[EN] People pay you, not pageviews. Customer acquisition cost & lifetime value
By Terence Lee
Editing by Osman Husain
Feb 22, 2016
If I asked you how healthy your business is, how would you answer? Would you give me total user figures, user engagement numbers, revenue, growth rate, or EBITDA?
These are all useful. But they’ve one flaw: they tell us the current health of businesses, but they don’t do a good job of predicting your business’ financial health in the months and years ahead.
That’s the job of unit economics. In essence, unit economics is a method of working out how efficient your business is in spending money to acquire customers on a per unit basis, that is, on the level of the individual customer.
It has two components: customer lifetime value (LTV or CLV), and customer acquisition cost (CAC). The basic rule is that you’ll want to increase your LTV and lower your CAC as much as possible.
Your company’s survival depends on your ability to nudge those two numbers.
How to calculate customer lifetime value?
LTV refers to the amount of money each customer is expected to spend on your products and services.
Your ability to get an accurate LTV depends on the stage of your company. If you’re still concocting your business plan, your LTV will be nothing more than a guesstimate. Once you start generating some sales however, you’ll have solid data to work with.
Now, let’s use an example. Suppose you run an online grocery delivery service which has been operational for a couple of years. How would you determine its unit economics?
Here’s a simple formula:
LTV = Average monthly revenue per customer ÷ monthly churn rate
Churn rate is simply the percentage of your customers who stop using your service after a certain time.
You can plug in annual instead of monthly figures – whichever you prefer. So, suppose each of your customers buy $100 worth of groceries each month and the churn rate is 5 percent, you’d have a LTV of $2,000.
This is not the only method. This infographic by Kissmetrics presents some rather complex alternatives (take a deep breath before you proceed):
How to calculate CAC?
Still following? Excellent. Now let’s move on to customer acquisition cost (CAC), which is simply the expenses for acquiring new customers. It covers sales and marketing costs, including the salaries of your salespeople and marketers.
It does not include fixed costs like salaries of the rest of your company, infrastructure, and rentals.
A simple formula:
CAC = Total sales and marketing costs ÷ Total customers acquired
MCC = Total marketing campaign costs related to acquisition.
W = Wages for sales and marketing team.
S = Cost of marketing and sales software, including ecommerce platforms, automated marketing, analytics, A/B testing, and more.
PS = Additional professional services used in marketing and sales, like designers and consultants.
O = Other overheads related to marketing and sales.
CA = Total customers acquired.
A useful trick is to break down your CAC by marketing channels. This allows you to determine which marketing methods are effective and optimize accordingly.
Weighing customer lifetime value and acquisition cost
Suppose you’ve calculated both numbers. What’s next?
A 1:1 ratio puts you in the red, since your business includes other costs, like the salaries for the rest of the team, office rent, and R&D.
In Zero to One, Paypal co-founder Peter Thiel groups CAC into four kinds:
For startups to scale, they should avoid the “dead zone,” where LTVs aren’t high enough to justify the high costs of sales. This usually happens to startups targeting small businesses as customers.
Back to our online grocery startup. If your CAC is $100 and your LTV is $2,000, that’s probably a great sign. What matters now is how expensive your fixed costs are, and it’s likely to be astronomical if you’re renting warehouses and delivery trucks.
Now you can see why businesses like software and certain types of ecommerce (especially those that don’t involve logistics) are attractive. With these companies, the cost of selling an extra piece of software or making an extra transaction are low or near zero.
Asset-light business models aren’t foolproof, though. They’re susceptible to a flood of competitors, which means you’ll need to invest heavily in R&D and marketing to stay on top.
Knowing your customer lifetime value and acquisition cost is useful in businesses where the people you market to are also the ones who buy your products or services.
It gets tricky when your business makes money mainly through advertising (like Buzzfeed and Facebook), because there isn’t a linear relationship between revenue and user growth.
In other words, Facebook at a billion users is exponentially more valuable than Facebook at a million users.
And even though the first 100 Facebook users didn’t benefit the social network monetarily, they contributed towards making Facebook the indomitable force it is today.
Now, there are ways to crack this. Andrew Chen, head of driver acquisition at Uber, notes that if we look purely at advertising, then the LTV of a user would be “the stream of all previous and future ad impressions that a user generates from their usage.”
So, if you multiply each user’s expected lifetime ad impression with cost per click, you get the user’s monetary value.
Beyond that, however, things get complicated. On social networks, some users add value in ways that can’t be tracked by impressions.
For example, some users create useful content on your site, which in turn acquire more users, and increase retention and engagement.
And suppose you’ve developed a way to track these actions. There are philosophical questions to debate, such as: if someone creates content that gets viewed a lot, do you give credit to the content creator or the reader?
In any case, figuring out your unit economics will take a lot of careful thinking, but the effort could well be worth it.
It’s a tool to project your startup’s future and decide whether to craft a plan to make it more sustainable, or ditch it before you sink any further into a business with little growth prospects.
If you’re keen to read more startup 101 stuff, head this way
When you’re talking about LTV, you can not focus only on the customer acquisition cost, but you have to also remember that customer retention also generates costs. The estimated CLV can not be achieved only through one-time acquisition cost.
At some point the customer acquisition cost will be higher than customer retention cost, and you’ll have to focus on the retention rather than overpaying to get new customers.
In the many thousands of articles advising entrepreneurs on what they have to focus on to build successful startups, much has been written about three key factors: team, product and market, with particular focus on the importance of product/market fit. Failure to get product/market fit right is very likely the number 1 cause of startup failure. However in all these articles, I have not seen any discussion about what I believe is the second biggest cause of startup failure: the cost of acquiring customers turns out to be higher than expected, and exceeds the ability to monetize those customers.
In this blog, Marc argues that out of the three core elements of a startup, team, product, and market, the only thing that matters is product/market fit. I agree with Marc’s view that product/market fit is extremely important. However after closely watching several hundred startups that have failed, I observed that a very large number of these had solved the product/market fit problem, but still failed because they had not found a way to acquire customers at a low enough cost.
I would like to propose that in addition to team, product, and market, there is actually a fourth, equally important, core element of startups, which is the need for a viable business model. Business model viability, in the majority of startups, will come down to balancing two variables:
Cost to Acquire Customers (CAC)
The ability to monetize those customers, or LTV (which stands for Lifetime Value of a Customer)
Successful web businesses have long understood these metrics as they have such an easy way to measure them. However there is a lot of value in looking at these same metrics for all other businesses.
To compute the cost to acquire a customer, CAC, you would take your entire cost of sales and marketing over a given period, including salaries and other headcount related expenses, and divide it by the number of customers that you acquired in that period. (In pure web businesses where the headcount doesn’t need to grow as customer acquisition scales, it is also very useful to look customer acquisition costs without the headcount costs.)
To compute the Lifetime Value of a Customer, LTV, you would look at the Gross Margin that you would expect to make from that customer over the lifetime of your relationship. Gross Margin should take into consideration any support, installation, and servicing costs.
It doesn’t take a genius to understand that business model failure comes when CAC (the cost to acquire customers) exceeds LTV (the ability to monetize those customers.
A well balanced business model requires that CAC is significantly less than LTV:
Since the above two diagrams are so obvious, you may wonder why I have included them. The goal is give the reader a sense of the balancing act required to create a profitable business. Hopefully the value will become more obvious with the third version of the diagram that shows the different factors that affect the balance.
Another reason for stressing the point using diagrams is that many entrepreneurs have realized that since the web provides some amazing new ways to acquire customers at low cost, several new businesses have become possible. The only thing that you have to consider is can you monetize your customers at a higher level than the cost to acquire them.
The Entrepreneur’s Achilles Heel: Optimism
To be an entrepreneur requires great optimism, and a very strong belief in how much customers will love your product. Unfortunately this same attribute can also lead entrepreneurs to believe that customers will beat a path to their door to purchase the product. This frequently causes them to grossly underestimate the cost it will take to acquire customers.
A common scenario is an entrepreneur that has dreamt up a cool new service that they can offer via the web. As a VC, I have sat through many presentations like this, and in most cases the service is actually interesting and compelling. However in the majority of these presentations there is little or no focus on how much it will cost to acquire customers. As I ask questions to understand the thinking, what usually comes out is something vague along the lines of web marketing, and/or viral growth with no numbers attached.
A quick look around all the B2C startups shows that, although viral growth is often hoped for, in reality it is extremely rare. When it does happen, the associated businesses are usually extremely attractive, provided they have a way to monetize their customers. (For more on the topic of Viral Growth, refer to my blog post on that topic here.)
Far more common is a need to acquire customers through a series of steps like SEO, SEM, PR, Social Marketing, direct sales, channel sales, etc. that will cost the company significant amounts of money. What shocks and surprises many first time entrepreneurs is just how high the numbers are for CAC using these kinds of techniques.
Some examples of CAC calculations
For example, if you are using Google Ad Words to drive traffic to your site, take a look at the following interactive spreadsheet. This example shows a cost per click of 50 cents, and the resulting website visitors converting to a trial at the rate of 5%. Those trials are then shown converting to paid customers at the rate of 10%. What the sheet shows is that each customer is costing you $100 in just lead generation expense. For many consumer facing web sites, it can be hard to get the consumer to pay more than $100 for the service. And this cost does not factor in the marketing staff, web site costs, etc.
One of the more interesting things that this model shows is how rapidly cost of customer acquisition climbs If your leads require human touch to convert them, (compare cell B23 with cell B22.) This human touch can be as light as email follow ups, or as much as inside sales people doing multiple sales calls and demos. I have seen this cost vary from around $400 to $5,000 per customer acquired, depending on the level of touch needed.
Another shocking computation is to look at the cost of a direct field sales force:
This shows is that it is not unusual for the cost of acquiring a customer to be as high as $100,000. This number is heavily dependant on the productivity of your sales teams. In the model above, this was set to 10 deals per year per team. Given the need to cover R&D and G&A costs, the average gross margin on a deal needs to be at least $150k.
Lessons Learned – Business Planning Stage
My advice to entrepreneurs working on a new business plan is to build a model similar to those above to estimate the cost of customer acquisition. This is going to show you the dependency on several critical variables:
Cost per lead
Conversion rates at each stage of your sales process
Level of touch required
Then compare this to your expected monetization. As a very rough rule of thumb here are two guidelines that you might find helpful:
LTV > CAC. (It appears that LTV should be about 3 x CAC for a viable SaaS or other form of recurring revenue model. Most of the public companies like Salesforce.com, ConstantContact, etc., have multiples that are more like 5 x CAC.)
Aim to recover your CAC in < 12 months, otherwise your business will require too much capital to grow. (Banks and wireless phone companies ignore this rule, but they have access to tons of capital.)
In the early days of the business, you will not be able to accurately predict your conversion rates, and the viability of your entire business may depend on this. So I recommend building an execution plan that focuses on finding out what these numbers will be as soon as possible in the lifecycle of the business. Good numbers will enable you to raise funding easily, and bad numbers may indicate that this is not a viable business.
The good news is that if you can monetize your customers at a higher rate than the cost to acquire them, you probably have a great business on your hands.
Because a number of smart entrepreneurs realized the importance of lowering CAC, they created new business models such as Open Source, SaaS, Freemium, etc. that directly tackled the problem of acquiring customers. Some of the early B2B pioneers in this space were companies like JBoss (story here), SolarWinds, ConstantContact, HubSpot, etc. Once others started to see the success these companies were having, they started copying the techniques.
These new business models focused heavily on how buying behavior has changed because of the power of the web. Think about your own behavior: if you are like me, you hate having to deal with sales people, and greatly prefer to do your own research starting with search engines, and leveraging free trials, on-line videos, blogs, reviews, and your social network. To adapt to this, the new business models make use of a variety of techniques described below:
Use of a free product or service to attract web visitors, and aim for a viral spread as they tell their friends. Examples of free products include Open Source software, services like HubSpot’s Website Grader, free versions of a SaaS service that have limited, but still valuable, feature sets, etc. For more info on this topic refer to The power of Free.
Use of a free trial, where the customer can easily download, or use a SaaS version of the full product to see if it works for them.
Leveraging the power of your customers’social networks to get viral growth where possible.
Use of the touchless conversion to convert trials to paying customers.
Using low cost inside sales when the touchless conversion is not possible.
Extensive use of software to automate all processes such as SEO, SEM, social networking, lead scoring, lead nurturing, CRM, etc.
Metrics on all aspects of the customer acquisition process to find out what can be improved.
These techniques are frequently referred to as the Low Cost Sales model, or as Sales 2.0.
Balancing Monetization with CAC
The way in which these techniques can work together with other techniques to drive up monetization (e.g. recurring revenue) are illustrated in the diagram below:
Lessons Learned – Ways to reduce customer acquisition costs
Conversion rates play an extremely important role in your customer acquisition cost. Anything you can do to improve conversion rates is obviously a good thing. For more on this topic, please refer to the Building a Sales and Marketing Machine part of this web site.
Consider using A/B testing to improve conversion rates. Web traffic can be easily split so that parts are fed to different landing pages with different offers, and the resulting conversion rates measured.
Look at the level of touch required to complete a sale. Some products are easily understood, while others may require a careful walk-through by a sales person. Sometimes, the customer will want a trial with their own data. With certain complex products, this will need an on-site installation by a sales engineer, which sends costs through the roof. Consider every possible way to minimize this. For example:
Create demo videos that answer every likely sales question.
List the common sales objections that come up in the sales cycle, and provide answers to these on the web site.
Try using customer references to avoid the need for a trial
If your customers are going to compare you to the competition as part of their process, consider doing this for them, with a section of your site that has a comparison matrix with appropriate check marks.
If you have a light touch sales model, consider setting yourself the goal of a “Touchless Conversion”, i.e. getting rid of, or minimizing the touch required to close the sale. As shown in the model, this has a huge impact on cost of customer acquisition.
Options for products requiring high touch
The toughest business models are those that employ expensive field sales organizations. The high salaries and commissions for sales people, sales engineers, travel costs, and office costs add up to an extraordinarily high figure. And this is before you factor in the failure rate (the percentage of sales people hired that don’t become productive). It is not too surprising that VCs are not aggressively pursuing these kinds of businesses. There are some ways you can look to address the problem:
If you are currently using a field sales organization that sells direct, look at whether it is possible to sign up OEM deals with strategic partners to leverage their customer base and distribution power. What generally works best here is allowing the OEM to sell only a base layer of your product with co-branding. Then you can go back into their customers and upsell them. Owning the customer base is an important way to control your own destiny, and will also earn your company a higher valuation. In addition to distribution power, these kinds of relationships solve the “safe choice” concern of many buyers, and can transform your business.
Consider converting to a channel sales model at some stage in the lifecycle of the business. Many times this requires that you “prime-the-pump”, as most resellers won’t sell a product until they see clear customer demand. Channel sales models usually only work when the company commits to them fully, and passes all orders through the channel, so be prepared for the loss of margin this will represent to your current order flow.
Another option is to evaluate whether you can move from field sales to inside sales people. Insides sales people are not only less expensive in direct salary costs, but also in travel costs. Other advantages of inside sales people is that they are far more efficient due to remaining in one location, and can contact more people in a typical workday. At a minimum, look at combining inside sales with field sales to improve the efficiency of field sales people.
If you are entrepreneur planning your next business, you can’t afford to ignore the cost of customer acquisition. The earlier you work on this the better, as many of the best techniques require you to build your product differently.
It is also important to ask yourself the question: can my business realistically expect to acquire customers for considerably less than the amount that I can monetize them?
Once you have completed the product, you will want to familiarize yourself with all the latest techniques involved in the low cost sales model, or Sales 2.0.
From a funding standpoint, it is useful to know that your ability to raise capital will dramatically improve as soon as you have proven that you have a viable business model. Think of that as two equations:
CAC < LTV (3x appears to be a rough minimum for SaaS businesses)
CAC should be recovered in < 12 months (for subscription businesses)
Once you have proven out the business model, hit the accelerator pedal, and invest as much as you can afford. You’ll want to grow the business as fast as possible before a competitor realizes what you have done, and tries to steal your market!