The One Question Nearly Every Business Owner Should Know but Doesn't

The One Question Nearly Every Business Owner Should Know but Doesn't

Are you thinking about selling your company? Or maybe you're in the market to buy one? There’s one crucial question you need to know, whether you're a buyer or a seller. It's a question so important that it can drastically improve your chances if you are selling or give you significantly more confidence when buying. Despite its importance, nearly every business owner I meet doesn’t know the answer to the question when I ask them. Curious what the question is? Read on, because this question can significantly impact your business's future.

For the past six years, the International Business Broker Association (IBBA) has named me the top business broker in the country. I mention this not to brag, but to highlight that I’ve closed a lot of businesses, over 663 businesses sold. In every deal, I ask the seller this one question. Yet, 99% don’t know the answer, don’t track it, and don’t understand why it’s so vital. When a business owner does know it, I nearly fall out of my chair!

So, what’s the question? Before revealing it, let's set the stage.

The Critical Concept in Business Valuation

Every seller likes to talk about their business's potential. They say how a new owner, by implementing a few changes, if they just do X or Y, could grow the business. Hogwash! Don’t buy into this pipedream, that isn’t how real-world valuations work. I take a different approach if I am doing expert witness work or in other situations, for this example, I am specifically referring to buying and selling businesses on the open market that are often tied to bank financing. 

While it might be true the business does have unrealized potential, valuations—especially in the main street and lower middle market—are based on historical performance, not hypothetical future growth. Specifically, they’re often based on a three-year weighted average, with the most weight given to the trailing 12 months.

Yet, there’s a key principle to remember: Buyers pay for historical performance but buy for potential. This is worth repeating: Buyers pay for historical performance but buy for potential.

So, how do you, as a seller, prove your business has potential? And as a buyer, how do you verify that a business is truly scalable? The answer lies in knowing two critical metrics: your customer acquisition cost (CAC) and your average customer lifetime value (CLV).

Understanding Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLV)

To illustrate, let’s consider an example. Imagine a manufacturing business that sells a product for $2,000, with a profit of $500 per sale (after all fulfillment, operational and marketing costs and assuming no repeat orders to increase the CLV).

If this manufacturer runs paid ads costing $20 per lead and converts 1 out of every 5 leads, their customer acquisition cost (CAC) is $100. 

Let's break it down step by step: 

• Product selling price: $2,000

• Profit per sale: $500

• Cost per lead: $20

• Conversion rate: 1 in 5 leads (or 20%)

Step 1: Calculate the number of leads needed to acquire one customer

Leads per customer = 1 / Conversion rate = 1 / (1/5) = 5 leads

Step 2: Calculate the total cost of acquiring leads for one customer

Cost of leads per customer = Cost per lead × Leads per customer

Cost of leads per customer = $20 × 5 = $100

Step 3: Calculate the CAC

In this case, the CAC is equal to the cost of leads per customer, as no other marketing or sales expenses are mentioned. CAC = Cost of leads per customer = $100

Therefore, the Customer Acquisition Cost (CAC) for this manufacturing business is $100.

Additional insights:

• Profit per customer: $500

• CAC: $100

• CAC to profit ratio: $100 / $500 = 0.2 or 20%

Now, why is this important?

Why CAC and CLV Matter for Sellers

As a seller, if your business has the potential you claim it does, you need to prove that your CAC is 25% or less of your average CLV. Then, scale the business to turn that potential into actual performance that is shown on your trailing 12 month financial statement. 

Why CAC and CLV Matter for Buyers

As a buyer, understand that most small business owners don’t track these metrics. However, if you can find a business where the CAC is 25% or less of the CLV, you have a golden opportunity. This means the business is scalable and has proven and predictable growth potential. Here’s why:

- If the CAC is lower than 25% of the profit per sale, you can invest in scaling up marketing efforts, knowing that each dollar spent will likely yield a 4:1 ratio (or thereabouts). 

- You can confidently project future growth and profitability, making your investment thesis stronger and more reliable. As a buyer, you should update your investment thesis or buying criteria to find a company that meets these criteria, assuming your goal is to buy a business and scale it.

The Key to Predictable and Scalable Business

Whether you’re buying or selling, make CAC and CLV central to your strategy. Sellers, prove your business’s potential by optimizing and tracking these metrics, then showcasing your results. Buyers, look for companies with a low CAC relative to their CLV to ensure scalable and predictable growth.

Knowing and understanding these numbers isn't just about making a sale—it’s about proving your business’s true value and potential. So, ask yourself: Do you know your CAC and CLV? If not, it's time to start tracking. This knowledge can transform your business and give you a significant advantage in the marketplace.

p.s. A common mistake to be aware of. Using CAC and CPA (Cost Per Acquisition) interchangeably: These metrics are often confused, but they measure different things. Using them incorrectly can lead to misguided decisions in growth projections and company valuations