Why Making Something Customers Want Isn’t Enough

Photo by Stinkie Pinkie

In his essay How to Start a Startup, Paul Graham famously stated there are three things needed to create a successful startup:

  • To start with good people
  • To make something customers actually want
  • To spend as little money as possible

This list is pure genius. However, over the past several years running my own businesses and working with hundreds of entrepreneurs, I’ve found a fourth ingredient that’s necessary for a company to succeed:

Customers must give you more money than what you spend to acquire them.

I realize this is an obvious statement. But here’s the kicker…

Once you understand that a customer will generate a specific amount of revenue during their entire relationship with you (called your lifetime value of a customer), and that you want to spend less than that amount to acquire them, this leads to a more practical point:

How do you know, in advance, how much it will cost to acquire a customer unless you know how you’re going to do it?

Let’s think about this for a moment. When most of us think about a startup we think about the sweet new technology we’re going to use, we (hopefully) talk to customers to find out what they really need, or we size our market using a top-down or bottom-up approach depending on how realistic we want to be.

(Hint: if you’re looking for funding, use top-down. If you’re bootstrapping, use bottom-up.)

But we rarely think about the specifics of how we are going to reach prospects, and how much that’s going to cost. The reason is that the answer is pretty scary in most cases. And nearly impossible to measure in others. It’s a lot of guesswork until you really dig in and actually try the marketing approach yourself.

A Look at One Acquisition Approach – Google AdWords
Since this will be easier to explain with an example, let’s start by looking at the cost of acquiring a customer using Google AdWords.

If you’re bidding on a term like  “invoicing software” you might have to pay around $4 to rank in the top 3. If you can convert 1% of your visitors to customers this means you need 100 clicks for each purchase, making your cost per acquisition (CPA) $400.

If, however, you convert at 0.5% your CPA jumps to $800. Ouch…this is why you can’t make money charging $1 per month.

Your lifetime value of a customer (LTV), cost per click, and conversion rate are critical in figuring out if you can build a profitable business or if the competition is too strong. The problem, of course, is you can only obtain one of the three numbers needed before you begin marketing your product. But you can make an educated guess at the other two.

Calculating LTV
If you have a product with a one-time purchase price (something like DotNetInvoice, which sells for $329), your conservative estimate is to assume your LTV will be that purchase price minus payment processing fees. I know you’ll be adding add-ons, upsells, and annual maintenance plans.

But in my experience these account for a small bump in LTV unless they convert well, which is the subject of another post.

If you own an application with a recurring pricing model, you need to know your price point and churn rate for each of your plans in order to calculate your LTV.

Churn rates are all over the place depending on the growth stage of the company, the industry, etc… When you’re just starting out you’ll probably have monthly churn in the 5-10% range. Some larger SaaS firms get their churn below 1% per month (see this post for some average annual churn rates based on SaaS company size).

Taking monthly churn at 8% and your monthly price at $19, your lifetime value of a customer works out to $237.50. This is calculated using the following simple LTV equation (there are more complex formulas for LTV that take expenses into account):

LTV = price/churn

LTV = $19/.08 = $237.5

With this number in mind, Google AdWords is not going to work unless you like buying high and selling low.

As an aside, even if your CPA using AdWords was $100, you would still need a pile of cash to finance your customer acquisition process since your lifetime value will take 12.5 months to arrive in your bank account. This is one case where venture funding makes complete sense.

How About a Few Others?

Most Facebook clicks run in the $.80-$1 range with no effort, but using tricks I mentioned in this guide to cheap startup advertising you can get clicks in the $.10-$.20 range.

If you convert 1% of traffic with an average cost per click of $.40, your CPA will be $40.

If you convert 0.5% you’ll be at $80.

SEO is a tricky one since your investment will pay out over time rather than send you a few clicks and die. If you can get in the top 3 for a keyword that will send you 200 clicks per month with minimal maintenance, but you need to spend $1000 (or a lot of up-front time), would you do it?

If you can convert that traffic at 1% you’ll make 2 sales per month. If your LTV is $250 per customer this is $500 in future revenue per month. As long as you have the cash to fund it, this is quite an investment.

Cold Calling
If you decide to go the cold call route you’re going to make 10 or 100 calls yourself to develop a script, but after that you’re going to hire a service to make the calls in order to keep your business scalable.  After setup fees, telemarketing services charge $15-$20 per hour. If they can make 20 calls per hour and close 1 out of 100 calls, you’re looking at a CPA of $75-$100 depending on the hourly rate.

Note: I’ve never used a telemarketing service and the numbers above are estimates only. If you have more experience with real costs and conversion rates, please post a comment.

Word of Mouth
Word of mouth is free, unless the referral requires a high touch sale. If you can encourage word of mouth with a healthy referral bonus, you can see pretty easily how this can work in your favor.

If your LTV is $250 and someone refers a new customer, sending them $50 or $100 is an easy sell. This explains how HostGator can pay up to $125 in cash for a referral; they know their LTV.

It  also explains how companies can afford to give you a $50 gift card for attending a webinar. They know their LTV and their conversion rates from the webinars. From there it’s simple math to determine what they can put on that gift card and still make a profit.

There are hundreds of approaches to acquiring customers. The point of this post is not to explore the economics of every one, but to get you thinking about the financial nuts and bolts of your marketing before you build your product.

Building something customers want is a critical step in the process of launching a successful startup. But if that’s your only metric of success, you may be unpleasantly surprised when you find out you can’t acquire a new customer for less than $250 when your LTV is only $150. Unless you’re doing dotcom math you’ll be out of business in no time. (BTW – If you are doing dotcom math you’ll have venture funding and be a billionaire in no time).

My hope is that this post encourages you to take your best shot at estimating your LTV and CPA before launching your startup and, better yet, encourages you to get out of your comfort zone and actually try some of your proposed marketing approaches before writing a single line of code. (BTW – if you’re looking for info on how to do that, I talk about it in chapter 2 of my book).

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#1 Michael @latteperday on 07.21.11 at 5:26 pm

Great timing of this post Rob and I’ve just gone and estimated my LTV and CPA. I was starting to drift but doing this startup math has refocused / remotivated me.

Thanks for the insight.

Rob Reply:

Cool 🙂

It’s “fuzzy” math at this point since we’re using estimates and rules of thumb, but at least it gets you in the ballpark.

#2 Andy Brice on 07.21.11 at 5:54 pm

It is worth noting the amount you have to bid per click to get in the top 3 positions in adwords varies greatly according to:

1. The market you are in. The more niche your product, the cheaper clicks will be.

2. How well you understand Adwords. In my experience (and I have seen quite a few adwords accounts) most people using adwords don’t take the time to learn the system and paying far more per click than they need to.

#3 Joe Franks on 07.21.11 at 8:37 pm

I’ve done a lot of telemarketing. There is a set up cost for campaigns and this can easily be $2k-$4k. On top of that you need to “rent” a list for the target market. Costs range from $300 to $40,000 – depending upon quality and size. Then you are lucky to get 8-10 “completed” calls / hour. The reason is that most calls go to voice-mail. On high quality lists, you are lucky to even get through to 30% of the members. So your CPA ends up being more like $200 – $300. But the real issue is that one campaign might see 3% conversions, whilst a virtually identical one could be like 0.2%.

Rob Reply:

Great info; thanks Joe!

#4 Jason Cohen on 07.22.11 at 12:10 pm

You have to take expenses out of LTV too. If it’s a SaaS app, it costs real money to host customers. Often founders ignore the marginal cost of an additional customer, saying that each takes “almost no resources,” however you’re forgetting the waste in eg a server not at capacity or costs of backup. Almost always you ignore the very real costs of tech support.

We find that when we’re honest about all the costs at http://WPEngine.com our true customer profit margin is more like 50%. Still a great margin but much smaller than you’d think at first blush. So our LTV is half of the by-the-revenue LTV.

Another trick for saas companies is to discount for 12-month prepay. Because you get a much larger amount of your LTV immediately, you circumvent rob’s astute observation that growing saas companies eat cash even when they’re doing well. And it’s why it’s worth providing a discount in that case — the cash flow is valuable.

#5 Jeremy Holman on 07.26.11 at 5:50 pm

I think there’s a mistake in your LTV formula, although you happened to get the right result. Surely LTV per customer should not depend on the number of customers?

I think that, assuming churn is expressed as a percentage (as in your example) the correct formula is perhaps

(100 / churn) * price

Rob Reply:

Jeremy – it turns out your correction to this formula was correct. I had a typo in the original (it’s now corrected), but since I was using 100 customers the results were the same as you suggested. Thanks for pointing that out.

The correct formula is:

LTV = price/churn

or in the example I used above:

LTV = $19/.08 = $237.50

Thanks for pointing that out back in November!

#6 Burke Franklin on 07.26.11 at 7:25 pm

I developed an LTV calculator for our Marketing Builder strategic planning software (www.jian.com) and discovered that one of the biggest drivers of lifetime value is referral rate. If people like your product, they’ll tell 3 people (if they hate your product they’ll tell 10… as the saying goes). Nevertheless, this also points to your customer service / tech support as a material factor in LTV.

#7 Josh Kohlbach on 07.31.11 at 1:36 am

Ahh I love that essay by Paul Graham, I just re-read it after reading this post. Brilliant stuff..

This post was a timely reminder for me to run the numbers on a couple of my ventures. Sometimes us programmers get carried away implementing our ideas that things like “is it worth it” seem to go by the way-side.

#8 James Mishreki on 08.03.11 at 5:25 am

Hi Rob

Love your blog and your start small stay small book, big big fan.

Just looking on dotnetinvoice.com, do you not find that people get confused on the email form? In the sense that there is no confirm button, they simply have to enter it, there is nothing telling you to click enter or what not.

Considering implementing one on my site (see my name above), was planning on putting the email box to the left of the ‘try it now’ button, but I was thinking I would also need some text along the lines of “enter you email here and click ‘try it now’ for instant free access”… although your site seems to do well without a prompt like that?