The Secret Formula to Match Demand CAC vs. Supply CAC in Marketplaces
The ultimate guide to VC’s LTV/CAC analysis — final
Customer Acquisitions Cost (or CAC when the two of you become intimate) is one of those keywords insiders drop at every conversation. I always found funny how you need the jargon to be considered “part of the club”.
Personal considerations aside, in this piece I’ll close the loop of my “Ultimate Guide to VC’s LTV/CAC analysis” (you can find Part1 here and Part2 here).
Demand and Supply have different lifespans
In the first piece I introduced the concept of total CAC for a marketplace business, and explained why it’s composed of Supply CAC + Demand CAC. The key take aways are:
a) in a marketplace the “conversion event” occurs when Demand and Supply meet. This is when the marketplace earns its commission for the “matchmaking”, hence it needs to invest to acquire both; and
b) the two sides most often have different behavioural patterns, which entails different lifespans.
In Part2 I explained how to identify the side on which to calculate the lifespan on. I concluded that, in the majority of cases, it’s the demand side because it’s the key stakeholder for the marketplace, in relation to its business model. Most marketplaces do not charge a fixed cost to suppliers but rather a fee on the volume transacted. This means that suppliers have little-to-no incentive to churn and their lifespan can be assumed to be longer and more predictable.
So when it comes to the CAC the challenge is the need to match the lifespan at the LTV with the lifespan of the other side. If the demand has (e.g.) a lifespan of 3 years and the supply of 2, the Total CAC is determined as
1x Demand CAC + 1.5 Supply CAC (3/2).
When the supply has a shorter lifespan than the demand, a company will need to acquire additional supplier to fulfil it, thus incurring into additional costs.
On the other hand, in the more common case where the supply has a very long lifespan, only a fraction of its CAC should be accounted for.
Let’s take an example: UBER
It’s fair to assume that the supply at UBER (i.e. the drivers) has higher retention than the demand. Point in case, the driver needs to recoup the investment in the car. Let’s assume that, once acquired, drivers tend to stay with UBER 5 years, while the customers 3.
Let’s also say that the cost to acquire a driver and get him/her ready for service is on average $10,000, whereas that the average number of rides / year is 5,000. This means that the AVG cost per rider over the lifespan is ($10,000/ 5 / 5,000) $0.40.
Customers are cheaper to acquire, say $100, and each of them requests on AVG 15 rides / year. This implies that the Total CAC that matches the lifespan of the demand is:
$100 + ( $0.40 x 15 x 3) = $118
What is the LTV is based on the supply?
My suggestion is to calculate the Demand CAC per “conversion event” — that is, per purchase.
Say the cost to acquire a customer is $100 and each customer performs on AVG 2.5 purchases / year, for 2 years. This implies a cost per purchase of $20.
To match it with the lifespan of the supply, we first need the AVG customers per supplier. Say each supplier performs 12 sales /year, over a lifespan of 5, this equal a demand CAC of:
12 * $20 * (5/2) = $600
You can quickly see how, due to the low retention on the demand side, the company will need to spend even further to keep its marketplace up and running, thus lowering its forward-looking marginal profitability.
Recap and matching formula for Demand & Supply CAC
Once we have chosen the side between demand and supply to focus on, the formula to match the respective CACs is:
matching CACs= { (CACs * Ed * LSd ) / (Es *LSs) }
for the CAC of the Supply, or
matching CACd = { (CACd * Es * LSs ) / (Ed *LSd) }
for the CAC of the Demand, where
CACd / CACs = Total Demand/Supply CAC, excluding the effect of the lifespan
LSd / LSs = Demand/Supply Lifespan
Ed / Es = # of conversion events on each side during a certain period (usually the last 12 months).
Concluding remarks
A good understanding of your LTV/CAC ratio is not only essential in approaching institutional investors like VC firms, but it’s also a must-have internal practice for any company moving from a Seed to Series A and Series B. If calculated correctly, it’s an insightful metric for founders, investors, VPs and department heads.
One of the hidden benefits of such ratio is its sensitivity to even small increases in the company’s cost base. I think this is a crucial aspect for a fast growing entity, where costs can easily get out of hand. Even a small increase in the overall cost structure can significantly alter the ratio, raising the first red flag.
It might be easy to think that “burning” few thousand dollars on a failed Adwords campaign is trivial for a company with millions of costs per month, but it’s not in the context of the LTV/CAC analysis. When monitored per department or per acquisition channel, it will have a positive impact in creating a more aware, more cost-conscious organisation from founders all the way to interns.
Another important aspect is the definition of historical trends. In the ideal scenario that your CAC decrease over time and the LTV increases, the marginal change over time can become a predictor for the future and be used to project today’s ratio: a very powerful indicator for VC firms. Sometimes the improvements and their foreseeable evolution in the future are more indicative of today’s data. The earlier your company becomes data oriented, the easier it will build a strong argument when raising capital. Data can’t make up the story for the founders, but can back up their claims and show their executional skills.
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