The Fallacy of Decreasing CAC
by Zach Thigpen, Venture Partner at UC Berkeley
On the occasion of Blue Apron’s IPO and Ben Thompson’s discussion around CAC, (apologies for the paywall, but it’s worth it) we want to highlight the importance of understanding customer acquisition cost (CAC) both at any given time, and over time.
Just as important as customer lifetime value (LTV), an accurate understanding of CAC provides a crucial snapshot of key performance indicators over a longer trajectory. This will inform company strategy as businesses enter and scale into new markets and demographics.
From there, LTV/CAC as a combined metric is one of the best indicators of a company’s ability to achieve sustained growth. We find this to be most crucial after a company has experienced the hockey stick exponential revenue growth when the growth percentage change (delta) begins to flatten. In the parlance of the adoption lifecycle, this would be the moment around the “early majority” phase. Put frankly, for early stage companies, it’s all about growing revenue. For later stage companies, it is about sustainable growth and controlling costs. Of course, even getting to maturity is rare and impressive and should be celebrated. But the ability to reach consistent, increasingly profitable growth determines long-term success.
The Fallacy of Decreasing CAC: the misperception that as the company grows and awareness increases, customers will grow organically and establish an increasingly sustainable CAC.
Take, for example, a company that provides on-demand laundry pickup and drop-off. The initial customers will most likely be more affluent and tech-savvy, work long hours, and live in an environment like an apartment building with suboptimal access to their own laundry machines. Once this service launches, it will naturally attract a) those who are looking for this type of solution and b) those who are already using a more manual pickup/drop-off service. Both types of customers might be attracted through advertising or through word of mouth; they will find and adopt the service quickly, and the company will get over the early-adoption chasm.
However, moving to the next tier of customers, who will be less apt to adopt the solution, poses new challenges. As the laundry company expands to new markets, it may find, for example, more apartment buildings with built-in washers and dryers. As a result, its network density diminishes and drivers deliver fewer units per trip. Fixed driver costs will be the primary eroder of profit per delivery. Further, this next tier of customers that the service must attract is likely to a) have less discretionary income, b) experience higher onboarding friction (they’re less tech savvy), and/or c) work shorter hours, making them less likely to be seeking an on-demand solution. In a very short time frame, CAC doubles or triples, and customer yield drops. Advertising becomes less effective and the adoption rate per dollar spent drops since eventually you are going after tier 2, 3, and 4 customers. Inevitably, churn increases (people only use the service with initial discount offers, then stop). This is the heart of the Fallacy of Decreasing CAC.
When evaluating CAC, it is crucial to be thoughtful about: 1) the mechanics of how customers are currently acquired, 2) what’s keeping them engaged, 3) what the current user base looks like and how big that market is, and 4) the biggest hurdles and pain points for future customers and how to get them to join. To clarify our thinking, we’ve identified the types of businesses that are likely to have decreasing CAC:
Market network effects (Tradesy)
As the network grows on the supply side (sellers), the service becomes more valuable to customers and more people use the service. The more customers on the platform, the more valuable for even more sellers, and both sides flock to the platform.
Reputation and premium brand (McKinsey, Bain, BCG)
As you gain a reputation as the best-in-class in an expensive or exclusive vertical, customers will seek you out. It might even be seen as a negative signal to have advertising at all. For example, you rarely see ads for the most expensive and prestigious restaurants.
Drastically decreasing pain, instead of increasing pleasure or providing a marginal improvement (Kayak)
Calling a number of airlines or going through a travel agent is time-consuming or expensive. A service that eliminates the need for either of those will quickly attract customers (though will also attract competitors).
Solutions that customers are already searching for and need (ChargePoint, Twilio)
If there are no charging stations for electric vehicles, then the value of having an EV is reduced. Consumers will be looking for chargers. If ChargePoint starts to expand, customers will gladly pay for their service and businesses/cities will get value for setting up the infrastructure.
In evaluating and interviewing companies, the crucial questions we ask are:
-What is the roadmap for getting to decreasing CAC?
-Is your business naturally set up to decrease CAC?
-Who is your first core customer and what do you predict for LTV, CAC, and churn? How does that change for your second-tier customer?
As a pre-Seed fund, Contrary Capital doesn’t expect Founders to have the perfect answer. BUT they should be thoughtful about how to achieve decreasing CAC without saying something vague like, “We’ll succeed by word of mouth.” As we see with financial projections, it’s not a question of whether the answer is correct, but of proving deep consideration about how your company can continue to grow 3–5 years from today. Founders that show this kind of reflection will be better prepared to understand the ups and downs of user adoption and, instead of panicking, will have a plan in place upon reaching various stages.
Zach’s a second-year MBA at Cal. He’s worked with a number of start-ups in a variety of roles including business development, strategy, and marketing. Over the past summer, he worked at Bee Partners, an Pre-Seed/Seed firm focused on enterprise SaaS. In addition to Contrary Capital, Zach is a Haas Venture Fellow, an Intern at SkyDeck Accelerator, heads up Long Term Strategy at LAUNCH Accelerator, and on the executive committee for the Venture Capital Investment Competition. He is passionate about helping start-ups and founders to solve problems for today and plan for future.