The Importance of Customer Acquisition Costs for Startups


I recently came across the blog of David Skok of Matrix Partners and was inspired to write this post by an article on customer acquisition costs. If you have not yet read through his blog’s vast resources for entrepreneurs, I suggest you do so – particularly if you plan to pitch your startup to VCs anytime soon.

After being pitched countless times by startups, as a VC I’d like to identify a common misconception that web-based startups often have about their own growth potential and the costs associated with their plans. Management of web services companies, SaaS companies and mobile (web-based) applications commonly believe that because they are situated online, customers will come across their service, submit a purchase order (or subscribe) and notify friends or other companies to use the service as well. Although this may happen from time to time, it is very rare for any company to experience sustained viral growth.

Many companies don’t understand the difference between viral marketing and viral growth. Viral marketing is essentially “word of mouth” or “person-to-person distribution” and is the latest buzzword. Viral growth implies a K-factor greater than 1 (i.e. for each new person who tries a product/service, they will each invite more than 1 registered user of the product on average). Since true viral growth is so hard to achieve in practice, many companies miscalculate the actual costs it will incur to acquire customers. As David points out in his article, the majority of startup pitches lack detail/emphasis on how much it will cost to acquire customers. I second this statement entirely.

Business Model Viability
For a business to be profitable on each new customer, startups must balance two variables: (1) Cost to Acquire Customers (CAC); and (2) Lifetime Value of a Customer (LTV).

CAC can be calculated by taking the business’s entire cost of sales and marketing over a given period (including salaries and other employee expenses) and divide it by the number of customers that the business acquired in that period.

LTV can be calculated by looking at the Average Revenue Per User/Customer (ARPU) over the lifetime of a business’s relationship with a customer.

As Steve Blank mentioned in his recent post, an early indication that a business has found the right business model is when the cost of acquiring customers becomes less than the revenues generated from the customer. “For web startups, this is when the cost of customer acquisition is less than the lifetime value of that customer. For biotech startups, it’s when the cost of the R&D required to find and clinically test a drug is less than the market demand for that drug.”


Credit: David Skok.

Zynga is a great example of a company that has managed to decipher the business model of online social gaming. After thousands of A/B tests and experiments, Zynga finally found a business model where CAC was less than LTV. Once they cracked the nut, the company spent so much on customer acquisition that it was rumored that they accounted for upwards of 30% of Facebook’s revenue in 2009 though its aggressive social ad buying strategies. Similar business models and opportunities exist in virtual worlds, massively multiplayer online games (MMOGs) and many other online businesses. Many social games, such as those created by Zynga, leverage virtual currency, micro-transactions, emotional response mechanisms and social influence to promote the sale of decorative and functional virtual goods.

Before investing in a web-centric startup, good VCs will look deep into a company’s business model and know to look for CAC and LTV metrics. In fact, Trident Capital recently held a meeting with their online advertising and ecommerce companies to help exchange best practices for customer acquisition and improving LTV. My advice to startups: prove out your business model and you will have a much better shot at raising VC dollars. Skok suggests that two key equations be followed by web startups:

  • CAC < LTV (3x appears to be a rough minimum for SaaS businesses)
  • CAC should be recovered in < 12 months (for subscription businesses)

Startups, if you’ve already figured out your business model and how to make CAC < LTV, stay very quiet and add as much fuel to the fire as you can afford. Your competitors will likely try to hone-in on your tactics and fight back for their share of the market.


Credit: Steve Blank.

Leverage Startup Metrics
Startups are different from larger companies and therefore need different metrics than larger companies. Metrics will give startups a lens into how well the search for the business model is going and help to identify when to scale the company. Besides CAC and LTV, some essential metrics that startups should be familiar with include Viral Coefficient (K-factor)  and Customer Lifecycle. Dave McClure from Founders Fund recently updated his Startup Metrics for Pirates presentation for web sales pipelines. Take a look!

Questions to my Readers
Please consider the following questions and share your perspectives with my other readers and the tech community at large.

  1. What metrics do you consider the most valuable?
  2. Do you use any tools to help measure specific metrics for your business?
  3. What mistakes have you made (and corrected) that can help others succeed?

4 thoughts on “The Importance of Customer Acquisition Costs for Startups

  1. Great post Josh!

    To answer some of your questions

    1) Important Metrics: Arguably your retention rate is the ONLY thing that matters for online / social games and the largest driver of your business. With longer tenure of users, you as the game developer have more opportunities to tune and improve your:

    – CPI (cost per install)
    – Life time K (viral acquisition over the lifetime of the user)
    – Conversion to pay
    – ARPPU (average revenue per paying user)
    – LTV (life time value)

    Also, tracking your CAC vs LTV per source (channel acquired, ad network, source of traffic) helps with cutting off unprofitable campaigns.

    2. Tools to measure: Kontagent, MixPanel, KISSMetrics, Google Analytics

    3. Mistakes: Retention is the new viral.

    -kli

  2. Kevin,

    I totally agree with you that retention is very, very important. It's much easier (and cost effective) to retain 1 user than it is to acquire 1 new user (generally speaking).

    With regards to “longer tenure of users”, this is one of the trickiest parts for developers since it becomes increasingly harder for online/social games to consistently deliver an experience that is increasingly engaging over time and that offers new elements that warrant re-engagement by existing users as they continue to play.

    It is a particular challenge for new games that are recently launched as “minimum viable product” to keep the steam building as innovators and early adopters will poke and prod the game to find ways to reverse-engineer it to gain competitive advantages within the game design and/or game mechanics. This first cohort of players will comment about and review the game on blogs and forums and will either hype it up or smash it. This is where being an agile development team is hugely important. As Kevin notes, companies must use tools to measure users engagement levels within the game and between different A/B versions; test, learn and then iterate quickly to stay ahead of competitors.

    – Josh

  3. Well, the tutorial is really great, you probably have invested a lot of time in the procedure and the downtime is really impressive. What interests me is one thing further – how did you make those nice pictures for the tutorial. They are really impressive.

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