1/ From fear to controlling your outcome

Will this be worth it?

Can we get a great exit?

Can we make it to an exit?

How do we get to stable, good performance?

Does this ever get easier?

It’s natural to have these thoughts. And despite what you read on X and hear on podcasts, every founder has them. You have worked hard. You and your teams have come far. You have a going concern. You have many attributes of success like happy customers, PR, revenue and growth. Yet the question remains - will you achieve the reward and success you want?

Achieving your goal, getting the payoff you desire, is within your control. My goal is to help you get there. This post is the playbook.

We all have different visions for our companies and whether your goal is to change the world, make a ton of money or somewhere in between, the best way to achieve your goal is to make your company financially successful. You can’t be altruistic or build a global brand or go public or be bought for billions of dollars or make a million dollars a year when you are bankrupt. Financial success is the precursor and the foundation on which everything else, including your vision, must be built. Sounds basic. Sounds almost like a tautology doesn’t it? The problem is many leaders don’t fully understand finance and they don’t fully understand what success looks like.

So what constitutes financial success? Profitability likely comes to mind as does revenue growth. Those are important, but only half the equation. Companies that showed great unit economics, high margins and rapid growth go out of business, all the time. The second half of the equation is capital and specifically capital efficiency. Building the right combination of margins, growth and capital efficiency creates magic. You can truly control your destiny.

Now we are going to steal a page from a group of people we have a love/hate relationship with - investors. Successful investors are good at recognizing patterns and trends. They do this by working backwards from the exit. If you have ever had experience with VC’s, you will know this. The seed investor is looking to the A investor who looks to the B through F investors who look to the public markets. At every stage of a company, the investors are keenly aware of what success looks like in the next stage as well as all the way down the line to exit or IPO. The private investor is working backwards from the public markets to your stage and assessing whether you are on the right trend line. The sudden collapse of VC funding to DTC is testament to this as VC’s asked themselves ‘why am I pouring hundreds of millions into this company for it to only have a market cap below what we invested?’ And they answered that question by looking for better alternatives to place their capital.

So we can identify financial success in public companies, understand why investors love them, understand the financial metrics that investors love seeing and then work backwards to create the milestones or trend lines that will get us those financial metrics at that stage. It is important to note here that financial metrics are stage dependent. You have to have a certain size to scale past your OpEx for example. So our focus isn’t on matching the best public companies metric for metric, but rather to know the financial metrics we would need and have the means to build our company to be able to deliver the right financial metrics at the right stage.

This Playbook lays out that process. We are going to:

1. Understand the financial metrics put up by the best in class.
2. Understand the Action Metrics that you, your leaders and your teams will use to make better decisions and drive your company to maximum financial success.

2/ A quick intro: who is Ben Tregoe?

I started my career in New York in investment banking and then moved to an in-house PE fund at Lazard Freres. While I loved some aspects of finance, I didn’t want to spend my career in it. After a detour to LA to pursue television writing where a one year writing gig at Disney cured me of that ambition, I found start ups and have been starting and working in start ups since 2000. I have done a few marketing tech and ad tech start ups and founded a couple of mildly profitable ecommerce companies.

I had an insiders’ view to the spectacular growth of Facebook as the head of partnerships at nanigans which for several years was the largest Facebook Marketing Partner as measured by ad spend. At nanigans I was also head of sales at various points and had the opportunity to see inside the performance ad teams of companies like eBay, Wayfair and Zappos. Our software was used by virtually every fast growing DTC brand at some point so I also saw inside companies like Warby Parker, Bonobos, Glossier, Peloton and dozens more.

Most recently I was founding CEO of Drivepoint which is FP&A software for ecomm brands and there I worked with twenty brand teams and had the chance to talk with over two hundred founders.

I have raised multiple rounds of pre-seed, seed, A and B rounds and have managed acquisitions as well as the sale of companies.

You can absolutely use this playbook on your own. But if you want help, I provide short term consulting projects to help you and your teams implement the playbook. You can reach me at ben@elephantherdconsulting.com or set up time to chat.

3/ How do you know best in class?

We can’t possibly look inside every private company or get behind the scenes at multiple successful public companies. We are too often left with tidbits gleaned from conversations or posts of founders flexing on X. But we can use the markets as a guide. There are a ton of smart investors and analysts scrutinizing the performance of public companies. We can see which companies they bet on and look at the financial metrics those companies deliver. When we dive deeper into their metrics, we see it’s not just top line growth or high margins these investors seek. They are also looking for proof of capital efficiency.

Who is exceptional?

Lululemon and e.l.f.

Lululemon and e.l.f. absolutely crushed 2023. LULU doubled the S&P return and ELF delivered a 6X better return! A quick look at their valuation metrics show that investors rewarded the companies with valuations far above peers.

Premium valuations

LULU and ELF’s valuation metrics are impressive alone but even more so when compared to the median values for the Elephant Herd Index of Omnichannel companies of which they are a part.

4/ How Investors Think

Best relative to all other options

Investors are looking for the best places to invest their capital. Opportunities are judged relative to each other as investors ask themselves ‘how close to the best option is this company?’ Whether public or private, the entire investment decision process is just seeking more detailed answers to that core question to increase investors’ confidence.

It is critical you know what ‘best’ looks like, how close to best you are and what your trend to being best is. While being best in class and setting the new standards would be amazing, your goal is to understand the financial metrics that matter and show progress to the benchmarks for those financial metrics over time. Buyers and investors are relying on trends and patterns. “OK” they say to themselves, “These guys aren’t best in class at X now, but for their stage, they are actually on trend to do better than X in 3 years. This is exciting. We can ride that trend…”

The coldly rational way investors view companies

If we put our investors’ hat on and view companies with cold rationality, we see:

Of course as a leader and builder you don’t see your brand and all that it stands for as just a machine taking in capital and cranking out profits. But that’s what investors care about. They listen to your big vision only to find evidence that you are building a good or bad machine. Remember we have our stone cold, hard-nosed investors’ hats on. There are endless investment opportunities and investors are going to seek the best returns for their capital.

There are two parts to the investors’ equation: returns and capital. In other words, profits are not enough. Good profits, but requiring huge amounts of capital is not good. The company must also efficiently use its capital. This concept is expressed most commonly as the ROIC or Return on Invested Capital. Your company is in one of the following 4 quadrants and by the end of this playbook, you will know the Action Metrics to get you to your desired quadrant.

Which quadrant are you? Which quadrant do you want?

Past performance predicts future performance?

So investors care about margins and capital efficiency and how close to best in class you are. But investors also want to understand a few more things.

1. How durable are those margins and profits?
2. What changes the capital efficiency? Can the company generate sufficient capital to fuel its growth or will it need continued outside capital and if so, how much?
3. How much can the company grow and how close is the company to its maximum size?

Let’s dive deeper into each.

#1 Durable profits; not just one time profits

Good margins are table stakes. What counts is evidence the company will be able to maintain or better yet, improve these margins. Repeat purchase dynamics are critical.

#2 Capital efficiency; specifically generating our own capital

First, how effectively does the company use capital? This will be evidenced by metrics like Days Inventory Outstanding, Inventory Turnover, Cash Conversion Cycle and Net Working Capital as a percentage of Revenue. The more efficient the company is with capital, the less outside capital it needs to raise. Equity investors don’t want to be endlessly diluted as the company needs to raise ever more amounts of capital. And these investors also don’t want to be held hostage to the vagaries of interest rates and lending standards if the company is reliant on debt to maintain operations. We have lived through VC’s abandonment of DTC and the difficulties in raising equity. And now we are seeing what high interest rates and lack of equity sponsorship do to borrowing. Retail and DTC is hard enough in good fundraising environments, but adding in the need for lots of continued outside capital makes the investment much riskier.

Second, how much of the needed capital can the company generate itself? Is the company generating Free Cash Flow (FCF) or even better Levered Free Cash Flow (LFCF) which accounts for debt payments? What is FCF as a percentage of Revenue? What is Cash From Operations (CFO) as a percentage of Revenue? How does FCF compare to the projected Net Working Capital (NWC) and Marketing needs of the company?

#3 Opportunity to expand; not just stay static

Growth at all costs was the rallying cry just a couple years ago. Revenue growth was seen as evidence of product market fit and a big potential market.

As you know, those days are long gone. There are plenty of companies with very modest annual growth, but exceptional margins and return on capital which investors love. If that is you, great. It is far better to generate your own cash and control your destiny than gamble your capital in the form of inventory and ad spend on growth and perhaps lose it all.

But if you are growing rapidly, you know that growth is intoxicating for both you and investors. For investors, it introduces variability to the upside and as investors’ expectations of growth widen in range, their valuations will widen too.

Obviously there are two ways to grow. You reach into new markets or you sell more to your current customers or you try to do both. Repeat customer dynamics, customer acquisition efficiency and profitable distribution rule here.

The more growth you seek, the more investors will worry about capital and revisit capital efficiency. Can the company support its own growth through organic FCF or will it require lots of outside capital?

Below is a table of how public company investors get the information they need to assess Durable Profits, Capital Efficiency and Expansion.

This isn’t an exhaustive list, but it is mutually exclusive. You can’t have bad numbers for these metrics and get premium valuations over time. Let’s look at what our heroes LULU and ELF do.

LULU and ELF’s Financial Metrics

Elephant Herd Index

5/ How do you make financial metrics actionable?

What would people on your teams do if you told them to increase your EV / EBITDA multiple? What would happen if you made 2024’s objectives be decreasing the NWC / Revenue percentage, increasing FCF / Revenue and getting EBITDA margin over X? Your CFO would understand (hopefully) but in my experience, you would get a lot of blank stares from everyone else in the company as they would be vaguely familiar with the terms and have little idea on how to accomplish them.

If we took out the jargon and said our goals are to increase profits and use capital more efficiently, we will get better ideas from the team members, but we are still unlikely to get as specific and comprehensive as we need. One reason is that all the financial metrics I have discussed above are averages. For example, ELF’s Net Income Margin is the average of tens of thousands of individual transactions across hundreds or even thousands of products. LULU’s Inventory Turnover of 2.3 is the average across even more transactions and SKU’s and channels. Our actions need to affect the unit level, customer level and specific channel level. A second reason is that financial metrics are lagging indicators. They are the accounting of actions and decisions that have already taken place. We need metrics that act at a granular level and can be used proactively to make better decisions and take better actions. I call these Action Metrics.

The Action Metrics we need are in 3 core areas:

1. Products
2. Customers
3. Distribution

When we look at our business as products, customers and distribution we are likely to think of teams and people. Lots of them. We may also think of capital. A lot of it. Your biggest consumers of capital (or budget) are inventory and marketing. So we have a lot of people making a lot of decisions about a lot of capital. Think about the volume of decisions being made. It’s not just a handful of big decisions made every quarter or month. Your financial metrics are the result of thousands of micro decisions over the course of the year.

To get the right results, individual team members must be making the right decisions using the right metrics. There is no other way. Your company is too big, too complex and moving too fast for a single person like the CEO or even single people (like the CFO, COO, CMO) to be correcting for poor decisions by the teams, no matter how well intentioned.

To put a finer point on this, you simply can’t correct at the budgeting or planning process for decisions being made using the wrong metrics. But teams of individuals who understand the right metrics, know how their decisions will impact those metrics and are incentivized on the quality of their decisions, will create magic for you.

6/ Action Metrics

Products

What you sell and how quickly you sell it directly impact your profitability and capital efficiency. For multi-SKU brands, their products usually break down into a Pareto distribution or 80/20 with 20% of the products driving 80% of the sales and profits or something close to that. We want to answer which products drive the most Contribution Profit and which products sell the fastest. For a sample P&L and to see what I mean by Contribution Profit, please see Appendix 2.

Leaders commonly make three mistakes with products. One, they expand product selection too quickly. The intent is to capture more share of wallet (’We have a customer! Let’s sell them more stuff!’) Undisciplined product expansion has multiple negative trickle down impacts. Every new product needs inventory behind it, so precious capital is used to support the new product across all its colors and sizes. New products require time and attention from various teams as they decide on designs, supply chains, buying, logistics and returns. New products require marketing support and ad dollars.

The second common mistake is over buying because of a fear of stock outs. As Daniel Kahneman pointed out, loss aversion is powerful and the fear of losses is thought to be 2X greater than the pleasure of gains. Overbuying to avoid stock outs is a form of loss aversion. “We had a customer and could have made a sale if only we had the inventory!” That fear and sentiment gets driven deep into the buying decisions. Which inventory planner wants to be on the receiving end of complaints from the CEO or CFO about missed sales? Who wants to feel they let down the marketing team? So planners overbuy with the acquiescence of leaders. “It just might take a little longer to sell” or worse “Worst case, we discount it and move it.”

The problem is that as this logic is applied across the hundreds and thousands of buying decisions, capital cycling slows down. Not only does the company require more working capital, the time to re-use that capital (Inventory Turnover and the Cash Conversion Cycle) lengthens. And profits are reduced because company Contribution Profit is the sum of thousands of individual transactions. So as the transaction times lengthen, you get less opportunities to add to Contribution Profit.

Worse, the need to move excess inventory usually leads to discounts and sales. The company starts attracting customers who only buy at discounts and sales and starts training the rest of its customer base to hold off on purchases because a sale or discount is certainly coming soon.

Third, products attract different types of customers. As we saw in the backpack story, the wrong product can attract the wrong type of customer. So while the ROAS might look good or the Payback Period is short, the product might not be attracting customers who will drive Contribution Profits over time through repeat purchases.

Actionable Metrics for Product

1. Return on Product Capital (ROPC)
2. Product IRR
3. Repeat Contribution Profit from First Purchasers

Why you need to include ad spend when evaluating products

The invested capital for Product Action Metrics is COGS and the estimated ad spend. We know from experience that ad dollars are not allocated equally across products. Some products or categories get more ad budget than others. Our analysis should account for that. Some companies may have the tracking and data to be precise about this allocation. But an educated guess here will be good enough.

1. Divide your products into groups. Use whatever categorization you already do.
2. Divide your ad spend into months.
3. Looking at campaigns and creatives, estimate amount of ad spend by category by month. This should be a quick process and in half an hour you have your monthly ad spend by category
4. Ad spend by product within a category likely follows a power curve with 10% or 20% of the products getting 80% or 90% of the spend. Make your best guesses by product and distribute the remaining 10% or 20% to the remaining products. A lot of products likely receive $0 in ad spend, so don’t worry about being too precise. For example, if we estimate that bottoms gets a third of our spend and we know that two styles of leggings get 90% of that spend, the top two styles would be 14.9% of ad spend each and all other bottoms would be somewhere between 3% and 0%.

Return on Product Capital (ROPC)

With this Action Metric, we understand the unit level profitability of each product including ad spend and cost to fulfill to customer. It is part 1 of the analysis to create our list of winners and losers so we can improve margins and better allocate capital.

Calculation

Cost per Unit includes the vendors’ price per unit or your cost to manufacture the unit plus all the costs to get the unit to our warehouse such as inbound freight, taxes and tarrifs.

For ad spend, we first calculate the ad spend per month per product and divide that by the amount of units sold that month to get an average ad spend per unit of product. We then average those monthly numbers for every month the product is sold to get our average ad spend per unit of product.

Depending on the quality of your data, you may have precise numbers for variable costs per product that take into account different pick & pack costs, warehousing, packaging and outbound shipping. If you don’t have that, then use an average variable cost per unit at whatever level of granularity you have.

Our formula is then ROPC = Contribution Profit per Unit / (Cost per Unit + Ad Spend per Unit)

Insights

Our ROPC is our Contribution Margin after Advertising at the product unit level. We can compare ROPC to the Contribution Margin after Advertising for the company. If it’s above, we have a product that’s potentially accretive. But if it’s below, it’s potentially dilutive.

ROPC is a first crack at sorting our products into winners and losers. When ad spend is taken into account, we may be surprised that some products are not as strong as we had thought (because they benefit from disproportionate ad dollars) while others are stronger than we had thought (because they have high ROPC despite little or no ad support). We will also begin identifying the lowest performing products and potential losers to be culled.

Decisions

We are seeking to concentrate our capital on our winners and not dilute our capital through losers. All new products must have an ROPC estimate. If they are not clearly a winner or potential winner, they should be eliminated.

It’s important to remember here that ROPC does not take into account time and the time value of money. We will add that with the Product IRR. But we can do a quick analysis at this point by taking the ROPC and multiplying it by the Inventory Turnover for that product. For instance, if we know that a product has a ROPC of 8%, but an inventory turnover of 1.75, we can multiply 8% * 1.75 to get an annualized ROPC of 14%. Conversely, a unit level ROPC of 18% but an inventory turnover of .75 will yield an annualized ROPC of 13.5%.

The Product IRR will give us a better answer because it takes into account the timing of the costs.

Financial Metrics Impacted

Sales, Margins, Days Inventory Outstanding, Inventory Turnover, CCC, NWC, FCF, CFO

ROPC is one step in eliminating losers and freeing up capital to invest in winners. While all Financial Metrics are impacted, the most immediate impact is on margins.

Product IRR

Product IRR is a measurement of the products’ return at a PO level. It is the second part of our winners & losers analysis.

Calculation

Our product cost in this case is the PO (or cost to manufacture) as well as the costs of inbound freight, taxes and tarrifs. We need to understand when the actual payments for those items were made.

We have to adjust the selling period for units already in stock. For example, if when the 1,000 units from the PO arrive at the warehouse there are already 158 units in stock, our selling period begins with the 159th unit sold.

Ad spend is the per unit ad spend from ROPC above multiplied by the number of units sold each month spread across the selling period unless we know that ad spend for that product was more heavily weighted towards certain periods (e.g. seasonal items).

Our inflows is Sales and the selling period begins as per the adjustment above for in-stock inventory and ends when all 1,000 units have been sold.

We then run an IRR for this series of cashflows and annualize it.

Insights

The Product IRR is the second part of the winners & losers analysis. Our winners and losers ranking will likely change because we now understand the timing of outflows and inflows. For example, a product that requires full payment at time of PO, will create a longer payback period than a product where we can pay the supplier 30 days after receipt at our 3PL. A product that has a lower margin, but sells quickly, will increase its IRR while a product that has a high margin but sells slowly will decrease its IRR. Over buying of a product will extend out the buying period as it takes longer to sell through thus reducing the IRR. Long selling periods and serious discounting will also make a product look worse than it may under the more simple ROPC.

Decisions

Because Product IRR accounts for the timing of cash flows, it’s the best metric to compare to our cost of borrowing. For example, let’s say we are borrowing money at 18% which is not crazy in this environment and from fintech lenders and even mezzanine / venture debt lenders. If we have a Product IRR of 12%, why are we borrowing money at 18% to invest it at 12%?

Proposed new products should have Product IRR projections before being bought. If the Product IRR is not above the target hurdle rate set by leadership, then the product does not go forward. Obviously leadership has to maintain rigor in the assumptions used for these projections.

Financial Metrics Impacted

Sales, Margins, Inventory Turnover, CCC, NWC, FCF, CFO

Decisions based on this Action Metric will impact both margins as well as capital efficiency. By putting more effort behind high repeat purchase products, we increase Contribution Profit and margins. By eliminating capital used to buy poor performers, we increase capital turnover and efficiency. We may also pick up some variable cost savings if 3PL and fulfillment costs are reduced (i.e. less warehouse space, maybe more efficient buying of packaging) and we pick up OpEx savings as time and effort is no longer wasted on low performers and instead reinvested in high performers.

Combining ROPC and Product IRR enables a very good picture of our winners and losers. Before we create our final lists of losers to be cut and winners to receive more investment, we need to run the third product metric.

Repeat Contribution Profit from First Purchasers

Calculation

We identify the customers whose first purchase was the product we are analyzing. We then take the Contribution Profits from the stream of subsequent purchases from those customers. As the data is likely in time series form, we can run an IRR. But if it’s not, an absolute return (like the ROPC) is fine.

Insights

This is the backpack analysis. We are searching to kill sacred cows and identify hidden gems.

Decisions

Kill the sacred cows (products that are bad at driving repeat purchase) and elevate the hidden gems. At the very least, try to understand why this is happening.

By adding Repeat Contribution Profit from First Purchasers to our winners & losers analysis, we may identify a product that we thought was a winner, but turns out to be a ‘backpack’ and we may rescue a product that we thought was a loser but is surprisingly good at bringing in high value customers.

Financial Metrics Impacted

Sales, Margins, Inventory Turnover, CCC, NWC, FCF, CFO

Customers

Let me go on a little tangent about accounting practices. Accounting views cash, accounts receivable and inventory as assets, but it classifies marketing as an expense and puts it on the Income Statement (P&L).

But which would you rather have? $10 million of inventory, but no repeat customers. Or a million repeat customers, but no inventory? Hopefully you say the latter because you know that with a million customers, you have an ongoing business but with $10 million in inventory you have a massive customer acquisition budget not to mention high 3PL costs all for the opportunity to make a first sale and hopefully build a customer base. The accountants would choose the inventory. In their eyes, the customer base would have zero value or maybe negligible value as a customer file worth a buck or two per name.

The business people know better. And accounting gets around this issue through the concept of goodwill. When a company is purchased for an amount above the book value of its assets (e.g. cash, AR and inventory) the remainder is called goodwill (technically goodwill and intangibles, but let’s make it simpler). That ‘goodwill’ is the value placed on the customer base.

Some may say that’s the value of the brand. I argue that a brand is people’s predisposition to buy from your company. Thinking from first principles as opposed to accounting conventions, my argument is that customers are your most important asset.

So, how should we think about that asset? You know that not all customers are equal. Some customers are Loyal Fans buying repeatedly and at full price. Other customers are discount hounds buying only when incentivized with deals, others are casual customers coming back infrequently and some buy once and you never see them again and worst of all are the fraud customers.

Cohort analysis can help you tease some of these insights out, but each time-based cohort is simply an average of all the types of customers grouped together by the date of their first purchase.

You want to group customers by repeat purchases and Contribution Profit. Are you getting better at acquiring customers who buy repeatedly? Are you getting better at acquiring customers who drive maximum Contribution Profit?

Understanding the potential value of your customers is critical because your customers represent forward potential cash streams. Your Loyal Fans are your best cash streams. Your fraudsters are your worst. You don’t know if, when or how much any individual will buy, but with enough customers as a group, you can develop good predictions around how the group will act. Putting our investors’ hat back on, our customers begin to look variable cash streams. Those cash streams look like investments or assets.

The customer pyramid is the most useful heuristic for thinking about your customer base as an asset and how well you are investing to grow that asset. At the top of your customer pyramid are your most loyal customers who buy repeatedly and at full price. Next layer down might be repeat customers who buy a little less frequently and maybe sometimes on sale and then your bottom layer is customers who have bought from you once. Even below that are customers who are aware of you, but have not yet converted. This is your brand. It is a group of people with a predisposition to buy from you.

Over time and as you invest in more marketing, does your customer pyramid grow? How much? And are all your layers growing equally? Ideally, your top layers are growing faster (i.e. your pyramid is gaining in height) and conversely it may be a troubling sign if your pyramid’s base were expanding faster (i.e. getting wider, but shorter). The ideal shape of your pyramid will change over time depending on your segment, business model and stage.

There’s a terrific description of Ferrari’s customer pyramid in this Business Breakdowns podcast.

Brian Lum - Ferrari: Magic from Maranello

Brian Lum is an Investment Manager at Baillie Gifford. We cover Ferrari's racing origins, how it maintains scarcity while growing revenue, and why electrification may benefit the business.

www.joincolossus.com

And Taylor Holiday does a nice job of explaining a variation of this grouping through his Active Customer Analysis. I also agree that predicting forward revenue using this methodology is superior to running cohorts forward.

When you view your marketing spend as building an asset, the natural questions then become how effectively are we investing those dollars? Instead of marketing being an expense and margin reduction, your mindset becomes investment and return on investment. The following 3 Action Metrics help us ask the right questions and point us to the best answers.

Actionable metrics for customers

1. Customer Pyramid
2. Return on Customer Capital (ROCC)
3. Customer IRR

Customer Pyramid

Some background theory

There are a ton of theories on customer acquisition, but most have a concept of building awareness, conversion and then nurturing. For most brands, this make sense. Exceptions would be single purchase, highly transactional companies where the product is more commoditized and the purchase is one and done as far as the customer is concerned. But for most brands, they build awareness (people talk about upper funnel), they convert (bottom of funnel) and then they continue marketing and advertising to these customers in order to drive more repeat purchases.

The problem with common measures of CAC is that it lumps all of the first two stages into one cost. For example, one way to measure CAC is to take all ad spend in a month and divide it by the number of new customers in that month to arrive at the paid CAC number for that month. Some measures take all marketing spend (not just paid) and some measures try to account for earlier periods by taking averages over the previous 3 months.

This is not to say you should abandon CAC and LTV. They are useful tools for creating guardrails for marketing teams and agencies as well as assessing various channels against each other. But it is important to remember that CAC calculations carry false precision. “My CAC on Meta last month was $70” is really just saying that last month I spent $1 million on Meta and acquired 14,286 customers. But is that what really happened? If you have been spending a million per month on Meta for a couple years and have several other channels running and strong customer word of mouth isn’t the truth closer to something like: as a result of years of advertising and great products and happy customers, I acquired 14,286 new customers. I also happened to spend $1 million on Meta?

It’s our discomfort with the vagueness of that statement that causes us to seek certainty through attribution tools and and feel relief as we swallow as gospel whatever the attribution tool du jour tells us happened.

Calculation

To judge the effectiveness of building our customer pyramid, we need to look at our investments in marketing over an extended period. The right length of period will depend on the nature of the business and observed or expected lifetimes of customers, but for sake of illustration, let’s choose 1 year, 2 years and 3 years where 1 year is the total marketing spend in the past 12 months, 2 years is the total for the past 24 months and 3 years is the total for the past 36 months.

We are going to classify our customers in order to create the layers of our pyramid. A simple layering might be Loyal Fans at the top who are customers who buy X times per year, Casual Customers is the next layer down and they buy Y times per year and at the bottom would be customers who bought once. We can obviously create all sorts of layers and refinements of layers which would be useful for internal analysis. But for high level analysis and telling our story to investors, simple is better. It is critical that the criteria for certain layers remains the same over the time of the analysis. For example, if we define Loyal Fans as people who purchase 6 times per year, then 6X per year is the criteria for Loyal Fans in every period analysed. We can’t have Loyal Fans be 3X per year one year and then 9X the next year and then 5X the following year. The Loyal Fan criteria and the bottom layer criteria (in our example customers who bought just once) will determine the criteria for the layers in between. So if Loyal Fans are 6X per year, then the Casual Customer purchases per year will go up and down as the number of Loyal Fans increases or decreases with each period.

With our layers set, we then take the Contribution Profit from each layer and divide it by the 1 year, 2 year and 3 year marketing spends. We can also aggregate layers and compare them to the various investment amounts.

For each layer, we will express:

1. the criteria for that layer
2. the number of customers in that layer
3. the average number of purchases per customer in that layer
4. the average AOV for that layer
5. the Contribution Profit for that layer and
6. the 1 year, 2 year and 3 year return for that layer (e.g. that layer’s Contribution Profit / 3 year total marketing spend)

We then want to show how the customer pyramids and their layers have changed over time.

Insights

Returns that are increasing over time are good. Returns that are decreasing may not necessarily be bad as it could indicate big investments in customer acquisition that have not yet paid back. The beauty of this analysis is it quickly highlights what is happening in our customer base. Are our Loyal Fans increasing in number year over year? Are they staying a constant percentage or increasing or decreasing over time (i.e. how is the shape of our pyramid changing over time). Is AOV for our layers increasing or decreasing? How much is repeat purchase rate for Casual Customers moving up and down?

This analysis produces the stories that everyone can understand. It leads to better questions, better investigations and ultimately better decisions. Because it is straightforward, the insights are closer to the surface. ‘We have been successful in converting new customers to casual customers and then Loyal Fans. In fact, we have improved this capability over time as you can see…Not only are we increasing the size of this layer, we have also been able to increase the AOV’s…’

Contrast this with a cohort analysis or spaghetti graph from cohorts which may show that the August 2022’s are better than the August 2021’s, but leave us wondering why. Are certain customers within the cohort spending more per purchase? Are they buying more frequently? Both? It immediately raises questions that require deeper analysis and explanation.

I realize I am beating on cohort analysis. It’s a tool adapted from SaaS by DTC and has its limitations. It still has value especially for internal teams and externally can be useful for subscription businesses.

Decisions

Multiple important decisions can be made or informed through this analysis. How big should the ad budget be? How do we convert more first time customers to repeat customers? How can we move more Casual Customers to Loyal Fans?

We can also make better decisions for target CAC’s and our expected lifetimes and LTV’s of various layers. The CAC for Loyal Fans is likely to be multiples higher than the average CAC (good news for the marketing team) but much lower for Casual Customers (you just made marketing’s job harder). But now you have better metrics for the team to aim for. Are we getting better at acquiring and nurturing Loyal Fans or worse?

Financial Metrics Impacted

Sales, Margins, NWC, Days Inventory Outstanding, Inventory Turnover, CCC, FCF, CFO

All the critical Financial Metrics will be impacted through the Customer Pyramid analysis.

In addition to the Customer Pyramid analysis, we want two additional metrics that use our traditional CAC because we want to be able to sort customers individually.

Return on Customer Capital (ROCC)

Calculation

Return on Customer Capital is Contribution Profit / CAC. While CAC will always be the same for any given customer (what was the CAC in August 2022?), the Contribution Profit from that customer should be measured at various time periods i.e. 1 month, 3 months, 6 months, 12 months, 24 months, 36 months in order to understand how quickly customers are getting to payback and then beyond. Remember that Contribution Profit is not good enough. We still need to cover OpEx so we need excess Contribution Profit beyond payback.

Insights

Similar to Return on Product Capital, your Return on Customer Capital or ROCC is part one of sorting your customers into high value and low value. Because we are focused on Contribution Profit, we will see customers who buy at full price and high contribution profit products be sorted into the high value layers. Customers with lots of purchases, but of low margin items and at discount, will be sorted into lower value layers.

This analysis gets even more interesting when you include returns.

Decisions

The obvious questions are how do we get more high value customers and how do we avoid low value customers? Because these customers are sorted by their Contribution Profit, insights and commonalities may be easier to identify as opposed to seeing customers sorted by the month of their acquisition.

Financial Metrics Impacted

Sales, Margins, Inventory Turnover, Days Inventory Outstanding, CCC, NWC, FCF, CFO

Customer IRR

Calculation

Your Customer IRR takes into account the timing of the outflows and inflows and expresses it as an annualized number. Your outflow is CAC in the period in which the customer was acquired and our inflows are Sales from that customer over time.

Insights

Because Customer IRR takes into account the timing of the cashflows, we can identify further differences in our high value / low value layers. For example, a customer acquired whose second purchase is full price and high margin sounds great, but when we consider that second purchase was 2 years after acquisition, they look less appealing. Conversely a customer who buys lower margin products might look more attractive when we see they buy frequently.

We want to compare this IRR to our profit margin. If the IRR is below the needed margin, the customer is likely dilutive and we should see if we can avoid targeting customers like them. Similar to Product IRR, when we compare our Customer IRR to our cost of debt, we shouldn’t be borrowing money at 18% to invest it in acquiring customers who deliver us 5%.

Decisions

Combined with ROCC, the Customer IRR helps us sort our customers into the appropriate layers and then find the commonalities so we can acquire more high value and avoid more low value.

Additionally, we can quickly identify the impacts of improving purchase frequency and contribution profit within certain layers. Maybe our targets can be better met with less resources by focusing on changing behavior among current customers than from acquiring brand new customers.

Financial Metrics Impacted

Sales, Margins, Inventory Turnover, Days Inventory Outstanding, CCC, NWC, FCF, CFO

Distribution

The table below shows the margin constraints and cash cycles for each channel.

Given the variability in margin structure and capital cycles by channel, it’s critical we understand and manage two metrics.

Return on Distribution Capital

Calculation

Return on Distribution Capital measures Contribution Profit over capital invested by channel over specific time periods. Similar to ROCC above, these time periods will depend on your business and model.

The capital invested is COGS plus all other expenses specific to that channel in that time period. For example, a sales rep focused on wholesale, their expenses, marketing and promotion for that channel including discounts and promotions, wholesalers’ marketplaces you have to support and the costs of those channels.

Besides the channel specific expenses, is our OpEx spread equally across channels? I frequently hear leaders complain about the amount of time and effort required for a specific channel or account. If you suspect OpEx is not allocated equally, now is the time to take a swag at dividing your OpEx by channel and adding that to your cost.

You also want to account for the cost of any channel specific borrowing you need to support that channel i.e. did you have to factor a PO in order to buy/create the necessary inventory for that PO?

RODC should be done at the channel level (DTC, marketplaces, wholesale, own-store retail) as well as the account level for your largest accounts (i.e. Wal-Mart v Target).

Insights

We know unit margins vary by channel, but we may be surprised by the variation when all the costs are accounted for.

Decisions

Are we allocating capital and effort to the best returns? Is our unit pricing taking into account our full cost for that channel? Should we be favoring accounts with better RODC and dropping accounts that have low RODC? Was winning Wal-Mart worth it?

Financial Metrics Impacted

Sales, Margins, Days Inventory Outstanding, Inventory Turnover, CCC, NWC, FCF, CFO

Distribution IRR

Calculation

Distribution IRR takes the outflows and inflows and annualizes the return. Again this is super useful as it allows us to compare this return to our cost of borrowing and to set hurdle rates.

Insights

A big insight here will be the impact of payment terms on various wholesale accounts and the channel as a whole. Being in Wal-Mart may sound great, but can we afford to subsidize their NWC by getting paid so slowly?

Sell through rates or sales velocity by channel will matter here too. Are we overbuying for our own stores? This will lower Inventory Turnover, increase CCC, and increase NWC.

And like all the IRR’s above, we compare our Distribution IRR to our margins and cost of debt. Are we borrowing money to invest it at a loss? Are the channels accretive or dilutive? Is the channel or account above our necessary hurdle rate?

Decisions

With Return on Distribution Capital and Distribution IRR, we are now armed to quickly run ‘what if’ scenarios. What happens if we cut a certain account or channel altogether? What would happen if we then invested that capital into a higher performing channel? What will it take to make a subpar channel account better? Is that even possible? Is it worth the effort?

Financial Metrics Impacted

Sales, Margins, Days Inventory Outstanding, Inventory Turnover, CCC, NWC, FCF, CFO

7/ Summary

You have worked hard and built something amazing. You deserve to be rewarded and achieving that payoff is in your control.

We started by identifying some examples of best in class public companies that get premium valuations. We put on our investors’ hats and saw that from their POV, companies are machines designed to maximize returns from various capital inputs. We then looked at the financial metrics that indicated proof of returns, capital efficiency, growth and the ability to sustain those metrics. Next we looked at how we can drive our companies towards best in class financial metrics and specifically the Action Metrics we need to focus on across products, customers and distribution.

Thank you for spending so much of your time working through this Playbook. I am rooting for your success! If something is not clear, let me know. I also want to improve and learn from you. So if you have suggestions, improvements, anecdotes, criticisms or even think I am flat out wrong, let me know! You can reach me at ben@elephantherdconsulting.com or set up time to chat.

8/ How I can help

I work with premium brands on short term consulting projects focused on driving measurable improvements and high ROI. If you want help implementing this playbook, let’s chat.

It all starts with a conversation and learning about your goals and vision. Let’s set up time to chat or you can email me at ben@elephantherdconsulting.com.

Appendix 1: the goal is better decision processes

Annie Duke is a former World Series of Poker Champion who has written a terrific book called Thinking in Bets

Thinking in Bets: Making Smarter Decisions When You Don't Have All the Facts

Thinking in Bets: Making Smarter Decisions... by Duke, Annie

www.amazon.com

One of her key insights is to avoid the error of resulting and instead focus on improving the quality of the decision making process. There are always factors outside our control. And we never have perfect information. Therefore, even decisions and plans in which we have high confidence can turn to failures. The mistake would be to look at the result of the decision to determine the quality of the decision making process. This is called resulting. Instead, we must focus on improving our decision making processes.

The Action Metrics are not just tools for making better decisions. They are also tools that help us track why we made our decisions so we can go back and improve our process. The incentives must be aligned around improving our understanding of the tools and improving our processes and not just looking at what happened.

Appendix 2: Sample P&L

Appendix 3: the implementation checklist

1. Understand who gets superior valuations
2. Understand why investors like those companies
3. Understand the financial metrics that investors like to see
4. Understand where you stand compared to those metrics
5. Chart your path to outstanding metrics
6. Understand the Action Metrics that will enable you and your teams to affect the financial metrics the way you want
7. Build these Action Metrics into your dashboards and plans
8. Build the incentives to drive these metrics