Two Financial Metrics You Need To Know

By Tom O’Neill, Exodus Capital Advisors

There are two critical metrics that apply to every portfolio company that you have, and for reasons that I’ll explain in this article, there’s a good chance that you have no idea what they are. In this article, you’ll learn why these two key metrics are a blind spot for most companies, how you or your management team can calculate them, and I’ll share four specific ways that you can apply this knowledge to boost earnings for your portfolio companies by 10 percent to 25 percent or more without heavy lifting.

Every company you’ve ever been involved with is in the same meta-business: customer acquisition. All of those other important metrics—sales, contribution Margin, EBITDA, and others—ultimately come from one place: customers cutting checks. Therefore, to really understand the mechanics of a particular operating business, you need to understand two things 1) What does it cost to get a customer? and 2) How much are they worth once we get them? As elementary as this knowledge may seem, it’s been my experience that not one in 10 companies knows either of these metrics. So, most companies are spending millions on sales and marketing activities designed to attract customers, without fully understanding what a customer is even worth, or what they’re spending to get one.

Before you start thinking that this may not apply to the companies you invest in bear in mind that it’s the mechanism, not the specific tactic, that I’m talking about. Every company has one or more ways of getting a customer in the door. For manufacturing companies, that often includes salespeople, manufacturer’s reps, trade shows, and advertising in trade publications. For a retail company, it will usually include Internet, possibly catalog, retail stores, and direct mail. For services firms, it’s largely professional referral and PR-based. The mechanisms will vary, but the fact remains that every company invests in one or more ways to acquire customers. And it is therefore imperative that you have metrics for understanding how well (or poorly) each of these mechanisms is performing. So why don’t you usually know how much it costs to get a customer?

Lifetime Value

First of all, if you don’t have a handle on these numbers for your portfolio companies, you’re not alone. One reason is that, due to a 700-year old double-entry accounting system, companies don’t usually roll up expenses around business processes. A direct mail campaign, to choose one example of a customer acquisition strategy, is scattered across several different accounts on an income statement (paper, copy, graphics, mailing costs, printing costs, etc.). This is useful for understanding the total amount spent with a particular vendor, but it’s not at all useful for understanding how well a business is performing a particular customer-acquisition function. So, in order to understand customer acquisition cost, you need to group expenses together around the business functions that they are funding. This can be a bit of a challenge in itself.

But this is only part of the work, because even if you know that it costs your portfolio company $5,000 to get acquire a customer, how do you know if that’s good or bad? In order to evaluate that, you’ll need to look deeper into the numbers and calculate the average value of a customer relationship (often referred to as “lifetime value,” LTV, or “marginal net worth” of a customer). LTV can be defined as the total gross profit of a customer relationship, over time. This is another blind spot for accounting systems for two reasons: Revenue is usually tracked as a homogenized number (not per customer account), and even if average sales per customer is being tracked it is only tracked within the standard accounting periods (sales per month, quarter, etc.), not over the lifetime of the customer relationship, which is a true reflection of what the customer is actually worth.

Going into fine detail on how to calculate lifetime value is beyond the scope of this article, but it involves understanding what the typical purchasing behavior of a client is, the average length of the relationship, and the total contribution margin resulting from that activity. For example, in a distribution company that my firm recently advised, the average customer spent about $2,050 per invoice, ordered 7.2 times per year, and remained a customer for 5.5 years. Since the company operated with a 25 percent gross profit, the average gross profit contribution from a customer relationship is $20,295. And to account for the time value of money, you might say that the net present value of a new customer is closer to $17,000. This is now your “yardstick” to measure against each customer acquisition mechanism in the company. If a client acquisition cost is well under that amount, then it’s a self-financing expense that you should continue to finance as long as you get a positive yield. If the acquisition cost is over that amount, that’s a sign the strategy needs to be immediately improved or dropped.

The most powerful thing about understanding these numbers for your portfolio companies is that it gives you the basis for calculating the yield on the core business processes for each company. After all, the yield on your portfolio investment is largely an aggregation of the internal yields within the business. And you now possess a tool for calculating yield on sales and marketing investments more accurately (one general partner told me that he thought of all sales and marketing as “voodoo” until he had an understanding of how to put these analytics behind it). There are numerous ways to apply this type of analytics in your fund, and here are four quick examples of how you can use them to create new value in your portfolio:

1) To reallocate capital more efficiently. One of the most powerful ways to pump up EBITDA without investing new capital is to re-allocate capital (or budget, if you prefer) according to which customer-acquisition process has the highest yield. I’ll give you a specific example. I advised a manufacturing company with a direct-to-consumer model that had two primary customer acquisition mechanisms—magazine advertising and Internet marketing. After evaluating customer LTV and the acquisition costs of the two channels, we found something shocking. Customer LTV was approximately $5000. But while it cost the company $5,500 to acquire a customer via their magazine ads, it cost only $230 via the Internet. Even more surprising was that magazine ads were getting more than 10x the budget of the Internet market efforts, despite the fact that virtually all of the contribution margin from the business came from the Internet channel. A simple shift of 10 percent of the magazine budget over to Internet created an opportunity to increase EBITDA by more than 27 percent, without risking a dollar. Capital re-allocation gains are the lowest of the low-hanging fruit, because they don’t involve any behavioral changes on the part of employees. By shifting budget toward mechanisms with higher yields, significant EBITDA gains can be harvested without increasing costs.

2) To identify process improvement opportunities. “You can’t manage what you can’t measure,” a famous management guru once said. Once you’ve ensured that your portfolio company is consistently monitoring these key metrics, you have provided management with the keys to improve them. If they see that acquisition costs are creeping up, it immediately tips them off to the possibility of saturation of a particular marketing effort, a problem with the sales force, or other areas. With regard to customer LTV, management can use the metric to determine the effectiveness of customer retention programs, cross-selling and up-selling efforts, and more. This can provide immediate feedback in areas where management may have otherwise burned substantial capital before realizing that a strategy is not paying off.

3) To identify a bidding “buffer” for M&A auctions. With increasingly fierce competition for quality deals, superior analytical knowledge of a target’s operations can be a strategic advantage in an auction scenario. For example, by using customer-acquisition and LTV analysis, you may determine that the target has $750,000 in latent EBITDA based on unharvested capital re-allocation gains. This can allow you to comfortably outbid your competitors without overpaying for the deal.

4) To evaluate add-on acquisitions. Strategically, all add-on acquisitions are driven by one or both of the following ideas: you’re buying customers (regional expansion, buying direct competitors, etc.) or you’re buying the capacity to increase the value of your existing customers (new products or services, cost efficiencies, etc.). Accordingly, once you know the customer-acquisition cost and LTV for your platform, it’s very useful to look at the same metrics for any add-on targets. If the target has a much lower acquisition cost or a higher LTV than your platform, that gives you the basis for calculating some of the potential synergies beyond the typical SG&A efficiencies. Conversely, if the target has a higher acquisition cost or a lower LTV, then that immediately tells you that your platform has superior business processes that can be transferred to the target post-closing. Most importantly, it gives you the basis for taking what are often anecdotal comments about strategic efficiencies, and turning them into an investment thesis with hard numbers behind it.

The critical metrics of customer acquisition cost and customer lifetime value can often be elusive, but you now have a handful of strategies for immediately exploiting this analysis for your benefit. And while it’s clear that performing this type of analysis on your portfolio companies is a non-trivial task, it should now be equally clear just how powerful these metrics can be when used to inform your enterprise value engineering efforts.

Tom O’Neill is managing director of Exodus Capital Advisors, a Mendham, N.J.-based advisory firm that helps private equity firms identify and harvest latent value from their portfolio companies.