The Game with Alex Hormozi - You will stay poor if you don't understand this equation | Ep 345

Episode Date: November 16, 2021

You need math people! Today, Alex (@AlexHormozi) talks about the two most valuable equations you need, why you need math when doing business, having high-quality data, and how these will help you make important decisions for the business!Welcome to The Game w/Alex Hormozi, hosted by entrepreneur, founder, investor, author, public speaker, and content creator Alex Hormozi. On this podcast you’ll hear how to get more customers, make more profit per customer, how to keep them longer, and the many failures and lessons Alex has learned on his path from $100M to $1B in net worth.Timestamps:(0:29) - Understanding basic business equations(1:05) - Exploring the fundamental equation of business(2:45) - Calculating lifetime gross profit per customer(4:05) - Case study: analyzing a marketing agency's business model(7:04) - The power of knowing your numbers(12:37) - Advanced strategies for business growth and cash flowFollow Alex Hormozi’s Socials:LinkedIn | Instagram | Facebook | YouTube | Twitter | Acquisition

And if you don't have high quality data, then you will have poor decisions and you will not like the life that you end up leading. Welcome to the game where we talk about how to get more customers, how to make more per customer, and how to keep them longer, and the many failures and lessons we have learned along the way. I hope you enjoy and subscribe. If you're an entrepreneur, then you need to be able to make decisions. In order to make good decisions, you need to have high quality data. And if you don't have high quality data, then you will have poor decisions and you will not like the life that you end up leading. And so one of the important skills or attributes that I believe successful entrepreneurs have, is an understanding of the basic equations of business.

And so what I want to share with you today are probably two of the most used that I use when talking to the portfolio companies that we have when analyzing decisions about what we need to do with the business, where our bottlenecks are, et cetera. All right? And so I also think that understanding the equations

will make you a better business owner because you'll understand the things that move the levers within how much money you're going to make in a business. And so if you understand that these are the most important levers in the business, then you'll be more prudent in terms of when you make decisions around them.

All right? So there's the fundamental equation that I like as a simple understanding of business, which is just number of new sales or sales velocity, right? Number of new sales. So this equation has three variables in it. One is the number of new sales per month, which most people know. The second is the lifetime gross profit per customer, which most people have no idea.

And then the third is hypothetical max revenue, which most people also have no idea about. And so then if this is the equation that I want to get to, right? Because from here I can tell if businesses growing or shrinking, because let's say your hypothetical max revenue is a million dollars a month and you're doing 1.5 right now. Well, it means that at your current sales velocity and current lifetime gross profit,

you're actually going to be shrinking, right? So I'm like, ah, that's probably a company that I don't want to deal with or I'm going to know that there's a problem, right? The flip side is, if I have a company that's a million dollars a month and they're currently doing $500,000 a month, then I know that they're going to be growing, and then they will cap it a million. So I know that this thing, if we change nothing, will double,

right? The third scenario, which is actually probably the most common, is when people or business owners have, they're at equilibrium. So they're pretty much maintaining the same sales month over month over month, and the revenue has remained more or less unchanged. That's actually pretty beautiful because there's other stats you can pull from that with very high degrees of certainty, the longer they've been maintaining that period of time. And so then you can actually make really good extrapolations about the future. All right. And so that is equation number one, which I would just call like fundamental to doing business. You have to know how much money you're going to be making and how many of those things you're going to sell. Okay. Now, the second is, is how do we actually

figure out what a lifetime gross profit is per customer? All right? So you've got price times margin divided by churn. The alternative to this, this is in recurring based businesses. The alternative to this is simply price margin, price times margin times number of purchases. So it's like if you sell a $100 widget and the average person buys, you know, three of them and you make a 50% margin, then it's 50 times 50, you know, 50 plus 50 plus 50, which is 50 times three. And so your lifetime, gross profit per customer is 150 bucks. The reason that that's so important is that if you know that it costs you $10 to acquire a customer, then you have a $15, one LTV to KAC ratio, which is awesome, right, which is high five, keep going. Keep doing more of that

thing. But a lot of times people don't know what these numbers are. And so then they can't make decisions. They're like, should we increase our marketing expense? Should we do more reachouts? Are these numbers good? Right? Because people want to understand, like, is this good or bad, right? Which is kind of funny because you want to wait for someone else's judgment on whether or not a number is good or bad. But anyways, we'll get beyond that. So when I know this, right, when I'm dealing with a company that doesn't know, you know, what their numbers are, I will walk through these two equations with them. So let's walk through one together. All right. I actually had a recent conversation with a company that had a service-based business. They were a marketing agency

of sorts. Cool little niche. And so they were selling $1,000 a month service. It cost them $100 a month, right? In cost. So there's price. They were selling 120 new units per month. at 40. So these are the numbers that we knew, right, that they knew as of right now. And so from these numbers, we're able to learn a lot about the business, right? So one of these is that they have 90% gross margins, right? Based on their new units per month, right? We know that we can go 120. Why is this not working?

Here we go. 120 divided by churn but we don't have the turn percentage ah but we do because 50 over 380 is your turn percentage which I'm guessing is going to be like 13 or something like that let's see here is 13.13.1 right so I'm going to divide this by 0.13 which is going to give me my hypothetical max ready this is how business really works my friends my Most people don't want to do this math, but this is why most people don't make money. All right. So 923 is the max amount of clients that they're going to be able to have at this current juncture.

So if nothing changed about their business, their turn stays the same, their number of new customers stays the same. That's where they're going to cap out, which means that this business will do $923,000 per month, right? That's where it'll max out. Right. Cool. Nothing wrong with that. And they have 90% gross margins, right? Now there's obviously other costs that have to go into doing the business, but they probably run this at probably at 40% to 50% net margin. Because if you're running 90, you can probably cover that, right? Which is good business. Six million bucks a year. Good business, right? And so the idea here is if they're currently, because remember, we know what they're current is. They're currently at 380,000 because we have 380 active customers per month. Then this business, this is going to be a fast growing business, right? I mean, think about it. They're doing 120 right now, and their turn is 13%. They're going to be, they're going to jump to, you know, 500 next month.

And, I mean, it's going to, they're going to jump pretty quickly here, right? But what it'll do because of the churn is the churn will start eveninging out their growth, right? Because this point right here is the point of equilibrium. It means that the number of new sales they make compared to the number of people that exit the business are the same. So let me actually spell it out because I think it might be useful. Real quick, guys, you guys already know that I, don't run any ads on this and I don't sell anything. And so the only ask that I can ever have of you guys is that you help me spread the words so we can out more entrepreneurs, make more

money, feed their families, make better products and have better experiences for their employees and customers. And the only way we do that is if you can rate and review and share this podcast. So the single thing that I has to do is you can just leave a review. But take you 10 seconds or one type of the thumb, it would mean the absolute world to me. And more importantly, it may change the world with someone else. So I said, 923 is the max, right, that this thing can do. Why is that? Well, we said the churn was 13%, right? So, times 0.13, right, is going to be equivalent to, do, to do, 220.

All right? Now, if 923 is equal to 120, which is the number of new sales, then it means you're going to have 120 new sales every month, and you're also going to be losing 120 every month, which means zero growth. All right, that is a point of equilibrium. The reason the equilibrium point is so important is that that's where we know we can, like that's where we're going to level out again. We have to find a new channel for growth, right?

Now, right now, if your business is plateauing, then you can make, you can make these assumptions and you can do this math about your business. A lot of people are like, I don't know what my LTV is, right? And I'll give you a simple, a simple, another example of something like that of a business in equilibrium. So let's say you've got a business that's doing $100,000 a month, right? $100,000 a month. Let's say, you know, the price point is.

is, you know, I'll use simple numbers here again. So let's say it's a thousand bucks a month, right, for the services. All right, which means that they have 100 customers. Simple business so far, right? So now the question is just gonna be sales velocity and churn. So let's say that they've got 10% churn and they get 10 new customers per month, right?

And the thing is a lot of people don't know this number, right? Which is silly to me, but a lot of people don't know the number. But the thing is, is if you are in equilibrium, and they're getting 10 new customers a month, then I can tell you the churn's 10%. I don't need them to calculate it for me. I know like, so you haven't grown for six months, yes. Let's average out the number of sales

that you get month over month over the last six months and they'll tell me it's been around 10. Like okay, well, if you have 100 current, right, and your outflow is 10 and you haven't grown, sorry, so your inflow is 10 and you haven't grown, then it means your outflow is 10. And then it's simply 10 over 100, it's 10 percent. That's the game, right? And so now you're like, well, why do I want to do all that stuff?

Well, now we know what the LTV is because again, they're probably not going to know what that number is. So we say, okay, well, $1,000, remember, do to do to do, times our margin percentage, right? I didn't put the margin in here. Let's just say it's 80%, right? Times 80%. And we divide it by churn, which is 10%, right? Which means that we're going to make $8,000 per customer. all right and gross profit the reason this is important is they might be like i don't know how to grow i'm like we're making eight grand per customer how much is it costing you do acquire a customer and this is this is where it gets funky a lot of people are like well it costs about a thousand bucks to acquire customer and i'm like great why don't we do 10 times more of that and sometimes it's really

that simple um it's like i just we never saw it like that i'm like right you're spending 1,000 to make eight let's play that game as many times as we possibly possibly can't right and if it's like well, we can't do, we've maxed out this channel. It's like, okay, well, we have $8,000 to work with in order to acquire our customers, right? But let's be real for a second. You don't want to run a nonprofit, even though a lot of people do. But if you're in the game to make money, right, then this $8,000, right, realistically, in order to have a sustainable business, you need to have a three to one or higher, right?

It's called LTV to KAC ratio, all right? And so for me, I personally really don't look at businesses that have less than this, 10 to 1. And that's just a choice. You can do that. But there's tons of research studies that have figured this out, especially in the software world. A lot of things are quantified or quantized or whatever we want to say here, right, is that 3 to 1 LTV to cat ratio or greater is what is necessary for growth. All right. And a lot of this also has to do with cash flow.

So imagine for a second that you had a $10 per month thing, right? Okay, and let's say you had someone and you know they're going to stay for 10 years, something super long, right? 10 years. That's a very long LTV. But the total, like lifetime value of a customer like this, right, 10 years is 120 months. It's going to be $1,200. Right? And let's just assume it's a digital product so that there's, you know, almost virtually all gross marks, right?

Well, the thing is, is you might have a three to one. So let's say it cost somebody, you know, let's say it cost you $200, right, to acquire this. you're like, who, I'm going to be rich, right? But the thing is, is $200 is $18 months, or 20 months, excuse me, is 20 months. It's going to take you 20 months to recoup off of your $10 per month, right? And so your cash flow is going to be horrible, right, even though the business fundamentally is good. And that's why people raise capital and they take outside investors and all that kind of stuff, right? But the game is then figuring out, which this is actually the topic of my third book that will come out probably in a year or so.

It's called money models, which is how can we figure out a way to make money getting this customer? How can we figure out a way that we can do a little bit of money kung fu and figure out a way to either decrease the cost of acquisition, right? If we can get this from 200 to let's say 50, right? It's like, okay, well, now I got five months. It's like, okay, can we put some sort of like, you know, buy three months up front, you know, or buy five months up front, by your first year's half off? right, if we know they're going to stick. So if we did first year at 50% off, right, then we're going to have $60, right, that we're going to make up front, right? And we know that it's going to cost us $50 to make this $60. So we actually have plus 10 in cash flow for the

business within on the first transaction. And then we can keep spinning our money around. And we just know that 12 months from now, this guy is going to start recurring at $10 per month, right? And then we're good to go. But this way we cash flow the acquisition. And so that's the kind of little stuff that I think it just sometimes just experience or having done this a lot of times to know. But anyhow, this is definitely a more in the in the in the trenches, how we look at businesses that we're looking to acquire percentages of in in the portfolio. These are the two fundamental equations you have to know like the back of your hand. Do to do right? You have to know this one and you have to know how to calculate LTV. If you have those two equations, you can pretty

much learn everything you need to know about a business on the back of the napkin. All right, so I hope you found this valuable. If you did, my name's Alex from Ose. We own Acquisition.com to portfolio companies that's at about $85 million a year. Keep being awesome, Mosy Nation. A lot of people are broke. I don't want you to be wonderful. That's why I made this channel. Click subscribe if you dig it. Don't click if you don't. Either way, love you. Catch you guys in the next video. Bye.