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Customer Economics: How much can you afford to spend acquiring a customer?

Customer Economics: Balancing LTV and CAC
Customer Economics: Balancing LTV and CAC

When launching a new startup understanding your customer economics is crucial. At its most basic customer economics means understanding what you can afford to pay to acquire each new customer, and what you can expect each customer to spend with your business. Get your customer economics right and you’re setting up your startup for long term success and profitability, get it wrong and you’re looking at failing very fast indeed.

Customer Acquisition Cost (CAC) is the amount you spend to acquire a customer. Life Time Value (LTV) is the total value that customer will provide to your business. In order to have a profitable business you need to ensure that you’re not spending more to acquire customers that they’ll ever spend with your business. Expressed more simply the golden rule is:

LTV > CAC

Estimating LTV and CAC

So to begin you’ll need to do some calculations to understand what your startup’s LTV and CAC are. To calculate your customer’s lifetime value you need to understand how long a customer will remain a customer, and how much they’re likely to spend over that time. Depending on your type of business your calculations may look similar to the below:

Life Time Value = (Avg Transaction Value) X (# of Repeat Trans) X (Avg Customer Lifetime)

The overall Customer Acquisition Cost can be calculated by looking at your overall marketing spend in a set period and dividing it by the number of customers acquired in that period.

Customer Acquisition Cost (CAC) = Marketing spend ÷ # of customers acquired in a set time period

Ideally you’ll want to work out your cost to acquire each paying and profitable customer as this is when you’ll start to get the pay back on your acquisition spend. This means that if you’re operating a freemium model or similar you’ll also need to factor in your conversion rate from acquired customer to paying, and profitable, customer.

By Campaign and Channel

It’s useful to go a step further with your calculations and look at each of your channels and campaigns to understand what their individual CAC and LTV is. This will allow you to understand which campaigns or channels are providing you with the most profitable customers. All customers are not created equally and often customers acquired from different channels convert at different rates, have different rates of churn and so on. Therefore its important to understand which of your channels and campaigns are producing positive returns, allowing you to focus on these channels as you scale.

Customer Acquisition Cost (CAC) = Campaign cost ÷ # of customers acquired through this campaign

Of course this also means that you need to be doing a good job of tracking your individual campaigns and channels in order to give you the data to make these calculation. Let’s hope you are!

Where to start? Estimating life time value

Unfortunately at the beginning of your startup journey you won’t have exact figures on the amount of money and time customers will spend with your business.   Therefore to begin with you’ll need to work off estimates. When estimating your lifetime value at the beginning of your start-up journey I’d suggest:

  • Be pessimistic to begin with. It’s better to have slower growth at profit rather than huge growth at ever increasing losses, particularly when you only have a limited amount of funds and need to raise another round soon.
  • Base your estimates off a short lifetime to begin with. For example if you imagine that your customers will continue using your service for 2 year then use 6 months or 1 year as an initial estimate. If your initial hunch of 2 years turns out to be true you’ll have better numbers than you’d initially estimated, however if the reverse turns out to be true shortening your estimates will have limited your acquisition spend on unprofitable customers.
  • Don’t forget to factor in churn. High churn will mean you have a short customer lifetime and therefore also a lower LTV.

Once you have some real metrics available revisit your estimates and establish your actual LTV. Hopefully you’ll discover that your estimates were indeed pessimistic and that you can afford to spend more on acquisition.

CAC: Start Small and Grow

For CAC the good news is you don’t have to work from estimates. You can start your acquisition efforts with a limited budget and cap what you’re willing to pay to acquire a customer at a low level to ensure you’re not spending more than your LTV. Ideally you should start with free channels and move towards paid channels as you capture real data and learn more about what your customers will do, how long they’ll stay and what they’ll spend. Your initial customers from free channels will help you to test out your on-boarding funnel and optimise your customer activation, retention and monetisation rates, ensuring that you’re working with a well oiled marketing machine by the time you start spending big money on acquisition.

Now it’s over to you, start doing some calculations and see what you can afford to spend on acquiring customers to break-even or even generate a profit!

The Few, Not The Many: Segmentation for Start-ups

Traditionally marketing teams can segment their target audience by any number of variables resulting in numerous segments on which to focus their marketing messaging and campaigns. For start-ups the temptation to ‘target’ everyone who could be a potential user can be immense. However when looking at segmentation for an early stage start-up the key is to focus on the few, not the many.

Fewer is faster and betterStart-up Segmentation

Given tight resources and fierce competition generally start-ups need to focus on one key segment and win it. By targeting just one segment you can better focus your product, messaging and marketing strategy on the needs of that segment, giving yourself a better chance of success. In addition by concentrating on just one segment you have a better chance of reaching product-market fit faster as you’ll be really focused on solving the problems of just one core group of users.

If groups require different distribution channels, relationships, offers or pricing they are distinct segments. Pick just one!

As always there is an exception, if you’re launching a marketplace type business where you need two groups, for example buyers and sellers, then you will have to target both segments and develop and execute marketing strategies for both groups simultaneously.

Picking that one segment

In picking the best segment to focus on think about the core group of potential users who really feel the problem that your product or service solves. People who feel the problem the most acutely will be highly motivated to try things that could help them solve it, and they may even be searching for a solution already making it much easier, and less expensive, to acquire them as users.

Get to know your chosen segment as best you can, understand who they are, what motivates them, how they’re currently dealing with the problem you solve and how it impacts their daily lives and of course understand what media they consume and how you can reach them and communicate with them. Use this in-depth knowledge and understanding of your audience to develop a highly targeted marketing plan that will communicate effectively with them and motivate them to adopt your product or service.

An additional benefit of this strategy is that users who feel the problem you solve most acutely are likely to be delighted if you can solve their issue and are therefore most likely to tell people about you and share your product or service with their friends.

Rinse and Repeat

Once you’ve achieved success in your chosen segment you can begin to expand to the next segment, working through each segment by order of how strongly they feel the problem you’re solving and also how similar they are to your previously successful segment. As you enter each new segment you can tweak the marketing strategy you’ve used previously to make it relevant to the new audience’s needs, media consumption and so on, plus use the learnings you gained from your previous experiences to improve and optimise how you market to this new group.

Avoid the temptation to target everyone who could possibly use your product and you’ll be able to get to know your customers better and be able to focus in order to achieve success more quickly and more cost-effectively.

 

Startup Pricing: How to Research & Choose the Right Price

Pricing is one of the toughest decisions for many startup founders. Often it feels like complete guesswork but it doesn’t have to be this way. There is a systematic way to choose a price and in this post I’m going to show you how to choose the right price to maximise profits for your startup.

First of all let’s look at why pricing is so important. Your price, and revenue model, are an essential part of your business and have a huge impact on how only your profitability and funding requirements, but also on your marketing decisions and ability to acquire customers cost effectively, or at all. Price can also serve as an obstacle to buy and plan a major emotional, as well as rational, role in buying decisions. For example if pricing is too complex it can be barrier and if a product or service is free people can wonder what’s the catch (to this day I’m still asked how Skype makes money!), and for many large organisations a paid service can be easier to get signed off and feel confident in using rather than a free offering.

Startup pricing
Choosing the right price is key for startup success.

There are also numerous considerations to balance when choosing a price that will work for you start-up. These include:

  • Costs
  • Strategy
  • Competitor’s pricing
  • Customer’s willing to pay
  • Conversion, and revenue projection, at each price

So assuming that you’ve thought about all of the above here’s a pricing survey that will help you to understand what your users are willing to pay and what price will yield the greatest revenues for your start-up.

Obviously you don’t just want to run a survey asking users to tell you what they’re willing to pay, as there’s a huge amount of bias to this and you’re likely to get suggestions of very low prices and be unable to weight these prices based on how likely these users are to become paying customers. The survey I outline below is something I have used successfully with numerous startups to understand what pricing will yield the maximum revenue. It’s also the mechanic which Sean Ellis used when making pricing decisions in Dropbox and LogMeIn (Thanks to Sean for sharing this framework with me!).

Reaching a Price

Start with some conversational research such as user interviews to help you make an educated guess at a price that users might be willing to pay.

Now that you’ve found a price point, let’s call this the centre point price, its time to move on to your survey. The users you want to include in your research are the users of your product or service who have experienced that actual value of your product, so for example with Skype this would have been users who had made a minimum number of calls using Skype, with Soluto it was users who were already supporting at least one other person’s PC on Soluto.

Create a survey using your centre point price and two additional points, one 50% higher and one 50% lower e.g. $5, $7.50 and £2.50. Then run a survey to three different groups. The three surveys will ask the question below and will identical apart from price.

If [COMPANY NAME] did [Enter value proposition] and cost [show one price point] what is the likelihood that you’d buy?

  • Definitely
  • Probably
  • Possibly
  • Probably not
  • Possibly not

Once you get the results back you need to apply a virtual pinch of salt to understand how likely the users are to actually purchase given their responses. To do this apply the following formula to the results to get a demand curve at each price point surveyed:

  • Of those who answered ‘Definitely’ assume 50% will buy
  • Of those who answered ‘Probably’ assume 20% will buy
  • Of those who answered ‘Possibly’ assume 2% will buy

Then model each price point to determine how much revenue you’d earn, and to find the max yield price for your startup.

If the results come out skewed at either end then re-run the survey with that as the centre point. So for example if you’ve surveyed $5, $2.50 and $7.50 and $2.50 comes out as the winner then re-run survey with $2.50 and also $3.75 and $1.25 to a new group of respondents.

The downside of this approach is that you will need a substantial group of users who are already using your product. In order to feel confident in the results you’ll want an absolute minimum of 50-100 responses at each price point.

Test Pricing

Of course it’s also possible to AB test pricing and understand what will deliver the best yield from this. To AB test different prices, create multiple tests shown to different users (make sure the same user doesn’t see different prices every time they come back or refresh the page!) and track clicks, purchases and revenue at each price point to find the best price. If you choose to take this approach ensure that you hold everything else steady and don’t make multiple changes, or you won’t be able to tell whether the big red button or the lower price, were the driving force for the improved conversion rate.

All does not end with Acquisition, Focusing on Conversion

It always amazes me how much time, effort and budget is spent by startups on getting more visitors to their websites. And then what. For the vast majority the job it seems is done. When in fact the job is only just beginning. Letting people know you exist and encouraging them to visit your website is only the first step in the process. Next you need to engage and encourage them to do something, take some action, register, sign-up, maybe even pay!

So what should you be doing and how can you do it? Conversion Rate Optimisation or CRO is the answer but where should you start?

Conversion Rate Optimisation
All does not end with acquisition. Focus on your conversion funnel to improve ROI

First of all you need to decide what the goal is. What is it that you want new visitors to your website to do? Depending on your product or service this could be to subscribe, pay, start a free trial or register. Decide on your goal and then review your homepage and landing pages to ensure that everything is leading them towards this goal. You’ll want to make sure that the call to action is prominent and easy to access, plus that nothing else is distracting user from completing the goal.

It’s a good idea to walk through each of the stages in the process to see how difficult you’re making it for users to complete these steps. Tiny changes to your calls to action or registration forms can have a big impact.

Next you’ll want to put some numbers against these steps. Hopefully you already have tracking in place (if not its time to get some!) and can easily put numbers against each step in the journey to show how many people arrive at and complete that stage. This will allow you to objectively see your conversion funnel, pinpointing major pain points that require urgent attention and helping you to consider steps that can be removed or bypassed, to boost the number of people completing the funnel and reaching the goal.

User testing and user feedback can also be hugely helpful in CRO. The process of watching and listening to real users as they struggle to find what they need on your site can be a real eye opener. However that’s a topic for another day.

Improving your conversion rate can help you to improve the ROI of your overall acquisition spend, by making it easier for each user acquired to achieve the desired goal. For example imagine you’re an online dating business spending £10,000 per month on acquisition. However your homepage conversion rate is 20%, meaning that you lose 80% of people on the first page. By focusing on CRO and what happens after acquisition you could reduce your drop-off rate considerably and make that £10,000 spend go an awful lot further in terms of real registered or paying users. By focusing on optimising your conversion rate you’ll make every £1 spent go further.

So before you decide to focus all your time and effort on acquisition take a look at your current conversion rate and fix any leaks in that funnel.