I see so many businesses that spend, say, $20,000 to acquire a $10,000 customer. You have a new customer, it's true, but that acquisition process is not scalable. I can't invest in that.
Now people generally understand they need more valuable customers, but how do you break down the analysis to achieve that value? You have to measure the cost of customer recruitment. Take your revenue generated, calculate your direct cost of goods sold (direct expenses) and add marketing and sales costs. This analysis is not what GAP (generally accepted accounting practice) labels as "gross profit," because we include marketing costs into our customer value measurement and GAP's definition of gross profit does not include marketing costs.
Why could AOL afford to send out millions of CDs every month? Because they knew their cost per customer was $46 and their average customer was worth $120.
Even start-ups can use this model. You can estimate what your anticipated revenues would be for a product or service and figure out the cost of acquiring those revenues. If results are different than the model - and they probably will be - make some adjustments.
Once you have a good handle on the value of your customer base, it's time to look into where you can make improvements. Do you need to cut down on the cost of goods sold in regards to a particular set of customers to make the operation more profitable? You may be spending too much time - another source of capital - on another set of customers and not getting what you need in return.
After you analyze your customer base, decide where to invest your time and money and whether that is scalable in a systematic way. If it is, you will find a very valuable business on your hands.
Kevin Custer is founding principal of Arc Capital Development in Golden, Co., a private equity firm that invests in companies that focus on the education market, pre-kindergarten through high school. He can be reached at (303) 278-3637 or kcuster@ArcCD.com.