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We've talked about CAC and LTV a couple times in this newsletter (
PT23,
PT39), but I have never really spent a lot of time talking about payback period. Payback period is exactly what it sounds like; how long does it take for a new customer to repay what it cost to acquire them.
This is an incredibly important concept for all companies, but in particular for those who don't want to raise VC money in order to fuel growth.
A business that is investing in paid marketing with strong cohort behavior and a quick payback period is still going to have a period of negative earnings as the total customer base builds up over time to drive profitable revenue. You will likely have a marketing profitability curve that looks something like this.
If you don't have a good amount of money in the bank, those 9 months of investment before your marketing turns a profit can be very scary. And even if you do raise money, this curve is going to look pretty similar, it's just going to stretch a little further out and be orders of magnitude bigger on the Y axis.
So what does profitable growth look like, and how does payback period impact that?
I built a simple model that looks at the implied growth rates based on a company's payback period, monthly churn rates, and what percentage of their gross profit they can afford to spend on marketing (because you should be calculating your LTV and payback period with margin dollars, not revenue dollars). That last part was my attempt to account for operational expenses (salaries, rent, etc) that have to get paid as well but it's admittedly an oversimplified way of doing that.
These were the different scenarios I compared:
Payback period: 2 months to 10 months
Monthly churn rate: 2%, 3%, 4%
% of Gross Profit spent on Marketing: 10% to 30%
And this was the chart of implied annual growth rates
The way to read this chart is that if you're churning 2% of your customers every month, have a 4 month payback period, and can afford to spend 25% of your gross profit on marketing, you can grow at 58% annually.
It's a messy chart to be sure, but there's some great stuff in here. For instance, if you are churning 4% of your customers per month and have a 6 month payback period, you better be able to afford spending 30% of your gross profit on marketing or you won't be able to grow.
Similarly, if you can afford to spend 30% of gross profit on marketing, it is more valuable for you to reduce your payback period from 4 months to 3 months (42% growth -> 82% growth) than it is for you reduce your churn from 4% to 2%.(42% -> 80%).
You only reduce your payback period by lowering your average cost to acquire a customer on increasing your average gross profit per customer. Neither of these are necessarily easy, but their impact can be the difference between profitably growing 100+% per year or 20% per year.
