Podcast 11: A Million Dollar Ecommerce Business Boils Down To These Three Equations

Hey, everybody. Welcome to the Nerd Marketing podcast, the only podcast where I open by, “Hey everybody, hey.” That little laugh there makes you feel better listening to this. We’re having a good time, right? I’m smiling. I’m in a room all by myself talking into a microphone, smiling, talking about e-commerce. It’s a good time. Hey, everybody. I’m Drew Sanocki. Welcome to the Nerd Marketing podcast.

We’ve been talking about how to grow an e-commerce retailer to $1 million in revenue. It’s something we did at Design Public within the first year, year-and-a-half. I want to take a different angle on that today. I believe in Occam’s razor and, as much as I can, I like to simplify what went into building a $1 million retailer.

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Today I want to talk about 3 core equations, and maybe 1 bonus equation, that got us there. The idea is if you keep these three core equations in mind and work such that they all are true, then I think you stand a decent shot at scaling up your business. As always, I’ve got a related cheat sheet to this article, in this case if you go to NerdMarketing.com to this podcast page you can download some of the templates where I work through the math and the equations in an actual spreadsheet that you can copy and use at your own retailer.

Without further ado, equation number 1 is: LTV must be greater than CPA, so customer lifetime value should be greater than your cost per acquisition.

I’ve seen it as CLV, LTV, same thing, customer lifetime value. CPA or CAC, customer acquisition cost, same idea. The idea is that you make more money that you spend to acquire that customer. This is the essence of product market fit for an online retailer. Go ahead and Tweet that out. What I mean by that, coming out of the gates with a new retailer you may not know if this equation is working for you. It takes some time to find what’s called product market fit, which is a good fit between what you’re selling and the market. The way you gauge whether you’ve successfully found this is that you’re going to make money on a sale. That’s what LTV over CPA means at the end of the day.

What your goal should be is to calculate your LTV and your CPA for each marketing channel. In other words, you’ve got a certain CPA for your email marketing. You’ve got a certain CPA for your AdWords campaigns, a certain CPA for your Facebook campaigns, even a CPA for social campaigns, which may or may not have a direct cost associated with them. The idea is each of these channels is going to have its own cost per customer that you acquire and each one will also produce customers who have different LTVs, or different lifetime values.

Now, a couple caveats, because on the surface it looks like a very simple equation: LTV must be greater than CPA. It’s actually pretty complicated. LTV is, to put it bluntly, a pain in the ass to calculate. It depends, often, on repeat purchases, on knowing how long someone is going to remain a customer. Maybe they’re a customer for a while, they go away, then they come back again. Is that the same customer or do you count it as a different customer?

A lot of those things cannot be answered in your first year, so what I would do is substitute your first purchase gross margin for lifetime value. What you try to do then is trying to find a marketing channel or several marketing channels where you make money on the first sale. Gross margin, if you’re a drop-shipper, say you make 50%. 50% is your cost of goods and you make 50%. You’ve got some other related expenses you want to take out of that remaining 50%, maybe some marketing expense, drop-ship fees, shipping, and you’re left with a gross margin and you want that to be greater than what it costs to acquire that customer. That means you don’t need repeat purchases from that customer. You’re going to make money on the first sale. That would be the first caveat, is that if you’re starting out or if you’re in your first year, don’t try to figure out LTV, the total profitability from a customer. Instead, just look at that first purchase gross margin.

The second caveat would be that this equation really doesn’t apply to venture-backed companies. If you are running Gilt Group, Fab, Facebook, you could turn off my podcast right now because in the early days these companies don’t care about profits. A venture-backed company is shooting for a billion-dollar valuation. Those guys just want to grow. When you read a lot of the growth hacking literature, the growth hacking blogs, it’s all about just growth at all costs.

What we’re talking about here is building a profitable $1 million retailer. If you care about profitability, obviously, you want to make profits on each and every sale. If you are a venture-backed company that may not be your top concern. Usually it’s driving revenue north is your top concern. That’s just two caveats to this equation.

The last thing I would say about the LTV must be greater than CPA is that even for harder to measure efforts you should try to figure this out. For example, we all know that in the early days of running a business you do a lot of things that don’t scale. You do things like send personal emails out to customers, send personal emails out to bloggers. I would say even for those efforts, treat them as a marketing channel and try to measure your costs and your ultimate profits on that channel.

What I did in the early days was use a timer. Now there’s some good options like Toggl. If you spend a day reaching out to bloggers or to influencers online that’s a great use of time usually. Just make sure you time it and put a number on it. Maybe count your time as worth $50 an hour or $100 an hour. If you pay someone to do it obviously you’ve got a direct cost there you can measure.

Then, on the flip side, when you’re going to measure revenue and profits look to Google Analytics. Make sure you’ve tagged everything properly and you can actually measure the revenue and, ultimately, the gross margin that comes out of your efforts. Even if it’s from a channel that’s not directly easy to measure, like AdWords or Facebook ads, make sure you make an effort to get at that equation and see if it holds true.

The overall goal, by the way, of lifetime value must be greater than CPA, it’s not going to be true on every marketing channel. Your job is to find a marketing channel where it is true. In many ways your first few months, if not the first year, in business is all about exploration. It’s about throwing a bunch of spaghetti against the wall and seeing what sticks, what individual piece of marketing spaghetti sticks. The one that sticks will be the one where you’re making a profit.

For you maybe AdWords is not working. It’s not sticking. That spaghetti is falling to floor. Instead maybe Facebook ads or Instagram marketing is actually causing the spaghetti to stick against the wall so you go with that. Once you’ve found the marketing channel where LTV is greater than CPA, you’ve got the ability to scale and you want to continue to push on that channel. That’s the first critical equation for someone looking to grow to a million in revenue.

The second one, the second critical equation, in my opinion, is ROAS must equal revenue over spent, so that’s return on ad spend equals revenue over your spend.

Very simple equation to calculate. What it means is you spend $10 on ads, you made $100 in revenue, your ROAS is 10, so 100/10. Super easy to calculate. Just like the previous equation you want to do this on a per channel basis. Figure out your ROAS for AdWords, Facebook, Instagram, email, things like that, and if you have the time and can go further than that you want to figure out your ROAS within each channel. A certain ad group might, and will, have a different ROAS than another ad group. A certain ad, a certain image ad on Facebook will have a different return on ad spend versus another one.

The goal of the first equation, LTV must be greater than CPA, is to find marketing channels where you can scale. The goal of this equation is to find where you want to spend your next marketing dollar irrespective of profits. In the early days you may not have any one profitable channel but your ROAS is better on certain efforts than it is on others. You got a 10-times ROAS on one ad group or one channel and you’ve only got a 1-time ROAS on another. Try to scale up the 10-time one.

It is, in many ways, a less sophisticated equation than return on marketing invested. That’s more of a return calculation. You want to get to that other calculation, which is called ROMI, but the appeal of ROAS is it can be done quickly and easily. It can be done by a 5-year-old. You’re just taking a simple ratio of revenue to spend. I encourage you to do that a lot. Whenever you’re comparing two ad groups or two possible efforts you can spend your time on, just think in terms of ROAS. Again, there’s a nice template to break this out on NerdMarketing.com so if you go to this podcast page on Nerd Marketing you can get the template.

The third critical equation is pressure over time. What does that mean? This is more of a mental and emotional equation but my e-commerce mentor, a long time ago, took me aside and told me, “Drew, you know what wins in e-commerce is pressure over time.” It was a time when I was looking for the home run. I was looking for the hail Mary pass, the one thing I could do that would 10X my company in a year. It really doesn’t exist outside of a couple blogs where these articles are featured. On average I don’t think it exists.

I think what wins is pressure over time. That’s the nice thing about e-commerce. E-commerce is not brain surgery. It’s very straightforward. You’re not trying to invent a new platform, like Facebook, a new SAS product that doesn’t exist, or a new app.

Buying and selling has been done for thousands and thousands of years. There are principles on how you do it. If you’re not succeeding you can change but the game is pretty straightforward and it’s one in which the tortoise actually does beat the hare over time. All it takes is just that mentality that you want to do better today than you did yesterday and that you are in it for the long haul. Again, if you’re running a venture-backed company this equation probably does not apply. You are going for the home run. For the rest of you, you’re going for singles and doubles. Do what works. Focus today on just beating yesterday.

The pro tip here, what I’ve found to be super effective for me in the early days, was to embrace a process approach to building my business. What a process approach means is that before you have the outcome, before you can achieve the outcome, you got to focus on the inputs, on the process. Before you have the $1 million revenue company implement the processes that it will take to get there.

Initially you’re going to have zero dollars in revenue but more important is you embrace the processes of a $1 million company. Here are some examples, just a few that came to mind that I used at my own retailer. One day a week is for analytics review. You go into your analytics, you review your dashboard. You review things like ROAS on your marketing campaigns. You review cost per acquisition, everything we’ve talked about today. You just make sure your marketing is on track.

You may also have a day a week or a day a month to review new out-of-box marketing ideas or tests, or anything you want to test versus what’s working now. You might have one day for financial review per month just to make sure you’re on budget. If you hold inventory make sure your inventory is squared away. Probably the most important, I think, is carving out one day a quarter just to review your processes. Get all your processes nailed and then you want to review those processes every quarter, every year, to just make them better.

If you embrace that process approach and just do the heavy lifting and the hard work every day when you get into the office, you apply that pressure over time, and you spend enough time, you’re going to build a successful business. We found thinks like Google Docs and Evernote to be sufficient to codify these processes, but I encourage you to just have that mentality. This may be one of the more important equations out of the three that I’ve just discussed.

I did promise one bonus equation and that bonus equation is sanity over losing it, or sanity must be greater than losing it. Again, I think of a tortoise and I think you’re in a marathon, not a sprint. The more you can have that mentality, the better. I’ll find that when I read blogs, especially when I was running my retailer, if I read blogs or newsletters or something like that and I just hear about all of the successes around me I kind of go nuts. I get frazzled. I want to do more. I want to try new, crazy, half-thought-through ideas, but the more you can rein that in and retain your sanity, the better.

For me, I found I used to build processes around daily meditation, around physical fitness, around carving out time outside of the office. If I did that I would retain my sanity and I would be sane more than I would be losing it. The danger was always there that losing it would completely take over. It would rear its ugly head and several times a month my business partners or I would, indeed, lose it. We’d have to leave the office, go a little crazy, but if you just take the long view, if you focus on sharpening the saw, as Stephen Covey says, on things like meditation and fitness and balance, I think this equation will hold true. It will increase your odds of success.

One pro tip here is I really don’t like people driving their income down to zero and going all in on a startup, partially because it introduces a scarcity mentality. As soon as you start freaking out about money I think it prohibits you from being creative. To the extent possible, if I were starting from scratch today, I’d want some income coming in or I’d want enough buffer in a savings account that I knew I could go for 6 months. That could be a consulting gig or it could just be a little nest egg, but certainly make sure the income is coming in and that increases the odds that your sanity will be greater than your insanity as you embark on this e-commerce adventure.

I’m reminded of a saying that venture-backed companies die when they run out of cash and bootstrapped companies die when their founders run out of energy. Keep that in mind. You’re in it for the long haul. Keep the energy going. Do what you need to do to keep that high and I think you’ll increase your odds of success. There you have it, three critical equations, one bonus equation. Number one, lifetime value has got to be greater than CPA. Find the marketing channels where that happens and then you know you can scale. Number two, return on ad spend equals revenue over spend. Again, use that to compare marketing channels and efforts and put your money behind the greater ROAS.

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Number three, pressure over time. Embrace the long view mentality and try to do better today than you did yesterday. Use processes, embrace processes and standard operating procedures. Number four, sanity over losing it. Maintain your sanity. Do things that increase the odds that your sanity will be maintained, things like physical fitness, meditation, and side income. Those are four critical equations I really believe in. Keep them in mind. Again, if you go to NerdMarketing.com and go to this podcast page I got a nice little download where you can get a very simple spreadsheet to calculate some of these. Obviously, not the sanity one, but everything else. Until next time, good luck.