A Crash Course in Customer Acquisition Costs

The Magic Number

I posted on LinkedIn about the Magic Number last week and received lots of insightful comments and questions. Rochan Kakar of Granimals said,

Asim Khaliq noted,

This is the issue when founders talk to investors. The value of the business depends on the value of your customers, but how do you know that when starting out?

John Kenny asked,

Great questions. Let’s find the answers.

What, Why, How?

What is the Magic Number? It’s the change in revenue in the current quarter divided by last quarter’s sales and marketing costs.

Why does it matter? Investors use it as a quick check on the efficiency of your sales process. If you don’t calculate it, they do it themselves.

How do you interpret it? Let’s back up a little to look at a more sophisticated version of the Magic Number.

The Lifetime Challenge 

There are costs of designing and building your product. In software, these include data purchase and hosting as well as software licences. Think of Github, Figma and SQL. You also include the cost of development and support staff.

These are the cost of goods sold (COGS). Revenue less these costs is gross profit. Divided by revenue this is gross profit margin.

Customer acquisition costs (CAC) include sales and marketing and implementation costs such as client specific software and hardware. Some people include customer service, but you shouldn’t if it’s already in COGS. Be clear with investors where these costs are included. 

CAC is a popular metric but what does it tell you? Say your average is $473, so what?

This is where customer lifetime value (CLTV) comes in. Multiply the average selling price by the number of purchases and deduct CAC. If you sell subscriptions, the number of renewals is the number of purchases.

How many times will customers renew? No one knows when starting out. Consequently, investors such as Andreessen Horowitz (A16Z) don’t include CLTV in core startup ratios.

They look at something else instead.

Beyond the Magic Number

A rule-of-thumb for the Magic Number is that above 0.75 you have room to spend more on growth. If you recover more than three quarters of your costs within three months, then your sales process is humming. Investors expect you to spend more on sales and marketing because it works.

If the ratio is below 0.75 and especially below 0.5 then your sales process is dragging. You are spending too much for too little return. But what about enterprise sales and those that take many months to close?

The magic number compares new revenue to new spending. It doesn’t matter if the revenue comes from a relationship started a year ago, or if the spending will produce results in future. Once your sales process is set you must demonstrate that it works. The Magic Number does this.

But it’s only a rule-of-thumb. A16Z prefers to use gross margin adjusted CAC payback, which is a mouthful.

This calculates how long it will take to recover the cost of acquiring customers. 18 months is a benchmark for brand new companies and 12 months for the more established.

If your payback is faster than this then there is scope to spend more on growth. But the longer it is, the less likely you’ve found product market fit.

The ratio uses the most recent numbers because investors are interested in trends. Founders try and hide a poor quarter by calculating ratios over estimated customer lifetimes. The payback ratio is investors’ way of seeing through this.

What’s Your Opinion?

I wrote about startup finance this week because I was working with a company on preparing an investor pitch. Sharing the ratios on LinkedIn generated real interest.

If you’d like me to write more about startup finances, please hit reply and let me know. You are welcome to suggest other topics too.

I'm Simon Maughan and I write The Profit Elevator to help turn startups into scaleups. Financial ratios are part of the Finance module in my P.R.O.F.I.T. Through Process programme.

If you found this edition valuable please share it with a colleague or friend.