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?

The Future of Contextual Mobile Commerce

In the early days of the gold rush to create location aware and contextually relevant mobile applications for smartphones, I was constantly bombarded with business plans that showed revenue models driven from advertising. Although advertising is a plausible way of earning revenue, there is a high level of inherent risk since those businesses are largely at the mercy of market rate CPMs/eCPMs and available ad inventory (unless you have a rockstar in-house ad sales team). Ad inventories are beginning to improve as advertisers are becoming more and more aware of the high interaction and engagement rates of mobile ads. However, for startups looking to differentiate in their niche, monetizing solely through ads is a risky road to travel. That being said, I believe that ads are still relevant  for *lite* versions of apps that supplement a paid model of some form and for monetizing certain consumers that would not otherwise become a paying customer.

Tim O’Reilly wrote a short article last week on the convergence of Advertising and E-commerce and I thought he hit the nail right on the head. He says that “E-commerce is the killer app of the phone world. Anyone whose business is now based on advertising had better be prepared to link payment and fulfillment directly to search, making buying anything in the world into a one-click purchase. Real time payment from the phone is in your future.” I completely agree. Square is a great example of real-time point-of-sale (POS) coming to iPhone.

In the article, O’Reilly arrives at this conclusion by making a few theories about what can be expected from the marketplace based on some recent announcements and common sense:

  • Google, Apple, and Microsoft will announce e-commerce programs akin to AdSense, in which retailers will register with “app stores” to allow physical goods and services to be bought as easily as apps
  • We can expect announcements of partnerships between phone providers and Amazon or Wal-Mart to fulfill mobile e-commerce requests

There are a number of mobile apps that are positioned well to capitalize on some of these trends such as foursquare and other mashups of local and geocoded information. IMHO, there is a more exciting category that is only starting to gain excitement. Companies like Layar, Tonchidot (Sekai Camera), Mobilizy (Wikitude) and TAT (Recognizr) are creating augmented reality browsers and applications that use location data and combine it with image recognition technology to recognize specific people or places in the physical world and allow the application user to interact with them in some capacity. I strongly believe that these are some of the fundamental technologies that will make this category of future applications possible. By linking interaction of location-aware data through to payment and fulfillment functions, one can point a phone at a local pizza restaurant and order a pizza to their home en route. Another example may be pointing a phone at a friend and performing a money transfer with only a few clicks.

What killer apps can you think of that combine hyperlocal, e-commerce and fulfillment?

Does Eliminate Pro Violate Apple’s Developer Agreement?

As an after thought to my last post on virtual goods, I published a comment discussing Eliminate Pro’s innovative play (or “experiment” says MTV Interactive)  on Apple’s changes to the App Store to allow for in-app billing on certain items. It’s been a successful experiment. As of yesterday, the game has been downloaded 500,000 times so far at a rate of about 25,000 an hour, currently making it the top free app in iTunes (via TechCrunch).

After some successful digging, playing the game and reviewing Apple’s Developer Agreement. Some red flags were raised…

Eliminate Pro, a game developed by ng:moco, is an action-packed first person shooter (FPS) game that progresses very slowly. The game uses this tactic to charge impatient users to play and progress through the game at a faster pace. The game allows users to buy more battery packs or cases (Power Cells) through the In-App billing system. This allows users to recharge faster, compete to earn more “credits” so that they can upgrade their fighter’s armor, weapons and other items (virtual goods). Power cells are the currency of the game.

What I want to know is where Apple is drawing the line in the sand in terms of what is considered a virtual currency and what isn’t. As per Apple’s iPhone Developer Program License Agreement (the “Agreement”), Apple states:

Additional Restrictions

2.1 You may not use the In App Purchase API to enable an end user to set up a pre-paid account to be used for subsequent purchases of content, functionality, or services, or otherwise create balances or credits that end users can redeem or use to make purchases at a later time.

2.2 You may not enable end users to purchase Currency of any kind through the In App Purchase API, including but not limited to any Currency for exchange, gifting, redemption, transfer, trading or use in purchasing or obtaining anything within or outside of Your Application. "Currency" means any form of currency, point, credits, resources, content or other items or units recognized by a group of individuals or entities as representing a particular value and that can be transferred or circulated as a medium of exchange.

Specifically, item 2.2 of ‘Additional Restrictions’ within ‘Attachment 2’ of the Agreement raises some obvious questions about how Eliminate Pro got approved. Eliminate Pro uses Power Cells (the virtual good that they sell) to buy additional energy (a resource) that they can use in a game to earn credits, which are redeemable for weapons, armor and other inventory items.

This seems to be in direct violation to the Agreement. Unless, however, Apple is okay with allowing “indirect” forms of currencies to work (Buy Energy > Spend Energy for Time > Use Time to gain Credits > Use Credits to buy Virtual Goods (weapons, etc…)). Some clarity please?

It would be great if some people (Apple execs, developers, anyone) could weigh-in on this matter. What types of “economies” or “currencies” can be established while still being compliant with Apple’s policies?

Please share your perspective below.

Lessons Learned from Asia

In researching the online and mobile worlds of virtual goods and avatars, I came across this interesting presentation by a consulting firm called +8* (Plus Eight Star) on Slideshare. It’s amazing how many things have been pioneered by those countries (largely Korea and Japan) that took so long to make it to the US.

I particularly like the reference to South Park.

Apple Keynote at WWDC

No doubt there is some excitement going on at the WWDC. So far (and I will do my best to keep updating this post) this is the list of notable feature upgrades they have made to the iPhone OS 3.0:

iPhone OS 3.0
3.0 Software is FREE for all iPhone owners and $9.95 for touch owners (and available on June 17th)

New Business Models (entrepreneurs, take notice) — In-Application Billing! Finally!!!
Push Notifications!
Cut/copy/paste. Works across all apps
Tethering is now supported.
MMS now available.
Want to undo? Just shake the phone.
Adding Spotlight: now search across your entire phone, apps and details within apps!
iTunes: Rent and purchase movies right from the phone!
iTunesU now also on phone.
HTML5 support in Mobile Safari. Javascript 3X faster.
Users can play your own music (from your library) inside applications
You can also send a “remote wipe” command to wipe your data remotely! (with MobileMe)
Login and it will show you a map of where your phone is located! (with MobileMe)

Random Stats:
40,000,000 iPhones/touches sold already
1,000,000 SDK downloaded

iPhone 3GS
“s” stands for “speed”
Up to 3 times faster than the 3g model
iPhone 3GS has a new camera (3.2 megapixel)
Video capturing is now possible on the iPhone 3GS!
30 frames per second with auto focus, exposure control, and more

Oh … and either iPhone 3.0 can show you real-time health information (with proper accessories, of course):

USSD: Lost in the Crowd?

All day long I am surrounded by BlackBerry and iPhone apps and business models. After listening to an intriguing talk by Nathan Eagle, a Professor at MIT, I started to think about how a single application can be developed to reach everyone in developing countries (a much larger proportion of mobile phone users than those in developed countries). Nathan mentioned that some applications in developing countries use USSD protocol as opposed to SMS or data-rich applications. I wanted to learn more.

Here are some of my findings:

USSD (“Unstructured Supplementary Services Data”) is a mature core mobile-network technology similar to Telnet; it is session-based. In fact, it is as old as GSM technology — and guess what — it works on EVERY GSM-based handset from a Nokia 1100 to a BlackBerry Bold.

Mobile software developers are constantly trying to find a way to write (code) once and reach many (different handset models). USSD can work for some application types, but not all. USSD will not offer feature-rich capabilities, but it can send and receive data through sessions (no data is saved on the device), allow for navigable menus, and it can interact with billing accounts on-file with wireless carriers.

After doing some research, it seems as though this technology is predominantly being exploited in developing countries, where there have been some very creative uses of USSD applications.

Here are some of the many uses this technology can provide (at a much cheaper cost than SMS messaging — a huge consideration for communication in developing countries):
– Mobile banking and payments
– Point-of-sale banking (using your mobile prepaid account as the source of payment)
– One-time password request notifications
– Weather services
– Menu-based navigation of corporate or city services
– Advertising
– Voice Chat
– Roaming

As it stands, USSD technology is being underused primarily due to a lack of available applications and content providers, a lack of understanding, and a lack of motivation at the operator level. Only recently, Bharti and Vodafone have productized this medium by launching USSD portals; largely however, this technology is under-developed and under-utilized.

Comments on a LinkedIN thread about USSD showed the following benefits of USSD technology (post from Gaurav Sarin):
1) Handset agnostic – 99% compatibility of active handsets
2) Easy Surfing – browser based experience for customers
3) Free content discovery for customers – since most operators do not generate CDRs of USSD sessions
4) Real Time session with the server – faster & more secure than SMS
5) Higher reliability as compared to SMSSMS has a 70 -80% successful delivery rate

What are your thoughts on USSD?

Global VC Blog Directory

Attention all entrepreneurs and start-ups!

A comprehensive list of VC-authored blogs have been compiled by Larry Cheng, a Boston-based VC. The list was ranked by number of Google Reader Subscribers as of May 2009.

If you’re getting serious about pitching for venture dollars, I suggest that you start subscribing to some of these blogs (just add them to your Viigo feeds).

It’s important for entrepreneurs to know about a number of things before pitching for dollars:
1. Understand the psychology of VCs
2. Understand the business models of VCs
3. Understand how to pitch VCs
4. Understand how NOT to pitch VCs
5. Understand WHEN to pitch VCs
6. Pitch VCs with a focus in your business sector
7. Don’t pitch VCs with your competitors already in their portfolios
8. Know your pitch cold
9. Spend a few extra minutes on the slide deck
10. Know the risks associated with your business (model) and suggest mitigating strategies
11. The list goes on…

Many of the blogs listed in the index will give you lots of tips in these areas. Happy reading!