I must talk about customer acquisition cost (CAC) fifty times a week with our cohort companies. They’re undoubtedly sick of me constantly going on about it, but I probably won’t be stopping any time soon. That’s because CAC is a hugely important consideration for startups, particularly for B2C operations like Pampr, Lendful, and Koho.
New businesses need to make money
At the very least, new businesses must show a clear path to making money – which means they need to know just how much they are spending on marketing and sales to convince potential customers to convert. You can have a great team and product/market fit, but if you’ve miscalculated CAC, you can sink just as fast as if you built something people don’t need.
As important as CAC is, it’s really just part of the equation. Customer lifetime value (aka CLV, aka CLTV, aka LCV, aka LTV – I prefer this last one), or the net profit derived from that customer over time, is crucial as well. Looking at the LTV:CAC relationship allows you to understand exactly how much value you get from customers over time versus how much it cost to acquire them in the first place.
Finding the right balance
Your business will fail if your LTV is lower than your CAC. You don’t need to be a rocket scientist to figure that much out. Here’s a snapshot of what different LTV:CAC ratios mean for your business:
- Less than 1:1 – You’re dead in the water if you don’t change this story fast.
- 1:1 – You’re losing money from every acquisition.
- 3:1 – This is the sweet spot we want to see as a business matures.
- 4:1 – You’re under-investing and could be growing faster.
- Entrepreneurs often figure out the cost of a lead, assuming each lead will convert into a paying customer. Sorry, folks. That’s not how it works in the real world. Time to do some customer discovery to estimate your end-to-end conversion rate.
- During customer discovery, you may speak to people in your sector who optimize for CAC and LTV. Relying on numbers from a mature business with mature processes and relationships can fool you into grossly underestimating your costs and overestimating your LTV.
- Entrepreneurs often look at the cost per click for digital advertising, and then ignore conversion rate differences between keywords. A cheap click that doesn’t convert might actually have a higher CAC than an expensive click that converts well. Some campaigns also target “try it once” customers, whereas others may give you a much better LTV. You really have to look at the end-to-end cost to know what’s working.
- It’s a mistake to believe that “we’ve never had a sale or marketing plan” is an acceptable answer to explain small numbers. This will not reassure investors — regardless of whether or not you’ve had 5-20K uniques — because it demonstrates you haven’t yet worked out details for half of your business. Scary.
- The cost for each type of channel behaves differently when you try to scale up by throwing in more money. Some get cheaper, some get more expensive. Many entrepreneurs run an Adwords test with $50/day and estimate their CAC for Adwords, then think that once they raise financing money and want to spend $1000/day their CAC will remain the same. It won’t. It will almost certainly go up, sometimes by a lot.
Each of these mistakes stems from an entrepreneur’s overabundance of optimism. You can’t be an entrepreneur without optimism, but at the same time, too much can prevent you from solving some very manageable problems that you simply refused to see.
CAC shouldn’t be an afterthought
We believe the CAC issue is something best dealt with early in a startup’s life, so here’s what we challenge our companies to do in their first two weeks:
- Come up with a marketing and sales plan. (Please don’t tell us “It’s so awesome it’ll just go viral.”)
- Figure out the LTV:CAC ratio. Is it possible to monetize customers for more than it costs acquire them? If so what is the projected time frame required to recover those costs?
- Think about how different marketing channels will result in different LTV:CAC combinations. You can’t know what’s most profitable without looking at both together. Also consider how each channel can scale and how costs may go up or down in each channel as you try to scale.
- Consider ways you can lower your CAC or raise your LTV to improve the LTV:CAC ratio.
CAC might not be the number one factor for determining the success or failure of a company, but it must be very high on an entrepreneur’s list of priorities. Figuring this out as soon as possible can help shape the product itself, making it easier to grow the company and move quickly towards profitability.