The Rise and Fall of “Growth At All Costs” for Digital Startups and DTC Firms
The critical importance of unit economics in today’s environment
By Ryan Mason, Growth Director and Giorgio Paizanis, Growth Director at BCG Digital Ventures
Two years ago, we released our first Margin-Based Marketing article debuting some of our core growth methodology from which startups can benefit in the face of a high-growth mandate. Our reflections were built on the foundation of a decade-plus of unprecedented venture investment and a sprawl of startups embracing a new digital model. During this period, it has been easier than ever to start new businesses: founders are empowered by a suite of modularized, plug-and-play digital tech stacks, highly effective customer acquisition engines, and record levels of venture investment. As we pointed out, much of this occurred without the requisite rigor behind growth strategy — and with little understanding of the impact of growth on the bottom line.
But what started as a warning to growth-stage firms flush with cheap capital has become even more true today: expensive growth is not healthy growth.
Promotional marketing, high customer acquisition costs (CAC), and long payback periods are not ingredients in a sustainable business model. In fact, it is quite the opposite — a sign that a firm may never achieve the financial fundamentals to acquire new customers at an appropriate cost.
Now, in the face of record inflation and rising interest rates, firms are waking up to the reality of unit economics. Capital providers are beginning to worry more about short-term cash flow than long-term customer growth potential. Consumer sentiment is cooling as uncertainty about the pandemic, war, inflation, and the economy looms over everyday spending decisions. According to research from Boston Consulting Group (BCG), 73% of consumers worry that the world will struggle with economic recession this year. The consumer sentiment index — managed by the University of Michigan for over 30 years — has reached its lowest ever recorded value, dropping 14% in May 2022 alone.
The bear market environment we are in is hitting private and venture investment particularly heavily. In the first three months of 2022, venture funding fell 21% and funding is on track to drop another 19% by the end of the first half of the year (link and link). Prominent venture firms like Sequoia and YC have issued extensive memorandums to their portfolio companies offering advice on cash conservation, while tech startups like Coinbase have laid off large percentages of their workforce. Your own wallet may have even gotten a little lighter lately, as is detailed in the Atlantic piece about the end of the Millennial Consumer Subsidy (link).
So, what can be done? Our first article detailed the mechanics behind the Margin-Based Marketing (MBM) approach for growing companies. Given MBM’s inherent relation to unit economics and profitability at the customer level, it may be even more relevant today. In this article, we’ll explore seven tactics you can apply in your business to build a healthy, sustainable foundation for growth.
Refresher: What is Margin-Based Marketing?
Margin-Based Marketing (MBM) is the practice of optimally allocating marketing capital to maximize profit or achieve a target profit margin over other KPIs (like revenue, app downloads, or site visits).
There are three guiding principles of MBM:
- MBM relies on a clear link between marketing inputs and bottom-line results.
- MBM compares the cost to acquire a customer (CAC) to the customer lifetime value (LTV), focusing on the margin.
- MBM should leverage predictive analytics and automation for calculating LTV and setting cost boundaries for CAC bids in a digital marketing auction environment.
Here are eight practical strategies rooted in MBM to maintain a healthy path to growth in today’s environment:
1. Get clear on your LTV.
The first and most important step is getting sharp on your LTV (margin, not revenue). It’s vital to use this value to absolute upper limits for CAC. Ideally, the LTV:CAC ratio is at least 3:1 when using Gross Margin LTV and including churn.
There are many different ways to approach LTV — it can be on a customer level, a cohort level, or a blended average of your entire customer base. LTV can also be reflected as predicted or observed. Predicting LTV is a challenging task, but if you have a few years of data, it can be done precisely enough to set your constraints.
Advanced customer analytics services can help pinpoint LTV on a per-user basis. But broadly speaking, a simple discounted cash flow model can be similarly effective.
For this exercise, it’s important to include all profit that a customer will generate over the course of their relationship with the business — not just the initial transaction. Take this figure and translate it to your ideal maximum upper bound limit for CAC. With flexible marketing budgets and auction-based environments, this is an effective lever to ensure you do not breach the limits of your business model.
This does not prevent choosing to acquire users at a near-zero LTV:CAC margin in order to maximize growth — if that growth will bring scale and drive better future unit economics. However, relying on the other half of the CAC:LTV equation is dangerous: if you have higher churn than your model expects, you’ll burn through a lot of cash — and fast.
2. Stop offering discounts for new customers.
Discounts and free shipping offers have become commonplace in the digital consumer industry, particularly for upstart direct-to-consumer (DTC) firms and other digital products companies. And it’s easy to understand why: these offers lower the trial barrier and are an accepted form of reaching an agreement with a prospective user, signaling that you value having their business.
But there are also some obvious downsides to using discounts. The most prominent disadvantage is that they cost money, effectively adding to your CAC (or depleting LTV). Many may try to justify this by leaning on the other side of the equation too much, hoping for increased LTV via more frequent purchases. However, new customers who do not pay full price often do not convert to high LTV customers and may never “graduate” to become full paying customers.
A constant reliance on discounts works to effectively drive out your payback period without really reflecting it in your business model. Even worse, this can spiral into existing customers waiting for coupons, cannibalizing existing revenue streams, and creating discount habits that are difficult to climb out of. If you need to lower the price to game enough demand to scale, you have a problem with price and willingness to pay (WTP).
3. Let churned customers stay churned.
It is best practice to continuously monitor customer behavior — at scale via a customer data platform (CDP), for example — in order to identify your highest value customer cohorts and predict their likelihood to churn. This way, businesses can plan automated interventions to prevent customers from churning in the first place (e.g., by surprising them with excellent customer service or a personalized recommendation).
However, once a customer has churned it is often not worth spending budget to re-acquire them via return discounts (“re-CAC”). These types of methods do not often lead to favorable customer relationships in the long run. While it might be tempting to reach out to a dormant customer list that used to have high potential, you’ll find yourself in a discount pattern from the start. This further dilutes your LTV margin and keeps adding to the CAC.
4. Revisit pricing early and often during high inflation.
With inflation skyrocketing over the past year to a 40-year high — reaching 9.1% YoY in June 2022 — brands will need to start making difficult choices about how and when to change prices to avoid reductions in margin. As these cycles of price increase play out, it is also important to consider the implications for LTV and CAC.
If prices are not rising in line with inflation of your cost structures, then the margin will be impacted and therefore LTV and payback periods for customer acquisition will decline as well — unless the brand is able to drive CAC down to compensate. This may also mean that some customers are no longer profitable to retain and acquire, creating a drag on growth. During times of high inflation, be sure to regularly review your pricing — and don’t be afraid to let go of unprofitable customers.
5. Double down on activities that improve unit economics.
To shore up margins, focus on activities that have a marginal cost of close to $0. Examples include:
- Retention and CRM activities (via owned channels like email or SMS)
- Conversion rate optimization and CX experimentation
- Referral programs (with fine-tuned economics to keep your CAC in line)
- Sales effectiveness/enablement upgrades
6. If your business is in a position of strength, consider increasing marketing investment.
If your business is lucky enough to be in a position of financial strength — with healthy unit economics and cash flow — increasing marketing investment offers a chance to leapfrog competitors.
Many companies will likely scale back their marketing spend, which may create dips in CPM on certain platforms. This occurred at the start of the pandemic and many marketers took full advantage. Those who can create gaps in the Share of Voice vs. Share of Market balance during this period may be able to gain market share if competitors are retracting into conservative positions.
7. During a recession, businesses can target “one level up” in their search for new customers.
In the face of inflation and recessionary pressures, some customers may start to “trade down” to lower cost brands or services. To take advantage of this, marketers can try to expand their target customer market “one level up” in terms of HHI or other demographic indicators to meet these consumers. For example, a group of high HHI consumers who previously might be categorized as too high end for a product or service may now be an ideal target. The hypothesis is that these consumers are now more price sensitive, but still have a higher inherent willingness to spend compared to current targets or existing customers.
8. Optimize for faster payback to become more cash-efficient.
Longer payback periods require more working capital which can divert cash toward subsidizing customer payments, away from being used on strategic initiatives. The shorter your payback period, the more cash-efficient your business can become — ultimately creating a strong buffer with critical runway extensions. Once you successfully acquire a customer, you can optimize for faster payback in a few ways: incentivizing a higher frequency of purchase, driving up-sell and cross-sell opportunities, or engineering a higher contribution margin.
Avoid the “Growth at All Costs” Mindset
Now is a time for active management and frequent measurement of marketing ROI. Given the rapidly changing landscape of customer sentiment and inflation, CAC and LTV are moving targets. Companies that don’t have the capability to track a MBM program effectively are at high risk of stagnating growth and profitability.
Simply cutting marketing budgets is often a knee-jerk reaction. A much smarter response is to manage the tradeoffs, scale back on your least profitable channels, and let go of unprofitable customers — while also doubling down on retention activities and excellent customer service. And most importantly, never overextend your CAC in hopes that LTV or payback periods will improve. That day may never come. By taking a disciplined approach to growth, companies can build a healthy foundation for a sustainable future.
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