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 case you are not familiar with the importance of Product/Market fit, Marc Andreessen has a great blog post on this topic: The Pmarca Guide to Startups, part 4: The only thing that matters.
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 topichere.)
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.
(To access the spreadsheet, please click here.)
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:
(To access the spreadsheet, please click here.)
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.
Next Generation Business Models
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:
- Extensive use of the web to drive lead flow. In particular, the best practices include using Inbound Marketingto build traffic, instead of paying for traffic with search ads. (Read Get Found using Inbound Marketing to find out more.)
- 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!
I would like to thank the management teams at JBoss and HubSpot, Gail Goodman of Constant Contact, Sheila Marcelo of Care.com, for contributing greatly to the ideas in this post.
December 22, 2009 • David Skok