Customer Acquisition Cost: Overpaying is Killing Your Startup!

Customer Acquisition Cost 

One of the biggest reasons for startup failure is downplaying the Cost of Customer Acquisition . While customer acquisition is essential, it's even more important to keep an eye on what it will cost you.  If the cost of the customer acquisition outweighs the value of the customer, then you find yourself quickly running in the red. For this reason, it's important that  startups  pay special attention to customer acquisition cost.

TLDR 

Converting a prospect into a customer comes with a cost.  Conversion strategies are executed via various channels with differentiating costs. But many costs may not be worth it. For example, if the Cost of Customer Acquisition (CAC)  far exceeds the Life Time Value (LTV) of the customer, then is it worth pursuing this channel?

 A Classic Example​

When Dropbox was first starting off, they used Google Adwords to acquire customers. But when the numbers came in, they quickly realized that Google Adwords may not be the optimal choice. Dropbox charged each customer 99$ annually, but the customer acquisition cost for that customer (via Google Adwords) was 350$.  

Required LifeSpan = 350$ / 99$  = 3.53

This means that the average lifespan would have to be 3.5 years to match the LTV.  But if you consider all the other associated costs (hosting, support etc), Dropbox wouldn't even break even. This made Google Adwords a very poor choice. Which is why they introduced their "Refer a Friend for Free Space" referral program. The customer acquisition cost was now some free storage space. Considerably cheaper.

Rule Of Thumb

As general a rule of thumb, startups should assign around 20% of the average LTV to the CAC. This will force them to use efficient & creative methods to acquire new customers.  This is essential in the early stages of a startup, when there is a lot that is uncertain. Minimizing burn-rate is crucial.

Allowed Cost to Acquire Customer =  20% * LTV

 If a company has a firm understanding of all it's costs (value creation, overhead, fixed costs etc) and a desired profit margin, it can use the following formula:

Allowed Cost to Acquire Customer =    (100 - Desired Profit)%  *  (LTV -  Total Costs Per Customer) 

Final Thoughts

Way too many startups turn a blind eye to their customer acquisition cost and end up paying far more than the average LTV.  Ignoring, the Cost to Acquire a Customer in an effort to 'grow' may boost vanity metrics, but will soon become unaffordable. 

For a more comprehensive read, I definitely recommend taking the time to read 'Bootstrapped CPC Rule: MRR/25'  by Jason Cohen (founder of WP Engine). The article is well worth the read!

About the author

Shawn Dexter

Shawn Dexter is a Product Manager, Entrepreneur & Software Developer. He is passionate about innovation management & technology.

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