Photo by Stinkie Pinkie
In his essay How to Start a Startup, Paul Graham famously stated there are three things needed to create a successful startup:
- To start with good people
- To make something customers actually want
- To spend as little money as possible
This list is pure genius. However, over the past several years running my own businesses and working with hundreds of entrepreneurs, I’ve found a fourth ingredient that’s necessary for a company to succeed:
Customers must give you more money than what you spend to acquire them.
I realize this is an obvious statement. But here’s the kicker…
Once you understand that a customer will generate a specific amount of revenue during their entire relationship with you (called your lifetime value of a customer), and that you want to spend less than that amount to acquire them, this leads to a more practical point:
How do you know, in advance, how much it will cost to acquire a customer unless you know how you’re going to do it?
Let’s think about this for a moment. When most of us think about a startup we think about the sweet new technology we’re going to use, we (hopefully) talk to customers to find out what they really need, or we size our market using a top-down or bottom-up approach depending on how realistic we want to be.
(Hint: if you’re looking for funding, use top-down. If you’re bootstrapping, use bottom-up.)
But we rarely think about the specifics of how we are going to reach prospects, and how much that’s going to cost. The reason is that the answer is pretty scary in most cases. And nearly impossible to measure in others. It’s a lot of guesswork until you really dig in and actually try the marketing approach yourself.
A Look at One Acquisition Approach – Google AdWords
Since this will be easier to explain with an example, let’s start by looking at the cost of acquiring a customer using Google AdWords.
If you’re bidding on a term like “invoicing software” you might have to pay around $4 to rank in the top 3. If you can convert 1% of your visitors to customers this means you need 100 clicks for each purchase, making your cost per acquisition (CPA) $400.
If, however, you convert at 0.5% your CPA jumps to $800. Ouch…this is why you can’t make money charging $1 per month.
Your lifetime value of a customer (LTV), cost per click, and conversion rate are critical in figuring out if you can build a profitable business or if the competition is too strong. The problem, of course, is you can only obtain one of the three numbers needed before you begin marketing your product. But you can make an educated guess at the other two.
Calculating LTV
If you have a product with a one-time purchase price (something like DotNetInvoice, which sells for $329), your conservative estimate is to assume your LTV will be that purchase price minus payment processing fees. I know you’ll be adding add-ons, upsells, and annual maintenance plans.
But in my experience these account for a small bump in LTV unless they convert well, which is the subject of another post.
If you own an application with a recurring pricing model, you need to know your price point and churn rate for each of your plans in order to calculate your LTV.
Churn rates are all over the place depending on the growth stage of the company, the industry, etc… When you’re just starting out you’ll probably have monthly churn in the 5-10% range. Some larger SaaS firms get their churn below 1% per month (see this post for some average annual churn rates based on SaaS company size).
Taking monthly churn at 8% and your monthly price at $19, your lifetime value of a customer works out to $237.50. This is calculated using the following simple LTV equation (there are more complex formulas for LTV that take expenses into account):
LTV = price/churn
LTV = $19/.08 = $237.5
With this number in mind, Google AdWords is not going to work unless you like buying high and selling low.
As an aside, even if your CPA using AdWords was $100, you would still need a pile of cash to finance your customer acquisition process since your lifetime value will take 12.5 months to arrive in your bank account. This is one case where venture funding makes complete sense.
How About a Few Others?
Facebook
Most Facebook clicks run in the $.80-$1 range with no effort, but using tricks I mentioned in this guide to cheap startup advertising you can get clicks in the $.10-$.20 range.
If you convert 1% of traffic with an average cost per click of $.40, your CPA will be $40.
If you convert 0.5% you’ll be at $80.
SEO
SEO is a tricky one since your investment will pay out over time rather than send you a few clicks and die. If you can get in the top 3 for a keyword that will send you 200 clicks per month with minimal maintenance, but you need to spend $1000 (or a lot of up-front time), would you do it?
If you can convert that traffic at 1% you’ll make 2 sales per month. If your LTV is $250 per customer this is $500 in future revenue per month. As long as you have the cash to fund it, this is quite an investment.
Cold Calling
If you decide to go the cold call route you’re going to make 10 or 100 calls yourself to develop a script, but after that you’re going to hire a service to make the calls in order to keep your business scalable. After setup fees, telemarketing services charge $15-$20 per hour. If they can make 20 calls per hour and close 1 out of 100 calls, you’re looking at a CPA of $75-$100 depending on the hourly rate.
Note: I’ve never used a telemarketing service and the numbers above are estimates only. If you have more experience with real costs and conversion rates, please post a comment.
Word of Mouth
Word of mouth is free, unless the referral requires a high touch sale. If you can encourage word of mouth with a healthy referral bonus, you can see pretty easily how this can work in your favor.
If your LTV is $250 and someone refers a new customer, sending them $50 or $100 is an easy sell. This explains how HostGator can pay up to $125 in cash for a referral; they know their LTV.
It also explains how companies can afford to give you a $50 gift card for attending a webinar. They know their LTV and their conversion rates from the webinars. From there it’s simple math to determine what they can put on that gift card and still make a profit.
Conclusion
There are hundreds of approaches to acquiring customers. The point of this post is not to explore the economics of every one, but to get you thinking about the financial nuts and bolts of your marketing before you build your product.
Building something customers want is a critical step in the process of launching a successful startup. But if that’s your only metric of success, you may be unpleasantly surprised when you find out you can’t acquire a new customer for less than $250 when your LTV is only $150. Unless you’re doing dotcom math you’ll be out of business in no time. (BTW – If you are doing dotcom math you’ll have venture funding and be a billionaire in no time).
My hope is that this post encourages you to take your best shot at estimating your LTV and CPA before launching your startup and, better yet, encourages you to get out of your comfort zone and actually try some of your proposed marketing approaches before writing a single line of code. (BTW – if you’re looking for info on how to do that, I talk about it in chapter 2 of my book).
