Back when I was practising case studies for consulting interviews, someone told me that the solutions to most, if not all, usual business case problems can be found by evaluating this equation: Profit = Revenue - Cost.

Revenue can be further broken down into its parts: price and quantity, cost split into variable or fixed costs. These four components of the profitability equation yield a surprising amount of insight into a company’s business model.

Fast forward a decade (wow has it been that long?) and the tech sector is booming and the world is buzzing with talks of funding rounds, valuations, growth, and flywheel. We use terms like “low moat”, “scale” or “first-mover advantage” a lot when discussing companies but is there a way to evaluate business models and tie these seemingly qualitative evaluations in a more systematic (mathematical) manner? In the absence of profit margins as a north star, what is the “Profit = Revenue - Cost’’ equivalent of thinking about the returns of different business models?

I may just be a slow learner but lately, I find myself gravitating to two primary metrics: Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV) in framing my thoughts around different business models.

ROI = LTV / CAC

Customer Acquisition Cost Most startups spend heavily on CAC in the first few years of growth. How much a startup chooses to spend on CAC in its early years largely depends on:

How much of a moat is inherent in its product (generally a function of how much R&D or upfront investment goes into building the product) How much immediate utility the product brings to its target market

In many cases, if the answer to (2) is “a lot”, there is still a significant amount of marketing spend to bring awareness of the product to the market. But it can be argued that this upfront awareness spend is more a short-term fixed cost (initial investment) and overall CAC will be low or trend to zero in the long-term as customers discover the product, quickly realize how much value it adds and organically start using it.

The challenge is when the answer to (1) above is “low”. This is usually true of startups built on innovations of existing business models that may not be “high-tech” e.g., aggregators, marketplaces [1]. If the utility of a product depends heavily on scale or access to a broad network of users/ suppliers/ partners, speed to getting to critical mass before a competitor emerges becomes extremely important. First movers have an upper hand in this user acquisition race primarily because they get to set the CAC benchmark for the market, and all other competitors (assuming no true differentiation in the product) have to follow.

Customer Lifetime Value [2] For a startup to decide to spend a disproportionate amount on CAC early on, they have to believe that customer LTV is worth a few multiples more i.e. ROI will be high. LTV is a function of:

Increased frequency / spend over the customer lifetime Higher spend (upsell/ cross-sell) on new products introduced over time Customer churn

Both factors (1) and (2) require time to materialize. Business models with a low moat may see competitors entering and increased churn before they are able to fully realize customer LTV.

Competition In a low-moat industry, competitors who enter the market after will almost always need to incur a higher CAC to switch a user over. To justify this, competitors would either need to: Believe that customer LTV is much higher either because of synergies with an existing portfolio of products or something the incumbent may have missed Be willing to accept lower returns on CAC Believe that their product fundamentally adds more value than that of the incumbent and thus organically drives higher LTV

(3) is true disruption of an existing business model.

To this end, localization of an existing business model / product alone may not be enough to truly win over a globally developed product (assuming the global company has had more time, resources and access to global talent to invest in innovating on the core product - these assumptions may not be true). The barrier to entry to most developing markets for global players may just be the cost of building out the core product to meet local needs. [3] But at some point, as growth matures in their original markets, global players will start viewing the returns to tackling these barriers high enough for them to enter. When that happens, incumbents may find themselves competing with a superior product.

A defense play: CAC as a recurring retention cost In most cases, when we think about unit economics of a product / service, we exclude the CAC of the business because we assume that this is an upfront fixed investment which will drop over time with network effects or increased brand awareness. But when a competitor emerges, the incumbent has no choice but to respond and to keep spending on customer retention as a defense. In these cases, CAC then turns into a continuing expense in the form of “customer retention”.

Simply put: CAC may be a one-time expense to bring a new user in but in a perfectly competitive market, customer retention cost will always be a cost of revenue for businesses so heavily reliant on scale

If we accept that for some business models or products, customer retention cost is a necessary cost of revenue to keep defending market share and growing, then LTV net of customer retention cost is much lower and we should question if the ROI from the early loss-making days was indeed worth it.

The top priority of any such business should be to:

Maximize dollar efficiency of retention cost Quickly invest in ways to differentiate. Some early thoughts: Build a superior core through investing heavily in R&D / product development. Or add enough critical value-added features for users that are difficult to replicate Build vertical integrations with enterprise/ business partners to increase switching costs (for consumers, it’s a lot harder) Deliver a superior world-class offline consumer experience

Exceptions I can name so many companies who have defied what I have laid out above and managed to build world-class businesses (e.g., Airbnb, Twitter). Perhaps dedication and sole focus on superior execution have supersized roles to play in building a moat around the business. I may also have underestimated barriers to entry (regulatory, local market dynamics) in these industries which may give incumbents a much longer runway before competitors emerge. But in a world where most startups often have lofty global ambitions (and valuations that reflect that), it may be worth having a more objective frame to assess business fundamentals.

[1] In a marketplace model, a company matches two sides (supply and demand) to enable a business transaction to happen. Without this company, the “matching cost” would be much higher (e.g., labor marketplace startups like Apna) or the transaction may not even happen at all (e.g., Airbnb). Business models of the former (where the company is just reducing the “cost” of a traditional way of working) arguably have an even lower moat than the latter. With the latter, competitors may be a bit more wary of entering an unproven market

[2] Unfortunately very tough to estimate and a useful but very theoretical concept in real life today

[3] Game theory at play: upfront setting an artificially high CAC in a market may actually deter global players from entering and buy incumbents long enough time to work on product innovation