The Lean Startup - Eric Ries [88]
Suppose an advertisement costs $100 and causes fifty new customers to sign up for the service. This ad has a cost per acquisition (CPA) of $2.00. In this example, if the product has an LTV that is greater than $2, the product will grow. The margin between the LTV and the CPA determines how fast the paid engine of growth will turn (this is called the marginal profit). Conversely, if the CPA remains at $2.00 but the LTV falls below $2.00, the company’s growth will slow. It may make up the difference with one-time tactics such as using invested capital or publicity stunts, but those tactics are not sustainable. This was the fate of many failed companies, including notable dot-com flameouts that erroneously believed that they could lose money on each customer but, as the old joke goes, make it up in volume.
Although I have explained the paid engine of growth in terms of advertising, it is far broader than that. Startups that employ an outbound sales force are also using this engine, as are retail companies that rely on foot traffic. All these costs should be factored into the cost per acquisition.
For example, one startup I worked with built collaboration tools for teams and groups. It went through a radical pivot, switching from a tool that was used primarily by hobbyists and small clubs to one that was sold primarily to enterprises, nongovernmental organizations (NGOs), and other extremely large organizations. However, they made that customer segment pivot without changing their engine of growth. Previously, they had done customer acquisition online, using web-based direct marketing techniques. I remember one early situation in which the company fielded a call from a major NGO that wanted to buy its product and roll it out across many divisions. The startup had an “unlimited” pricing plan, its most expensive, that cost only a few hundred dollars per month. The NGO literally could not make the purchase because it had no process in place for buying something so inexpensive. Additionally, the NGO needed substantial help in managing the rollout, educating its staff on the new tool, and tracking the impact of the change; those were all services the company was ill equipped to offer. Changing customer segments required them to switch to hiring a sizable outbound sales staff that spent time attending conferences, educating executives, and authoring white papers. Those much higher costs came with a corresponding reward: the company switched from making only a few dollars per customer to making tens and then hundreds of thousands of dollars per much larger customer. Their new engine of growth led to sustained success.
Most sources of customer acquisition are subject to competition. For example, prime retail storefronts have more foot traffic and are therefore more valuable. Similarly, advertising that is targeted to more affluent customers generally costs more than advertising that reaches the general public. What determines these prices is the average value earned in aggregate by the companies that are in competition for any given customer’s attention. Wealthy consumers cost more to reach because they tend to become more profitable customers.
Over time, any source of customer acquisition will tend to have its CPA bid up by this competition. If everyone in an industry makes the same amount of money on each sale, they all will wind up paying most of their marginal profit to the source of acquisition. Thus, the ability to grow in the long term by using the paid engine requires a differentiated ability to monetize a certain set of customers.
IMVU is a case in point. Our customers were not considered very lucrative by other online services: they included a lot of teenagers, low-income adults, and international customers. Other services tended to assume