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!