[CEO Friday] 3 Reasons Why ROI Analysis Doesn’t Work for Freemium

David Barrett —  December 13, 2013 — Leave a comment

Most VC pitches hinge on a key number:

Return On Investment (ROI) = LifeTime Value (LTV) / Cost to Acquire a Customer (CAC)

And I can’t blame them: VCs are in the business of selling money.  They want to know that if they sell you their money (paid for with equity), it’ll be put to good use.   This is more true today than ever because startups are so cheap to run anymore, meaning the only realistic way you can spend millions of dollars is on customer acquisition.

But the open secret that has taken me years to learn is this: it’s all bullshit.  Yes, all startups do present those numbers (you can’t not), and some even believe them.  And the more confident (or deluded) you are by those numbers, the more aggressively you can bet (excuse me, invest) into it.  But in the vast majority of cases, for the vast majority of successful startups I’ve researched (both old and new), the numbers are total crap.  Again and again, I see:

  1. LTV is usually infinite.  The easy place to start is estimating LTV = Monthly Churn / MRR.  But monthly churn is always super erratic (due to the law of small numbers) and MRR is always changing (hopefully going up), meaning due to “accumulation of error” the statistical relevance of that number is so low as to be useless.  Furthermore, even if it wasn’t useless, oftentimes that method of estimating LTV is flat out wrong.  If you have a large variance in your MRR (for example, Expensify has customers who pay under $5/mo to over $5K/mo — all for the same basic product) and low churn amongst real customers (versus those who just did a “paid trial”) you might find yourself ending up with “negative revenue churn”.   This means that the people who stay continue to pay you more over time than the people who leave, indefinitely.  Which means your LTV is, effectively, infinity.  Which isn’t nearly as awesome as it sounds, because it’s immediately discarded out of hand as impossible.
  2. CAC is usually zero.  Most freemium businesses (and many of the top non-freemium businesses) don’t pay for leads — or if they do, pay for them in ways that are completely unquantifiable.  (Dig in to Intuit, Xero, Yammer, Box, Atlassian, Salesforce, or a dozen others and you’ll typically find that less than a third of marketing spend can be attributed directly to new revenue.  Nobody likes to admit it, but in most cases — especially for the most successful businesses — marketing is largely of matter of faith.)   But again, like an infinite LTV, having a zero CAC isn’t actually that awesome because it doesn’t mean your leads are actually free (in a non-marginal sense), but rather that you don’t have any realistic way to buy more.
  3. Therefore, LTV / CAC = Infinity / Zero.  What does that even mean?  I have no idea, but that’s what the math says.

The dirty secret that I think is gaining more traction in Silicon Valley is that the classic metrics we’ve all grown up with aren’t making nearly as much sense as they once did.  You know you’re talking with a savvy VC when they don’t freak out when your business doesn’t fit these outdated formulas.  You know you’re talking with a great VC if they don’t even ask outdated questions in the first place.

David Barrett

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Founder of Expensify, destroyer of expense reports, and savior to frustrated employees worldwide.

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