It’s one of the most important metrics for startups.
“What is your cost of customer acquisition?”
Early in the life of your startup, someone is guaranteed to ask you this question.
That someone will likely be a person important to the success of your business—a well-connected mentor who can open doors, perhaps, or an interested investor.
When we recruit businesses for our startup accelerator, we ask about customer acquisition cost (CAC) repeatedly and have heard every imaginable answer, including:
» “Virtually nothing. My co-founder and I are handling sales, and we are taking no salaries.”
» “We expect it to be essentially zero when this goes viral.”
» “Other startups tell us that their cost of acquisition is $200. That should work for us.”
» “We have looked at other software-as-a-service (SaaS) startups and have reverse-engineered their sales and marketing approach. Based on what we’ve learned about cost and conversion rates in similar companies, $300 appears to be a reasonable customer acquisition number. We’ll know a lot more in six months. However, we know that the average lifetime customer values in our space exceed $1,600, so we have some room for error.”
Why This Question Is Important
Your answer to this single question illustrates how much your startup team understands about its business.
The question the investor is really asking is, “How many customers would my investment buy?” The follow-up question is, “What is the expected lifetime value of customers?”
How you answer the CAC question will illustrate the extent to which your team understands the relationship between investing for growth and the potential return on that investment.
Remember, many investors will expect to see a customer lifetime value that is five to seven times the customer acquisition cost.
Here are some tips to help startups think about how to better understand and calculate a plausible CAC.
Customer Acquisition Cost (CAC) Defined
According to David Skok, entrepreneur and VC at Matrix Partners …
“To compute the cost to acquire a customer … you would take your entire cost of sales and marketing over a given period, including salaries and other headcount-related expenses, and divide it by the number of customers that you acquired in that period.”
Three things to note about working with customer acquisition costs:
- As a startup with minimal experience in a market, your calculated CAC will be a projected number that reflects what you expect after you are funded and operating. It is based on the best-documented intelligence you can find from mentors, peers and credible journalists. The key to presenting your CAC is to reference your sources and admit you are learning as you go.
- As you begin to market your product, capture all the data you can, especially your close rates, and update your calculated CAC based on your company’s experience.
- There is only one way to evaluate your CAC, and that is to compare it to your Customer Lifetime Value.
Customer Lifetime Value (LTV)
For established brands, LTV is a way of life. Given the breadth of customer data available to big brands, there is endless opportunity to deploy sophisticated analytics and tailor offers to each customer, based on the proj- ected lifetime value of these customers.
For a startup with limited customer history, estimating a customer’s LTV is a tough, but necessary assignment.
The format is very straightforward: Number of customer acquired per interval, revenue per customer per interval, adjusted through time for the churn rate. It is common for startups to assume churn will be minimal. That is rarely the case.
Your best source of help in estimating LTV is probably another entrepreneur who has been through the process of building a business plan, creating LTV estimates and then creating the company. His or her insights will be invaluable.
Building your financial models for CAC and LTV are among the toughest startup assignments, but both are crucial to your success. No other tools will help you focus on the central task of creating your company with a solid foundation and path to potential return on investment.
