When you hear people talk about the economics of a startup, they often mention CAC or Customer Acquisition Cost. CAC is the amount of money a startup has to spend, on average, to attract a single new customer. Think about salaries and overhead for sales, marketing and implementation teams, their primary job is to get customers to buy whatever it is you are selling and that makes up the majority of your CAC (there are a few other things but we want to keep it simple for now). Often you hear people discuss why you need to minimize your CAC, while in general we agree that if you can lower CAC it is a great step, but it is a bit more nuanced, let's dive into why.
Given that the majority of startups are built on the recurring revenue and/or subscription business model these days, acquiring customers is typically more costly than the initial amount of revenue they will generate. The model is that the business' product or service offers the customer so much value, they stick around for a while and generate long-term recurring revenue or what the startup world calls LTV (Lifetime Value), the total amount of revenue a customer will generate for your business before they churn off and stop paying you. To better demonstrate this, let's look at two sample recurring revenue startups:
In the above example you can see that Company B has a 50% lower CAC ($1,250 vs $2,500). Most of you will be quick to point out that Company A has better financials because they have a higher Avg. MRR and longer customer lifespan, no matter what the CAC is, those things lead to better unit economics, int his can a 3x better LTV/CAC ratio. For Company B, simply lowering CAC might not be the best way to help improve the economics of the business, let's breakdown a few scenarios starting with introducing an add-on product for an additional $50/month:
As you can see above, still better LTV/CAC economics for Company A, but without trying to force CAC down, by introducing a new add-on that you can charge customers for will increase your LTV/CAC ratio by 75% and produce nearly an extra $1,000 in lifetime profit after you take out CAC. But introducing a new feature that your customers love and start paying more for means it's adding value, and that value reduced customer churn and increases their average lifespan, lets see how that impacts the economics:
That new feature is so valuable to Company B's customers that their avg. lifespan increases by a full year to 31 months. That also means 12 additional months of revenue and our LTV has now jumped from $1,881 to $4,619 without touching CAC. Out LTV/CAC ratio has improved a full 100% and it is now roughly 75% of Company A while still charging less than a 1/3 of what Company A charges their customers. Now let's go back to our first example where Company A only charged the $99/month on average and they never added that new feature. Instead, they tried to "minimize CAC" to improve the economics of the business, let's see what would happen if they got it down $500:
Having reduced our CAC by roughly 33% our lifetime revenue (minus CAC) has only increased by roughly 79%, not bad, but cutting your CAC by 1/3 is harder than it sounds. In the meantime, if you had built that new feature, even without the reduction in customer churn, your lifetime revenue minus CAC increased by 150% and once you factor in decreased customer churn, that number increases by 434%!
While CAC is an important number to keep an eye on in any recurring revenue or subscription business our goal today was to outline that there are other growth levers that you and your business can pull. Our hope is this outlines for founders and startup leaders some ways to examine their revenue, customers and unit economics to help analyze these growth levers and determine which one will drive the greatest impact for your business. If you want help discussing how to test and implement these strategies with your startup, send us an email to firstname.lastname@example.org or head on over to our Contact Page where you can send us a message or find us on LinkedIn/Twitter, our DMs are always open!