Why do startups succeed? Disruptive technologies, differentiated products, large markets, outstanding teams, excellent execution – the list is familiar. For most entrepreneurs, these factors tend to fall into the pantheon of motherhood and apple pie.
A more interesting question is why good startups fail. Many startups that have all of these things going for them nevertheless fail. What is particularly interesting is that they often fail for the same reason. They are often sunk by something they don't see clearly at first and become acutely aware of only after it is too late: customer microeconomics.
That Sinking Feeling
Failure for these companies generally follows the same pattern. A great product is launched. Early adopters like it. The company invests in sales and marketing to grow the business. Things feel good, and the company steams along. Growth continues, although not at the expected levels. Plans are missed. Profitability proves elusive. More money has to be raised. Expectations are lowered. The company realizes that it can’t reach profitability on its given course and downsizes. Downsizing makes it harder to compete, and profitability proves more elusive. Cash starts running low, and viable financing options appear increasingly out of reach. Ultimately the company sells, goes into maintenance mode or sinks completely.
If one were to dissect this pattern on a micro level, the root cause of the problem is typically that it costs these companies more to acquire their customers than they can make by monetizing them. There is a failure of customer microeconomics. At a deep and very frustrating level, these companies can’t afford to sell their products.
The Customer Profitability Axiom
An important piece of advice I would offer to entrepreneurs is to think about customer microeconomics early, ideally before you launch a business, but if you have already done so, then before you start investing significantly in sales and marketing. Customer microeconomics are so important to the success of a startup that I would elevate them to the level of a business axiom. Let’s call it the Customer Profitability Axiom: that in order to be successful, a company’s lifetime customer value (LCV) must be greater than its customer acquisition cost (CAC). Blindingly obvious in a way, this axiom is often overlooked in the startup world and discovered painfully only after a significant amount of time and money has been invested in a company.
The internet has brought this axiom into sharp relief because the LCV and CAC of internet companies are often quickly and easily quantifiable. Companies in our portfolio such as TheLadders.com, Care.com and Hubspot monitor these variables on a day-to-day basis. This affords them an extraordinary degree of visibility into their businesses. Their visibility is not perfect, because customer acquisition costs can change and in particular can rise with scale, and lifetime customer value depends on assumptions of future customer behavior. But by historical standards, it is very impressive.
Most enterprise and carrier-oriented businesses, in particular those that use direct sales forces, have a harder time measuring LCV and CAC given long sales cycles, uncertainty around customer conversion and slower feedback loops regarding sustainable price points and repeat purchasing behavior. If these companies succeed in selling their products at high price points and in relatively rapid sales cycles, they will generally be successful. Many, however, discover too late that it costs them more to acquire customers than they ultimately can earn from them.
Key Questions to Answer
I think it is very helpful for entrepreneurs getting ready to build new businesses of any kind to think carefully about the Customer Profitability Axiom and a number of questions it raises. Passion around a business, product or technology idea – the natural foundation of any great startup – sometimes defers thinking around the specifics of customer acquisition and lifetime customer value. These variables are best thought about rigorously early on, however, as they determine not only if a company can be viable and how profitable it can be, but how capital intensive it will likely be, how quickly it can grow and often how big it can be.
So what are the questions associated with the Customer Profitability Axiom? There are basically seven:
1. How will I acquire my customers?
2. How much will it cost to acquire my customers?
3. How will I monetize my customers?
4. At what level will I monetize my customers?
5. What is the timing associated with the spending required to acquire customers and the cash received in monetizing them?
6. Given the delta between my LCV and CAC and the timing associated with each, how much capital will be required to finance my business at different growth rates?
7. What is the optimal growth rate and capital required to create the most valuable company?
Making Educated Guesses
It is difficult to know the precise answers to all of these questions right off the bat, of course, but one can make very educated cases. For internet companies, these guesses can be arrived at by looking at variables such as search volume, CPC’s for relevant keywords as well as traffic volume, conversion rates, affiliate fees, and advertising or subscription rates for similar businesses or businesses with similar demographics. Internet companies can often use seed funding to test conversion rates and get a ballpark sense of acquisition costs and LCV on the basis of an early service offering. TheLadders.com, for example, used a small amount of seed funding to figure out its CAC by online marketing channel and to estimate its LCV through monthly retention numbers. The large gap between their LCV and CAC, along with a strong team and defensible marketplace model, suggested the foundation of a great company.
For enterprise and carrier-oriented companies, these guesses can be arrived at by looking at variables such as the likely price point for a given product or service, the length of the sales cycle, the balance of inside and outside sales, the time for sales reps to ramp to productivity and the likely cost per sales rep. When we invested in JBoss, for example, we worked with the team to develop a bottoms-up financial model to get a sense of how much capital would be required to get the company to profitability and to think through the optimal growth rate for the company. We find it very valuable for startups of all kinds to build bottoms-up financial models that illustrate the customer microeconomics associated with scaling their businesses. Done properly, these models can provide first-draft answers to all of the above questions.
The Capital Efficiency Theorem
There are two points relating to the Customer Profitability Axiom worth highlighting that are particularly important to startups. Let’s stretch a bit and call them theorems. The first is the Capital Efficiency Theorem: if LCV > CAC, the greater the delta between the two and more importantly the shorter the payback period on one’s LCV, the more capital efficient the business. If a company has an LCV significantly higher than its CAC and can earn all or most of this LCV in a short period of time, future customer acquisition can be financed out of cash flow as opposed to outside capital.
Lead generation companies have often had famously low capital requirements – sometimes less than $10K – because they earn their LCV shortly after spending their CAC, generally within a month. To remain capital efficient, of course, these companies must maintain a reasonable delta between their LCV and CAC, something that arbitrage-oriented lead generation companies have sometimes had difficulty doing.
Online subscription businesses can also be very capital efficient. Even though they typically don’t earn their entire LCV up front, they often cover all or most of their CAC with an initial subscription payment. TheLadders.com, for example, was able to scale to an annual run rate in excess of $90m and cash flow profitability in six years while spending less than $10m in total capital.
Why is capital efficiency important? The more capital efficient the company, the less money it has to raise. The less money it has to raise, the more equity its founders and early employees ultimately own, and the more money everyone will ultimately make. Investors love capital efficiency as much as founders and employees, because it means their investment dollars go further.
The Profitability Potential Theorem
The second point related to the Customer Profitability Axiom is the Profitability Potential Theorem: if LCV > CAC, the greater the delta between the two, the more long-term profitability potential a company has and hence the more valuable it will be. This point is particularly interesting for virally-driven businesses such as Skype, Facebook, LinkedIn, Gilt, Club Penguin, etc. and UGC/SEO-driven companies such as TripAdvisor, because their CAC is effectively zero. If you take sales and marketing out of a P&L, as these companies do, there is a lot more P to go around. To achieve this P, of course, you need to be able to monetize your users at a reasonable level, and some of the fastest-growing virally driven businesses, perhaps most notably social networking and media-sharing sites, are still in the process of figuring out how best to do this. But the profitability potential of companies with a CAC of zero is very intriguing.
Because the other major driver of profitability, gross margins, tend to be highest for information services companies, the most profitable companies of all tend to be information services companies that are driven virally or by UGC/SEO and have high LCV’s. eBay in its early days, before it began using paid marketing, is a notable example in this category. Not all information services businesses have high gross margins, however. Video sharing companies, for example, have high bandwidth costs associated with delivering their services and so tend to have low, if positive, gross margins.
Avoiding the Iceberg
How does an entrepreneur avoid being sunk by poor customer microeconomics? The best advice I can provide is to think about the Customer Profitability Axiom and the questions it raises early, preferably before you start a business. If your business is already up and running, make sure you understand your customer microeconomics and the variables that affect them before you start spending heavily on customer acquisition.
Another important piece of advice is to monitor your customer microeconomics constantly and always look for creative ways to lower your CAC and raise your LCV. Whenever possible, test these variables and strategies that might change them on a small scale before making big spending bets. This is easier for companies that rely on the internet for customer acquisition than it is for companies that rely on direct sales forces. For companies in the latter category, test sales cycles, likely price points and ramps to productivity with a few sales reps before ramping the sales force in a significant fashion. If your customer acquisition ceases to be profitable, it is important to spot this early and slow your acquisition spending and potentially change course.
Seeing New Opportunities Through the Lens of Customer Microeconomics
When customer microeconomics work poorly, they can sink otherwise promising startups. When they work well, they are the engine that drives high-performing companies. A very valuable exercise for entrepreneurs thinking about what kind of new business to start is to look at opportunities through the lens of customer microeconomics and to ask where will there likely be the greatest delta between LCV and CAC.
One strategy is to think about where LCV will be highest. Who has the most money to spend, and who has the biggest problems to solve? Investors love businesses focused on deep-pocketed customers with major problems to solve. Remember Red Adair, who made his fortune putting out oil well fires for large oil companies? That sounds like a high LCV business.
Another strategy is to look at free or low-cost acquisition strategies. This will likely lead you very quickly to the internet. Perhaps the most significant revolution in internet business models since 2000 has been the revolution on the customer acquisition front, whether through viral adoption, SEO, paid search or other forms of targeted online marketing. If you can create a company that acquires lots of customers or potential customers at little to no cost, there may be a foundation to create a significant business, whether through a fremium, paid services, ad-supported, ecommerce or mixed revenue business model.
If Not the Whole Ballgame, Most of It
There are many other considerations to think about in building a successful startup, of course, beyond customer microeconomics. There must be a great product, a solid business model, a strong team and other factors like the ones mentioned above. In our view, a strong team tends to outweigh the other factors significantly, because a strong team will tend to figure the other factors out. Many of these factors, however – in particular a strong team – will ultimately be reflected in customer microeconomics. A strong team will generally only charge into a customer profitability battle it thinks it can win and will tend to improve customer microeconomics as it goes.
There must also be efficient operations that are not reflected in the variable economics of customer acquisition and monetization. Gross margins should be as high as possible, and G&A as low as possible.
Customer microeconomics are really just a financial perspective on what drives success or failure in startups. I think it is a particularly valuable perspective that is often underappreciated or overlooked. Although customer microeconomics are not the whole ballgame, they are generally most of it. If LCV < CAC, a business cannot succeed. If LCV > CAC, the greater the delta between the two, the more valuable and capital efficient a business will be.
A Caveat, and More to Come
One caveat worth mentioning. Not all customer microeconomics translate directly into LCV and CAC. In particular, digital media companies with CPM or CPC ad-supported business models generally look at customer economics on an aggregate traffic flow basis with the key monetization variable being RPM. Some of these companies can’t afford to buy traffic, so profitability becomes a matter of making sufficient revenue to cover fixed costs. But for digital media companies that can afford to buy traffic, the basic principle of not spending more to acquire your traffic than you can monetize it for over time remains the same, even if the variables measuring acquisition and monetization are different.
In future posts I will take a deeper look at customer acquisition and monetization dynamics for different kinds of internet and enterprise businesses and lessons we have learned that can be helpful for entrepreneurs in each area.
