Max Revenue

CliffLooking
Let’s say you are a CEO of a rapidly growing startup (or a VC deciding whether to invest in a rapidly growing startup).  All the numbers look up and to the right. How do you know how big this company will get?

When looking at subscription-based companies (or any company that is based on Lifetime Value vs a one-time transaction) a few simple equations can help you predict your maximum engagement levels, maximum revenue or (in a future post) maximum EBITDA or profit.

In this post I’ll describe the equations first (sorry – have to go into a little math) and then discuss the repercussions.

The simplest equation is figuring out your peak or maximum engagement.  

Equation #1 – Maximum Sustainable Engagement =  1/CHURN x NEW GROWTH

To figure out the maximum sustainable engagement, take the reciprocal of your churn (i.e. 1/CHURN) and multiply it by your average new growth.  

For example: If you lose 25% of your customer base year over year and get 1000 new customers a year, your max customer size will be 1000 times 1/.25 or 4000.  At 4000 customers you will be losing 1000 (or 25%) each year due to churn which is exactly the same amount of new members you get.  

You can use a similar equation to determine your maximum revenue.

Equation #2 – Maximum Revenue = 1/(ARPU CHURN) x GROWTH x (INITIAL ARPU)

To determine your maximum revenue, instead of churn, use ARPU churn (Avg revenue per user) churn or the fraction of money you make per cohort in year 1 vs year 2.  For example, if you make $1000 from 100 customers in their first year and $800 from those same 100 customers in year 2 you have an ARPU churn of 20%.  ARPU churn accounts for not only churn in terms of inactive members but also churns in terms of less revenue per customer due to less engagement or declining purchases over time.  So if you are growing at 1000 new customers a year with a $10 ARPU (Average revenue per user)  in year one and  a 20% ARPU churn, without any other changes your company’s maximum possible annual revenue would be $50,000 or (1/.20 * 10 * 1000).

In both of these equations, the reciprocal of your churn (i.e. 1/churn) is your multiplier effect.  If you have a churn of 50% you maximum size is 2X your annual new membership. If your annual churn is 10%, your maximum size will be 10X your annual new membership.

So why do these equations matter?  First, by understanding your max sustainable revenue you can start to predict how big of a company you are actually building.  Second, if you play around with the model you will start seeing some key take-aways.  Specifically:

  1. Churn – not growth – is the key metric to building a long-lasting great business.  Increasing your growth or your revenue will linearly increase your market-size potential, but reducing your churn can grow it exponentially.  If 50% of your existing customers drop off each year, you have to make up for 50% of those customers each year before you can start growing.  On the flip side, if your customers stay 99% active a year later retention rate, you only need to make up for 1% of your existing base before you can grow your audience.   You can cover up the churn problem in the short term by growing quickly but eventually it will come back to haunt you.  (Note: this is one of the reasons I am so bullish on building fantastic long-term engagement.  Long-term engagement of existing customers is the key to long term profits – even more than new membership growth)
  2. Churn is the combination of both people who stop using the product AND a decrease in revenue.  Companies often think of churn as the % of customers they lose completely each year.  But real churn is the amount of % of revenue you lose each year from each customer.  This is particularly true for ecommerce-based and entertainment-based companies where customers may still be active but just buy less in year two than they did in year one.
  3. All else being equal, all companies that have churn in a steady state have a maximum size.  If you are losing customers (or revenue per customer) each subsequent year, you will have to make up for it.  Eventually the existing customer base will get so large that the company can only replace its churning revenue and basically be running to stand still

I find it interesting that a large number of investors, press and potential employees considering companies overlook these numbers and just look at the hockey-stick rate of growth.   In my mind they are missing a key component that may eventually come back to haunt them.

In future posts, I will delve into more of the details on how you can more accurately estimate churn, and growth rates and eventually start predicting the max sustainable EBITDA.

Notes:

  • The Max Revenue model is a simplified equation.  In particular, it assumes long term industry growth is similar to the discount on future revenue.

Creating vs. Disrupting

The word “disrupt” is everywhere these days. In Silicon Valley today you can’t spend more than 5 minutes in a coffee shop without hearing someone describe how their company is going to “disrupt industry <fill in the blank>.”  Entrepreneurs and business school students are repeatedly taught case studies of companies who ended up “disrupting” markets.  It’s even the name of TechCrunch’s popular startup conference.

Disrupting a market to improve it is definitely a difficult and noble cause.  But Silicon Valley’s obsession with focusing on disruption is leading people in the wrong direction.  You don’t build the biggest companies purely by focusing on disrupting an existing market.  You have to come at it from a different angle.

Here’s why:  Thinking purely in terms of “disruption” psychologically limits your direction and potential. If you are just thinking about disrupting an existing industry, you will tend to narrow your market size to just the current market’s customers and their needs.  And product-wise you are led to think of big improvements to current products (i.e. “How can I make a faster horse & carriage for people who currently use it” or “how can I build a better flashlight”?) vs thinking of something completely different.   For example, ten years ago, if you were trying to disrupt the personal flashlight industry would you have thought of developing an iPhone?

Most of the most successful Internet companies today did not find wild success by just taking over old industries — they found it instead by first focusing on creating a new market where nothing previously existed.  They targeted the customers who were not currently served and found a better way of serving them.  And in the act of creating that new market they ended up disrupting many existing markets along the way.

Much has been said about how Uber, Lyft and other ride-sharing services – today’s poster children for “disruption” –  have “disrupted”  the taxi industry.  Yes, people are now definitely taking Uber and Lyft instead of taxis. But they are also using those services in ways in which they never would have used a taxi.  Commuters are taking Uber and Lyft instead of driving to work and paying hefty city parking fees.  People are now choosing Uber over walking, taking the bus, or just not going somewhere.  And the designated driver is getting replaced by the Uber driver.  Uber/Lyft have not just replaced the Taxi service, they have made personal transportation so convenient and inexpensive that they serve a market need an order of magnitude larger than just the one served by yellow cabs.

Other highly successful companies have similarly disrupted an existing industry by creating a new one. Apple’s iPhone is used for so much more than a phone, AirBNB is addressing a much larger market than just hotels, Pinterest is used for much more than pinning images, and Facebook was used for much more than the original college picture directory or “Facebook”.

My advice to executives, product managers and entrepreneurs:  When you are thinking about building out your new enterprise, don’t limit yourself to “disrupting” an existing market and the people who are already served.  Instead, focus on creating a new industry.   Look at who is not being served and go after them instead.  You far more likely to come up with a much larger idea and business .

Takeaway:

  • Disrupting an existing industry is too narrow of an approach.  Think about creating a new industry serving people who could not originally be served.  You’ll end up with a bigger total market, a more creative solution and a willing audience eager for a new indispensable product.

Do You Believe in Magic?


sparkles

 

I have been helping a few startups try to reach product-market-fit and have encountered a common theme: everyone is too tactical.  Discussions quickly digress into incremental benefits and features.  Attend any company’s product meeting and you’ll often hear debates about adding Feature X vs Feature Y based on criteria like development time and which one the customer would prefer.

Want to build a truly great customer experience? Stop talking about features – or even benefits – and start talking about creating an overall “magical experience.”

Think of it from your customer’s perspective.  Ask customers to describe their favorite products and they will almost never list out features.  Instead they describe an experience that is so amazing and so over-delivers on expectations that they can’t help but feel like something magical just happened.

Some examples:

Uber:  Need a ride somewhere? You used to have to wait for a cab and hassle with cash payments.  Now just push a button.  A personal driver *magically* appears and takes you wherever you want to go.  When you arrive you just get out.  The rest is all taken care of.

Sprig/Munchery:   Need dinner? Don’t think about cooking or calling for delivery. Choose a picture of a beautiful meal prepared by a professional chef.  Push a button and it *magically* appears at your house in 30 minutes.

Amazon Prime:  Need to buy something?  Don’t deal with the hassle of driving to a store and parking.  Tell this website what type of item you are looking for.  Then push a button and in 48 hours it *magically* appears on your doorstep.

At their core, almost all of the most used Internet services today are defined not by their features but by an experience so impossibly simple it just seems magical.

So what makes an experience magical?  Three key elements:

  1. It’s absurdly simple. Something as simple as “Push a button” or  “type in a word” or “wave a magic wand”.   Any work required by the user and the magic goes away.
  2. It’s doing a task that is normally hard. The harder the task feels to begin with, the more magical it will feel to make it simple.
  3. It’s helping solve an important need.  If the task you solve is not important you’ll get a nice “wow” but it just won’t have the same emotional appeal as fixing something that matters.

Before you create incremental features, take the time to flesh out the ideal “magical experience” for your customer.  What very difficult, important task are you going to make impossibly easy?  Ask your customer “If you could push a button or wave a wand, what would you like to have happen?” It’s a much easier way to figure out their most pressing problems and their ideal solution.   Then back into what exact product changes – feature additions, changes AND removals –  you need to make that happen.

Takeaway:

  • When building your roadmap, rather than focusing on features, focus on creating an experience your customer would describe as “magical” – then back out the minimum amount of features or changes to make it happen and remove everything else.