When growing a new business, getting new customers and making sales is your number one priority. The only thing you should be concerned about is reaching profitability before you run out of money. It doesn’t matter if you are bootstrapping or you’ve raised millions of dollars in venture capital, making sales is all that matters. Business is not about getting a lot of web traffic, twitter followers, facebook likes, or good PR. Business is about trading value for money, and acquiring customers is the only thing that is going to keep your business alive.
Since customer acquisition is so critical, you need to find ways of measuring your progress. The information in this post will give you tested methods for maximizing your investment in customer acquisition.
First, a few definitions.
Lifetime Customer Value (LTV): This is the amount of revenue that you expect to earn for a single customer over the life of your business. Business can increase this number by offering back end product offers, and subscription plans for their services.
Monthly Recurring Revenue (MRR): This is how much money your customer is billed every month. For example, the MRR of a Netflix account is $7.99.
Customer Acquisition Cost (CAC): This is how much money you spend to actually acquire a new paying customer for your business.
Marketing Funnel (no fancy acronym): This is the journey of potential new customers for your business. It starts with awareness, then opinion formation, consideration, and eventual purchase.
Conversion Rate (CR): The percentage of people that enter your marking funnel that actually become paying customers. Usually only 1-2%.
Cost Per Click (CPC): The amount of money you need to spend to get people to the top of your marketing funnel, or in other words to make people aware of your business. Often businesses use services like AdWords to drive CPC traffic.
These terms can apply to many different industries, as all businesses need to acquire customers. While the specific assumptions I use in the following formulas are geared towards web based companies, the formulas themselves can apply to all sorts of businesses. Lets begin by establishing the LTV for our business.
Here we assume that the customer lifetime is at least 20 months. If through testing you find that customers end their contact with you before 20 months, you need to do everything you can to change that. Ideally, you want to make this number as high as possible. It is far cheaper to sell to an existing customer than having to find a brand new one, so extending the amount of time existing customers continue to use your product can turn a fledgling company into a cash machine. Use this next rule of them to use LTV to gauge the total amount you can spend on customer acquisition.
Whoa inequalities?? All this expression says is that you customer acquisition cost should be between a fifth and a third of the total amount of money a customer will make you during the life of your business. Ideally, you want to minimize this value. For example, if you think on average each new customer you get will spend $75 with you during their lives, you’d want to spent anywhere from $15 to $25 at the most to make that person a customer. In a perfect world you would like your front end sale to exceed your CAC, but many business take a loss on their first sale because they know that on average you will spend more money with them in the future.
To figure out how much MRR should be spent to acquire a new customer, lets use LTV/5=CAC. If you plug this equation into LTV=20(MRR), you have a new formula pricing CAC in terms of the monthly revenue per customer.
This means that if you assume a 20 month customer lifetime, it would be ok to spend 4 months of revenue/customer on the acquisition of that customer. This equation works well for subscription models like Netflix. If Netflix had a 20 month customer lifetime and they charge $7.99 per month, they could spend $31.96 on marketing and other CAC in order to get a new customer. As you can see, all of the equations are assumption driven, so its absolutely critical in the early stages of a business to talk to customers and test your products to improve the accuracy of your assumptions. You don’t know if you have a viable business until you TEST!
Now let’s figure out how much money you can spend on making people aware of your business. If you are doing a web based business, this is called CPC. To figure this out, you need to assume a conversion rate for your customer acquisition funnel. Lets assume that of every person who finds out about your business, 1% actually buy your product. Again, this is a hand-wavy starting number that needs to be tested for your specific business. To figure out how much you should pay for CPC, or how much you are paying in advertising to get a person to click through to your website, use this formula.
Where CR is your assumed conversion rate percentage (in the case 1%). If we continue with the Netflix example, lets use a 1% CR and their $31.96 CAC to figure out what we can spend on each click. If we use this formula, their recommended CPC would be $0.32. Notice you plug in the actual percentage nominal value into the formula, not the decimal conversion.
Putting your customer acquisition activities in terms of these formulas is much better than just guessing before launching an advertising campaign. Without data, you have no idea how to measure your progress. Play around with these numbers, test assumptions against your specific business results, and iterate accordingly to polish your customer acquisition strategy. If you are not currently profitable, make this a key priority! Once you crack this code, its time to think about scaling your business.
This post was inspired by the work of Tim Huntley over at AnEntrepreneurialLife.com. For more great tips from an experienced entrepreneur, I recommend his website.
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