Customer Acquisition and Startups
Investors say customer acquisition cost is essential in investment decisions
A conversation with an investor recently brought out that customer acquisition cost (CAC) is one of the essential elements of his investment decision-making process. It occurred to me that many new entrepreneurs may not consider how valuable, such a metric is for their venture, whether or not they are seeking investment. Customer acquisition cost is not just a measure to determine the average cost to acquire a customer; it is also used to determine the overall health of the business, the marketing budget, and the effectiveness of marketing and sales programs. For an investor, it will demonstrate the short- and long-term viability of the venture.
Let’s examine customer acquisition cost in a little more detail.
Customer Acquisition Cost
Calculating customer acquisition cost is not difficult. Start by totaling all of the marketing and sales costs for a period, and then divide those costs by the number of new customers acquired for the same period. Easy enough, right? Except that many entrepreneurs — myself included — may miss costs in the calculation and do not get an accurate number against which to measure the customer acquired. Experienced investors anticipate such errors will occur.
For a more detailed analysis of CAC, I think about spend and acquisition by channel. For example, in the chart below, I list the number of channels and further categorize them in measurable and non-measurable buckets. Measurable channels are those from which a customer’s purchase is trackable to the marketing or sales campaign, either through a link, a promo code, a unique call-in number, or a sales order tied directly to a salesperson.
Non-measurable channels are channels which do not provide for an easily trackable source for a specific sale but are likely to contribute in some way to sales in general and should be calculated as part of the overall CAC. Brand campaigns might fall into this category, as would most promotional activities such as an entrepreneur’s speaking engagements, and networking events, to name a few. By adding the costs together and then dividing by the number of customers acquired for the period, we arrive at an Average Customer Acquisition Cost.
One of the advantages of tracking spend and acquisition by a channel is the ability to determine which channel is most effective in generating customers. If, as in the example above, Inbound CAC is lower than PPC CAC, one might look more closely at the PPC campaigns to determine how and where improvements may need to be made if it appears those costs are out of line with expectations. But, how to do we determine what is reasonable? We need to calculate the lifetime value of a customer.
CUSTOMER LIFETIME VALUE
The Customer Lifetime Value (CLV) helps us determine the value of a customer over time. This helps us identify how much we can spend to acquire a new customer, and how much we could pay to retain that customer. The CLV estimate considers several key things: The average order value, the average number of purchases, and the average customer lifespan. The customer retention rate, average margin per customer, and a “discount rate,” which adjusts the future profits from the campaign for the uncertainty of performance vs. investing instead in other business operations.
In the chart below, we estimate that a customer will have three purchases per year with an average order size of $35. We anticipate that the average customer lifespan is three years, and we will have a 75% customer retention rate. Based on the particular product, we have an average of 70% profit margin per customer. The discount rate in the example chart below is set to 10%; however, the longer a period for which future customer revenue is expected, the higher the discount should be to factor the greater the possibility of inaccuracy.
We use three different LTV calculations in the chart above: A simple LTV which calculates the sales over the customer’s lifespan, a more customized LTV based on the average gross margin on sales over the customers lifetime, and the more traditional LTV calculation which incorporates the discount rate. Then we average the three methods to arrive at an Average Customer LTV. Using the data in the above chart, the average customer has a value of $316 over his or her lifespan.
Now that we know our Customer Acquisition Cost and Customer Lifetime Value, we can determine whether our cost of acquiring a customer is reasonable given our assumptions, or if we’re using actual numbers, whether we may be overspending or under-spending to gain a customer.
Customer Acquisition Summary
Our CAC calculations indicate the average cost of acquiring a customer is $100.00. Our CLV calculations suggest that the average customer spends $105 per year. For most business types, an entrepreneur would want to limit the cost to acquire a new customer to approximately 30% of what an average customer spends in a year. Considering that the customer spends $105 per year, the target expenditure to acquire a new customer should approximate $35.00, as shown in the chart below.
The numbers used in this scenario suggest overspending on customer acquisition by about 186% more than necessary.
As a result of the overspending, the average customer is unprofitable the first year and reduces the overall profitability during his or her lifespan, assuming the customer is retained as shown in the next chart. If the customer is not retained, the loss would be much more significant.
In the scenario outlined here, the cost of acquisition is much too high, and the possibility to recoup the investment over time is suspect. These factors would likely be a red flag for an investor.
Remember, Customer Acquisition Cost and Customer Lifetime Value will vary from venture to venture and industry to industry. Benchmarks are challenging to find, but models can help establish a baseline from which to work forward. As with all financial analysis, each entrepreneur should develop his or her own CAC and CLV models so that the specifics of the business are incorporated.
Understanding the Customer Acquisition Cost is critical to business operations. Every entrepreneur should know what it costs to acquire a new customer and how those costs flow through the business in particular to the impact on marketing budgets, the effectiveness of marketing and sales expenditures, and overall business profitability. Spending too little for customer acquisition will result in missed opportunities, but spending too much will decrease profitability. Keeping track of Customer Acquisition Costs is a good first step in ensuring profitability, and it will likely play a role in a prospective investor’s decision-making process.
A version of this article was originally published at https://www.mrharkins.com.