It’s easy to grow a consumer business: attract new customers, increase your sales. Just give your prospects money. That’s right, get on top of a nearby building and scream “Anyone want money? Take some of my money! I’ll pay for your first 5 purchases from me! And give you a $50 gift card!..”
What, you’re not compelled to try this?.. Good. You’re thinking about profitability – acquiring customers in a way that actually allows you to have a sustainable business instead of just burning your investors’ money.
And yet, the approach of giving prospects money so that they become customers is surprisingly common. Humans are amazing at optimizing for the goal that’s set for them; the CEO asked for new customers? Great, we’ll give each consumer $20 to give our product a shot!..
An obvious constraint must be added here, a profitability constraint. If we give a customer $20, we better be sure that in the time horizon we deem appropriate, we are going to get at least $20 back in profit from this customer. That is, that the long-term value (LTV) of this customer is greater than or equal to the cost of acquiring this customer.
This is seemingly self-evident – and yet so few consumer companies are doing this well. Folks face several problems:
- Modeling LTV is difficult. You need lots of data: transaction logs of previous customers who signed up with you and made a bunch of purchases. You need a statistical model that predicts how much, and how often, a given consumer will buy in the long-run, given their behavior in the first ~30 days. This is easier to do in industries with high purchase frequency (ex. food delivery, Grubhub); there are inherent difficulties for industries with lower frequency (ex. electronics, Best Buy). Check out this article for some practical advice on how to model LTV.
- A typical growth marketer’s mindset is all about CAC, not LTV. They think about driving their cost of customer acquisition (CAC, also sometimes referred to as CPA) down, so that they could get more customers at their fixed budget and hit their new customer goals. “It used to cost us $40 to acquire customers through these ads, it’s now only $20” – they’ll say, hoping that you’ll get all giddy about their success. When you raise your eyebrow and ask, “and what are the LTV’s before and after?” – they are often puzzled. Aren’t CPAs enough?.. Nope.
In order to understand profitability more deeply, let’s examine the law of diminishing returns in marketing. There are two aspects: CPAs increase as you pour more money into a channel; and LTVs decrease. Let’s illustrate this with a coupon (concession) example:
- If you give 100 prospects a $10 free-trial coupon, 20 people will use it. Of those 20, 10 will remain your customers 6 months from now.
- If you give 100 prospects a $15 free-trial coupon, 30 people will use it. Of those 30, 12 will remain your customers 6 months from now.
Notice how in the $15 example, it both costs us more money to acquire these customers (CAC = $15) and the customers are less valuable on average (they don’t stick around). This is only natural: a higher concession attracts lower quality prospects, those deal hunters, who aren’t really interested in your product and just want to save some money. If you were evaluating these two approaches, which one would you pick? Or, more importantly, what would be your approach to picking the right one?
Here’s one framework that can help: your old microeconomics class… Yeah, that econ 101 that seemed so irrelevant back in the day. Behold, those thousands of dollars you spent on that seemingly useless class are about to pay off in a minute.
Remember marginal revenue (MR) and marginal cost (MC), and profit maximization condition for any firm, MR = MC? Marginal CPA nicely maps to marginal cost. And marginal LTV maps to marginal revenue.
What does this mean in practice?
- If your CPA > LTV, you are losing a money! You are that guy, standing on top of the building and screaming “someone take my money!” Adjust your program to target better-quality prospects, or stop it altogether.
- If your CPA < LTV, you are leaving potential growth on the table! You could be growing faster than you are now, profitably. Inject more money into the program – increase your concession, increase your bids… Your ROI will go down – CPA will get closer to LTV. And that’s a good thing, because your total new customer count will go up.
A corollary here is that growth-oriented consumer companies should not have a pre-set marketing budget. The real constraint is profitability of marketing efforts. If you have confidence in your LTVs and CPAs, pump money into each of your marketing channels up to the profitability constraint.
There’s a gotcha in here. The concept of LTV is about “long-term value” of a customer. CPA, on the other hand, is the cost of acquiring a customer that you need to pay *right now*. This means that if your LTV horizon is 3 years, you invest at CPA = LTV, and then don’t have the cash to support the growth, you will go bankrupt. You’ll have all these customers who are *going to* be so profitable in the future – but that future doesn’t come soon enough. So be careful with the cash flow.
A growth-oriented marketer should not be a radical. At different times in the company’s lifecycle, the strategy might be to optimize for growth and pour all the profits into it – pedal to the metal! Set the average CPA to be equal to LTV! Or, it might be to optimize for profitability, when you don’t want to burn all the profits on growth. That latter spot is where every sustainable business must end up.
Further reading on this topic: breakeven periods and LTV proxy metrics.