We are big believers that the most important success factor for a startup or an idea is not how it will make money. The ability to execute on the idea is always much more important, which depends on management talent, commitment, and especially luck. However, at some point all successful products or companies will eventually have to make money. This post covers the basics of how an early stage company should frame its thinking around monetizing those hard earned customers.
It costs money to acquire customers. This can take many forms of incremental or fixed costs and typically entails some form of advertising. To grow the customer base, there will ultimately be a cost to acquiring each additional customer. Understanding this number, and how it scales, is the first step in putting together a proper P&L projection.
The customer acquisition cost is important, especially once we have determined the value of a customer. This should represent the lifetime value of the customer, or more appropriately the present value of the customer lifetime value. This is typically shortened to CLV. CLV must be higher than customer acquisition costs at scale in order for a product to make money.
This post will simplify the process by ignoring present value in a sample CLV calculation. The first step is to calculate what percentage of customers will become paying customers. You may have some customers that produce different levels of revenue for your firm. If so, model it as such. The idea here is that not all customers will generate revenue; try to accurately reflect how much you will earn on average per customer. The following example illustrates such a calculation.
Assume all customers download your app for free initially, and 20% of your customers will spend $1 for your paid basic app (think of 20% as a conversion factor). Of those, 20% will buy a premium offering for $10 (another conversion factor). In this scenario, 20% of $1 yields $0.20 and 20% of 20% of $10 yields $0.40 on average for each class of customer. Technically your premium customers probably apply the $1 they paid in upgrading to basic towards their premium purchase, so they actually only yield $9 of incremental revenue. It’s more accurate to look at 20% of 20% of $9, or $0.36. If you add $0.20 to $0.36, you have a CLV of $0.56. Hopefully you can acquire customers for cheaper than this if you hope to build a sustainable business around your product. If you can acquire customers for $0.25 (all customers, paying or non-paying), then you will make $0.31 per customer, or 55% gross margins. If it costs $1.25 to acquire each customer, you will lose $0.69 per customer.
An alternative way to think about CLV and acquisition costs in the above example is to think about acquisition costs of each class of customer. If you pay $0.25 per customer (nonpaying customers), you have three customer acquisition costs to think about. It costs you $0.25 per customer. It costs $1.25 ($0.25 divided by 20%) per basic paying customer. This portion of customer is not profitable or sustainable when considered purely by itself ($1.25 > $1). However, your $10 premium customer costs you $6.25 and yields $9 of incremental revenue. Technically, there is no incremental cost of acquisition for this customer, so the $2.75 in margin -> 30% margin calculation is not entirely accurate. You actually have 100% margins on these customers since you’ve already acquired them, your job is simply to convince them to upgrade to the premium product. When conducting this type of analysis, it is helpful to think about the contribution of each type of product to overall profitability. Just realize if you look at a single customer class in isolation you may miss the bigger picture.
What if during a pilot you find that your acquisition costs are greater than CLV? This is obviously not sustainable, but by improving the product you can change the assumptions and move CLV above cost (typically this will also involve increased retention. For instance, if you increase the percent of customers that pay, you can drastically improve your CLV to cost ratio. Or you can lower your costs. Or you can increase your pricing, if possible. You can also get creative and think about new product payment levels that may entice your best customers to fork over more cash. The point is that once you create a model that captures your costs, conversion ratios, and revenue, you can simulate various changes and then test those assumptions in pilots to determine optimal levels of pricing. Keep in mind that if you are acquiring customers and paying by click versus paying by conversion, you will need to model at least one more conversion factor. Feel free to download a sample pricing worksheet to see how adjusting these variables changes the overall picture.
Doing the hard work of building the product is only part of the equation in building a successful business. Make sure you think through costs and CLV, especially as volume grows, as part of the overall product planning and development process.