How do you market your business to promote growth in revenue? In this episode, Jeff Smith breaks down the two principles of growth marketing: Lifetime Value (LTV) and Customer Acquisition Cost (CAC). He shares concrete examples with easy formulas to help you digest the concepts better. Tune in to get business advice that could be key to taking your business to the next level in terms of revenue and growth!
---
Listen to the podcast here
2 Principles Of Growth Marketing
In this episode, I will talk about two fundamental principles of growth marketing. The first is Lifetime Value or LTV. The second is Customer Acquisition Cost, which is referred to as CAC. The reason I get into this is two important topics in this episode in developing a growth model and understanding how to allocate resources to add one more customer, the ratio of LTV over CAC is an incredibly important metric. This will help you raise financing, plan your business in even the pre-commercial stage, and best of all, make it a lot easier to raise capital from investors. I hope you enjoy the episode.
---
In this Office Hours episode, we're going to be talking about growth marketing. I don't love terms like that but the whole idea behind sales and marketing, after you've developed a medical device or treatment or therapy that's going to address an unmet need, you've got your clinical evidence or performance data. You've received regulatory clearance or approval, and now it's time for the commercial stage.
Now the commercial stage is an important stage to achieve because it's where the majority of the capital is allocated from venture capital and even at the private equity stage. It's also where companies that plan an IPO to access public capital markets get capital. It's hard to get there, but what often happens is companies will get to a commercial stage. They'll generate some level of revenue on the basis of investing some money in salespeople and some marketing programs.
The goal here is by the time you get to the growth equity stage or when you're raising your venture around for the commercial stage, you know your sales motion. You know what each of the steps is towards converting a new customer. Also, you have a good expectation of what revenue you can count on each year from that surgeon. You also know an important thing which is, what is your churn?
One case does not a user make.
In a perfect world, we access a customer or a physician after a series of interactions. It could be emails, text, face-to-face meetings, a video conference or some type of training event. After an average number of interactions, the average surgeon will elect to trial your product. In the trial phase of a new product, it's important to understand what your trial conversion is. What I mean by that is if you can access a physician, establish that there's a need in his or her practice, position your solution to that need, get through value analysis and hospital approval, and then actually get a case or a trial of your product.
That is a long journey and it's a great accomplishment to get a physician through that stage. However, one case is not what a user makes. If you were to look at 100 med-tech companies that are at the commercial stage and you added up all their users and you listed them. Let's say it's 1,000 users. More often than not, between 300 and 400 of them are one and done. It means they tried it and decide not to continue.
This is key to understanding your sales model. Each product has a certain number on average of users at which point, if the surgeon can get to the 3rd case, the 5th case, the 10th case, there's some point where if they achieve that milestone from an experience standpoint, they tend to go on and use the product and become a regular user. Let's go after these two topics.
Lifetime Value (LTV)
The first one is LTV or Lifetime Value. There are a lot of different ways to get the LTV. These terms are primarily developed for software as a service business or just rather subscription businesses, but I find them very helpful for med tech commercialization. What I like to do as a rule of thumb is assume the lifetime value is three years of revenue. First, you have to then determine what is the average utilization per case? What is the average selling price of your product? For example, the ASP for your implant is $2,500 on average across all your hospitals. One thing that investors don't like is when they ask for averages and you say, “It depends. We have one account that pays X and some accounts that pay Y. It's like, “Yeah, that's why we asked for an average.”
Let’s say your average selling price for your implant is $2,500. The average utilization of your implant per case or UPC is 2. So you have an ASP of $2,500 each, and you have utilization or UPC of 2 per case, which gets you to an average revenue per case of $5,000. Now you know the revenue per case. The next question is, is this something a surgeon will use once a week, once a day, once a month, once a quarter, or once a year? In the early commercial stage of the business, the first 10 or 20 customers, it's important to start defining what these averages are. For purposes of this discussion, let's assume the revenue per case is $5,000. On average, a surgeon will use your product two times per quarter. That’s eight times per year.
You have a $5,000 case that's performed on average. I emphasize average because you'll have your power users and the onesie-twosies per year. The average customer that you acquire to use your technology is going to do eight cases per year at $5,000 of revenue per case. That gets you to $40,000 of Annual Customer Value, also known as ACV. Because we're saying that this is the lifetime value of this customer, we're going to peg it to three years. That would mean your ACV is $40,000. Your LTV, Lifetime Value of that customer is $40,000 times three or $120,000.
Customer Acquisition Cost (CAQ)
Now that you've defined your LTV of $120,000, you can start planning your tactics for going about acquiring new customers. That is where this concept that has been around for quite some time is, which is the concept of Customer Acquisition Cost or CAC as it's referred to. If your LTV is $120,000, as a rule of thumb, to start your customer acquisition costs or what you invest to bring in one customer can't be greater than the LTV.
If it costs $121,000 to bring on a customer and the customer is only worth on average $120,000, you've built a sales process that loses money forever. In the early days, your CAC may be greater than your LTV because you don't have that many customers. As long as your model for LTV over CAC shows that it could start above 100% or over one but it starts, it has to decline over time. Over time meaning the relevant investment horizon for the investor.
If the investor is going to invest $10 million to help you expand your sales force, you have to show in 2 to 3 years that the lifetime value of $120,000 over the customer acquisition cost of $121,000, that denominator or the bottom number is going to start to decline. That usually happens because as you have scale, the cost of things gets a little less expensive. For this purpose, we're going to stick to one sales rep and one customer or the average customer that you acquire.
Let's assume you're targeting an LTV to CAC ratio of 2:1, and this is the key to this order. In this example, the lifetime value of a customer, which is broken down is three years of revenue. That's $40,000 per year and that revenue is generated by performing an average of eight cases per year or two a quarter at a revenue per case of $5,000. If you're going to start adding customers with an LTV to CAC ratio of 2:1, what that implies is that it's going to take two years to pay back your customer acquisition cost.
The sooner a person can understand these metrics, the more you're going to save a lot of capital and build trust and confidence with your investors.
With the $60,000 of CAC that you invest this year, you'll breakeven in two years. It's a two-year payback because the LTV over CAC is two. With that in mind, we started to know realistically what we can spend on sales and marketing. We also start to figure out what sales comp could likely become. If you have a case that's going to generate $5,000 and the average customer is going to be $40,000 to get to a $1 million of revenue for a single sales rep or sales territory, at $40,000 of revenue, they're going to need 25 customers.
That alone gives you a sense of what this business you're planning. Twenty-five customers are going to take some time unless you have a very specific hook to how you're going to generate new customers fast. For instance, if you can train 50 surgeons in a single lab, it's unlikely. That would be an example where you can do things quickly. Let's assume for this example, you're going to hire a sales rep. You're going to put the sales rep on a $150,000 guarantee for one year. What this accomplishes for you is you're going to give the sales rep time to invest in his or her training and development. They're not going to have the near-term pressure of generating commissions right away because it's going to take time.
It's important to note that in that one year or $150,000 guarantee, because this is sales and because you need productivity, I strongly recommend having $50,000 of that guaranteed incentive-based but tied to inputs that will lead to growth. That would mean training a surgeon, getting hospital approval, or beginning of sales dialogue with a certain minimum number of prospects. That's what you're looking for.
You're telling the rep, "Come join our company. We're addressing an important unmet need. Your career is going to grow here. We're going to invest a year in you. You're going to invest a year in us and together we're going to transform healthcare. In order for us to make sure that you're pacing to where you need to be in year two, we're going to give you a base salary of $100,000, but each quarter, we're going to pay you a bonus of $12,500 tied to your ability to access prospects, get hospital approvals, site of care where they perform their cases. The later outcome is we want you to train these surgeons.”
Depending on the sales cycle, you could even say a number of trial users, but the general idea is that. If their sales rep starts at the company with an expectation of $150,000, if you were to transition in year two to a $100,000 base and a 10% commission rate, in order to make $50,000 of commission at 10%, that means the sales rep has to generate $500,000 of revenue in his or her second year. The goal is $500,000 in revenue in year two. That means to get $500,000 of revenue in year two, this particular sales rep is going to have to generate a number of average customers and our ACV here is $40,000.
That means they're going to need between 12 and 13 users performing an average of eight cases per year. I can't emphasize enough average. There's going to be the rep that lands a high utilization customer. That's always exciting and great. It's hard to build a business around it. If you go with the averages, you're going to tend to have a pretty predictable commercial expansion, which is what you're looking for.
In order for this sales rep to get to twelve average users, the question then becomes, what percentage of the surgeons that trial the product get past that first case fourth case or whatever your main milestone is where they become a regular user? For the purpose of this discussion, let's use 50%. That means to get twelve users, the sales rep is going to have to get 24 people to try all the products.
Fifty percent of the trials go on to be users. If you have twelve users doing an average of eight cases a year, it gets you 100 cases times $5,000 of revenue per case. You have your $500,000. The sales rep is making the $150,000 that they were recruited to the company with and then they have the upside from there because they're continuing to add customers. At that point, after the second year, you've invested $300,000 in the sales rep. The first year was $150,000. The second year was $100,000 base plus the 50,000 in commissions. Now you're at $300,000 of sales rep customer acquisition costs.
A footnote here is true customer acquisition costs is to add up all the costs that would go into sales and marketing, but to keep this example simple and also to focus on the marginal sales rep costs, we're just thinking of our CAC as marginal CAC per sales rep. In this case, after two years of investment of $350,000 with payroll costs and benefits. The first year, maybe there was $100,000 of revenue or maybe there was nothing. In the first year, you get $0 to $100,000. In the second year, you get $500,000.
At that point, you're nearly breaking even on that territory. Let's say you did $150,000 to $200,000 in the first year and then 500,000 in revenue in the second year, you've got up to $700,000 of revenue and invested about $700,000. That commercial model would resonate with a lot of investors. One of the things it tells you is that this is a viable product to hire a direct sales force. The next thing that comes into play, when thinking about how much to raise for the sales force expansion is the fact that of the reps that you hire, not all are going to make it.
It’s a problem when you’re raising lots of capital and investing it at an increasing rate but your sales aren’t growing commensurately.
It means not all of them are going to get to that model. Some people are going to leave one year in. Some people are not going to have the ability to do this hard job like access busy physicians, ask good questions, establish an unmet need, and then build the trust and confidence to become a partner in their OR procedural suite. In building out your model of, “How do I get to $10 million of revenue?” It's not as simple as I'll hire 20 reps and they'll do $500,000 of revenue in year two.
It's usually probably more like, "I'm going to hire 40 reps and 80% or 10 are going to make it to the model." The point that you're going to make to investors is we will make a decision on the viability of this rep in an average of nine months. Meaning that we're not going to invest a year and a half in somebody that's not going to get there. It's not that we don't want to. It's not that we don't care about the person. It’s just we have a small amount of capital to scale this business.
To review some of these concepts. When planning a commercial effort for a medical device, it's very important to understand this. In the beginning, you won't know so you're going to have to use your best assumptions. You can come up with a hypothesis for what you think the Average Selling Price for your product will be or the ASP. You can then come up with an assumption on how many of your products will be used per case. That's the Utilization Per Case or UPC. That will give you the product of that, ASP times RPC equals revenue per case. Average selling price times utilization per case equals revenue per case.
Once you have RPC, you can make the next assumption. Again, this is just a model. It’s a hypothesis you have to test. Assumption three is the average customer and my recommendation is to be conservative. How many cases will they do a year? In this example, we used two per quarter or eight per year. Now you have your revenue per case, which was derived from ASP times UPC. Your RPC times your average cases per year get you your annual customer value, an ACV a year of $40,000. Because we're making a conservative assumption that in three years there could be some new game-changing technology and it's also just conservative to do this. We're going to say that our lifetime value for this customer is going to be three years at $40,000 and we arrive at an LTV of $120,000.
To wrap this all up and I know this is dense. I'm happy to speak with anybody that wants to do Office Hours and get on my calendar. You can go to JeffSmith.co and click on the link from my calendar. We can do a quick 30-minute session and go through some of this. Once you know your LTV is $120,000, your customer acquisition cost or CAC of one rep, because we're talking about territory, if you're going to invest $150,000 a year, you have to bring on four customers.
It’s four average surgeons because that's going to get you $160,000 of revenue per year or ACV. The breakeven at this point is if you can bring on sales reps and you're paying them around $150,000 because your ACV or Annual Customer Value is $40,000, as long as they can bring on for customers per year and they have to be able to stack them. It can't just be four and then they never bring on anymore.
If they can bring on four people in their first year, depending on the gross margins of the product, you're going to be able to expand in a way that is nearing or profitable. I hope this is helpful. If this is too dense or if it's plain boring, drop me a note. You can send me an email at Jeff@JeffSmith.co. The sooner a person can get to understand these metrics, you're going to save a lot of capital. You're going to build trust and confidence with your investors. It amazes me the number of incredibly well-trained, successful and experienced commercial leaders that have no idea about how this works.
Part of the reason they don't know is that the approach has been to hire direct reps and burn money until the revenue grows. That works if you're able to raise lots of capital. The problem is when you're raising lots of capital, you're investing at an increasing rate, but your sales aren't growing commensurately. Usually when you see that, if you want to have some fun looking at income statements for a public company, look at the quarter-over-quarter revenue growth. That goes from $50 million to $60 million of revenue growth until they grow $10 million.
Look at the growth in sales and marketing. If the sales and marketing expense went up to $30 million, all that is showing you is that they're increasing their investment in revenue growth by 3X. It's not even quite that much. They're investing $3 to get $1 of growth. That's not necessarily a bad thing if you're building capacity for faster growth, but any time you see as an investor the ratio of increased sales and marketing expense, let's say 2, 3 or 4 times the ratio of growth, you want to make sure that in the future, 6 months, 12 months or even 2 years, there is a revenue spike in the order of 3X. I hope this is helpful and thank you for tuning in.
---
I took a chance on something different in this episode. It's an Office Hour concept but it's getting into the whiteboard discussion on how to plan a sales force expansion. Most of us as entrepreneurs, when we set out to build a business, we're so focused on the product and understandably so. How it's going to change patient lives, and how it's going to make physicians' practices more efficient, safer and happier patients.
A lot of focus goes on the exciting and critical technical parts of designing the tech. The reason I'm talking about the commercial stage is that ultimately when we build businesses, we have to think about the end at the beginning because the cost of commercializing the business is what's going to drive how much capital is needed to fund this business. While it might not be at the top of our list as entrepreneurs, I can assure you when you get into the investor meetings, high-net-worth individuals and certainly VCs, this is going to be where they're focused.
Having a simple model to speak to how you think about commercial expansion and just being able to articulate and even have hypotheses for average selling price, utilization per case, revenue per case annual customer value, lifetime value of a customer, and customer acquisition costs are going to set you aside from the overwhelming majority of med-tech entrepreneurs and the MBA holders as well. I hope this helps and we'll be in touch soon.