In this blog post, I want to share my thoughts on the funnel from my unique experience working as a venture capital investment analyst at Peak Capital. Before you continue reading, let me emphasize that what I am going to tell you was key to my decision to start a Growth Hacker career after working in venture capital.
In the venture capital world, it is conventional wisdom that a startup with product-market fit should be able to afford the acquisition of three new clients for every client they bring in. In more technical terms this means your startup should have a ‘customer lifetime value’ / ‘customer acquisition costs’ ratio of 3 or higher (CLTV:CAC > 3). Here, CLTV is the total profit an average customer brings to your business minus the costs to acquire him.
The effectiveness and simplicity of the CLTV:CAC ratio is astounding as a metric for product-market fit and is, in my opinion, the most important metric that any startup should focus on after they managed to secure initial cash flow.
So how does this north star metric relate to the AAARRR pirate funnel? Let me explain.
The AAARRR funnel contains all the elements needed to explore and optimize your CAC and CLTV. In fact, your CAC is a function of Awareness, Acquisition and Activation (AAA), while your CLTV is a function of Revenue, Retention and Referral (RRR).
Therefore it follows that CLTV:CAC equals RRR:AAA.
For me, this was one of my most important realisations in Growth Hacking.
To clarify, let’s first consider Awareness, Acquisition and Activation and assume you are doing paid advertising. If you know the costs of your ads and you know at which rates you can acquire and activate your customers, you can easily calculate your customer acquisition costs. For example, if you have a ‘cost per click’ (CPC) of EUR 0.15, an acquisition rate of 10% and an activation rate of 5%, your CAC is 0.15 / 0.10 / 0.05 = EUR 30,-.
Similarly, for Revenue, Retention and Referral, you can determine your CLTV by multiplying the average profit per purchase by the number of purchases that your average customer will make and the number of additional customers he will bring in on average. For example, assume that you have a subscription model and your profit margin on an average customer is EUR 5,- monthly. Also, you know that the average customer churns after 18 months and provides you with 0.10 additional customers, he will provide you with a CLTV of 5 x 18 x 1.1 = EUR 99,-.
Now that we know both our LTV and CAC we can see that paid advertising at an average CPC of EUR 0.15 is scalable for our business (= 99,- / 3 > 30,-).
You have now successfully validated your business model, pretty cool, isn’t it?
In summary, make sure you thoroughly understand your CLTV:CAC ratio and use it to optimize your AAA and RRR in your funnel by determining which channels scale and which do not.
Want to read more about how to calculate your CLTV if you don’t have a subscription model?
Read this article.