An easy way to calculate the limit to what you should spend.
I’ve written before about managerial ratios like the spend on employee development. One of the metrics that has come into vogue in recent years is something called customer acquisition cost (CAC), which is the ratio of dollars you spend to acquire a new customer to the revenue from that customer. More sophisticated companies take that measure to the next level by comparing their marketing and sales costs with the lifetime margin that customer will generate for their business. That’s the formula we’ll use here.
CAC got its start in the software-as-a-service (SaaS) world to gauge whether those companies had the potential to reach launch trajectory. Investors also use CAC to decide whether a business is worth making subsequent investments in.
But understanding the amount of money you spend to acquire new customers relative to the value those customers drive in the long-term value of your business matters to just about every business out there, not just software companies operating in the cloud. The better you home in on how much it costs to acquire a customer, the better sense you have of how much capital your business will require to grow.
So how do you know how much is enough–or too much–to spend on CAC?
The short answer is that a lot depends on what industry you are in as well as your business model and margin. But a good goal is to shoot for 25 percent of lifetime margin or under.
In the software business, we can apply the rule of thumb that you can spend about 20 percent to 25 percent of the lifetime margin of the customer on CAC. Software is a high-margin business at around 80 percent. It also tends to have long customer retention periods, with the magic number at about three years. That means that a company can afford to invest up to 25 percent of that value up front, or almost 60 percent of the year one revenue if they have the typical 80 percent gross margin (25 percent of 240 percent).
Now consider an example on the flip side that operates with higher costs and lower margins of, say, 20 percent. Assuming a three-year customer life, this business can spend around 12 to 15 percent of year one revenue to acquire a customer. If this business is above 15 percent, it will put a lot of pressure on the business’s capital to grow since the margin can’t fund all the growth. Companies like this will burn an enormous amount of cash to acquire customers until they reach a large enough scale where the cash flow and margin from operations can fund their CAC.
That’s a second rule of thumb: If you have a CAC that is greater than 25 percent of your customer’s lifetime margin, you will need significant capital to grow the business. The lower your CAC, the less capital you need to scale your customer growth.
If you have a contracting business that has one-time contracts that last a year or less and a 20 percent gross margin, for instance, you can only afford to spend 5 percent of your revenue on CAC (25 percent of the 20 percent margin). Any more and the business will not be able to self-fund that investment and would need outside capital to grow. On the other hand, a professional services firm with a 50 percent margin where customers stay for two years could afford to spend something like 25 percent of its revenue on CAC (25 percent of 100 percent).
Again, the key is to find that level of CAC that makes sense in your industry and that your business can afford to self-fund.
I recently worked with a cybersecurity software firm to solve this very issue. Its issue was with one of its product lines, a single-server version of the company’s product that had a low price point, around $200 a year, and the company would keep clients around three years. But, as part of its sales and marketing process, the company was investing 300 percent of the first year’s revenue on CAC. It was obscenely out of whack–at least five times higher than it should have been. Consequently, the company had a constant need for external funding to grow the business.
We worked together to develop a fully automated and digitized process where users could download and demo the product and enter a credit card to purchase it. By eliminating the human costs of winning those new customers, the company was able to drive down its CAC to 10 percent or even 5 percent of first year revenue. That then allowed the company to start making money overall–while also enabling it to grow as much as it wants without the need for adding additional capital.
So, when it comes to assessing how much you’re spending on acquiring new customers, keep the 25 percent of lifetime margin as a customer acquisition cost rule in mind. If you can do that, the sky’s the limit in terms of your future growth.