Over the past few weeks we have undertaken some preliminary research into the various sections of the One Million by One Million Global Virtual Accelerator run by Silicon Valley entrepreneur, Sramana Mitra. This week we consider the single most important criterion for success in the life of any business, let alone the nascent startup.
A budding entrepreneur might be surprised to learn that launching a startup is (relatively) easy. So is building technology. As are fundraising, hiring and all of the other horror stories associated with startup business development.
There is actually one simple, surprising aspect of building and scaling a startup that one may not realise is the most challenging. It’s not particularly sexy, and it’s something that has been a challenge for every business everywhere on earth, since the beginning of time.
Customer acquisition…that is, getting the word out about your business and having people pay for the product/service in a cost-effective, scalable manner.
Scrutinise a broad cross-section of startups, about 30 or 40 or more, enough to screen out the pure flukes and look for patterns. Two obvious facts are apparent.
First obvious fact:
There is an incredibly wide divergence of success as some of those startups are insanely successful, some highly successful, many somewhat successful, and quite a few of course outright fail.
Second obvious fact:
There is an incredibly wide divergence of calibre and quality for the three core elements of each startup, namely team, product, and market.
At any given startup, the team will range from outstanding to remarkably flawed; the product will range from a masterpiece of engineering to barely functional; and the market will range from booming to comatose.
And so one wonders, what correlates the most to success, team, product, or market? Or, more bluntly, what causes success? And what's most dangerous: a bad team, a weak product, or a poor market?
Market is the most important factor in a startup's success or failure.
In a great market, one with lots of real potential customers, the market pulls product out of the startup. The market needs to be fulfilled and the market will be fulfilled, by the first viable product that comes along. The product doesn't need to be great; it just has to basically work. And, the market doesn't care how good the team is, as long as the team can produce that viable product. And when you have a great market, the team is remarkably easy to upgrade on the fly.
Conversely, in a terrible market, you can have the best product in the world and an absolutely killer team, and it doesn't matter, failure is imminent.
Failure to get product/market fit right is very likely the number one cause of startup failure. Further, a very large number of startups that had solved the product/market fit problem, still failed because they had not found a way to acquire customers at a low enough cost.
More specifically, the hardest part of building a startup is figuring out your customer acquisition cost (how much it costs to acquire each additional customer) as well as scalable channels for acquisition. Startups state the most common forms of customer acquisition in their sales and marketing slides or sections in their business plans: paid search, organic search/SEO, PR, social media, inside sales, channel partnerships, etc. What ends up happening is that a lot of these assumptions are wrong, or just plain too expensive.
Business Planning Stage
Good advice to entrepreneurs working on a new business plan is to build a model to estimate the cost of customer acquisition. This is going to reflect the dependency on several critical variables:
- Cost per lead
- Conversion rates at each stage of the sales process
- Level of touch required
Then compare this to the expected monetisation. In the early days of the business, it may be difficult to accurately predict conversion rates, and the viability of the entire business may depend on this. The solution is to build an execution plan that focuses on finding out what these numbers will be as soon as possible in the lifecycle of the business. Good numbers will enable funding easily, and bad numbers may indicate that this is not a viable business.
The new generation business models make use of a variety of techniques described below:
- Extensive use of the web to drive lead flow. In particular, best practices include using Inbound Marketing to build traffic, instead of paying for traffic with search ads.
- Use of a free product or service to attract web visitors, and aim for a viral spread as they tell their friends. Examples of free products include Open Source software, services like HubSpot’s Website Grader, free versions of a SaaS service that have limited, but still valuable, feature sets, etc.
- Use of a free trial, where the customer can easily download or use a SaaS version of the full product to see if it works for them.
- Leveraging the power of customers’ social networks to get viral growth where possible.
- Use of the touchless conversion to convert trials to paying customers.
- Using low cost inside sales when the touchless conversion is not possible.
- Extensive use of software to automate all processes such as SEO, SEM, social networking, lead scoring, lead nurturing, and CRM.
- Metrics on all aspects of the customer acquisition process to find out what can be improved.
These techniques are frequently referred to as the Low Cost Sales model, or as Sales 2.0.
The Immutable Law of Business Success
Business model viability, in the majority of startups, will come down to balancing two variables:
- Cost to Acquire Customers (CAC)
- The ability to monetise those customers, or LTV (Lifetime Value of a Customer)
Successful web businesses have long understood these metrics as they are easily measurable. However there is certainly value in applying these same metrics for other business types.
To compute the cost to acquire a customer, CAC, take the entire cost of sales and marketing over a given period, including salaries and other headcount related expenses, and divide it by the number of customers acquired in that period.
To compute the Lifetime Value of a Customer, LTV, calculate the Gross Margin expected to generate from that customer over the lifetime of the relationship. Gross Margin should take into consideration any support, installation, and servicing costs.
It is thus evident that business model failure comes when CAC (the cost to acquire customers) exceeds LTV (the ability to monetise those customers).
A well balanced business model requires that CAC is significantly less than LTV:
The goal of the fairly obvious diagrams is to give the reader a sense of the balancing act required to create a profitable business. Hopefully the value will become more obvious with the third version of the diagram that shows the different factors that affect the balance.
Balancing Monetisation with CAC
The way in which these techniques can work together with other techniques to drive up monetisation (e.g. recurring revenue) are illustrated in the diagram below:
Conversion rates play an extremely important role in customer acquisition cost.
- Consider using A/B testing to improve conversion rates. Web traffic can be easily split so that parts are fed to different landing pages with different offers, and the resulting conversion rates measured.
- Look at the level of touch required to complete a sale. Some products are easily understood, while others may require a careful walk-through by a sales person. Sometimes, the customer will want a trial with their own data. With certain complex products, this will need an on-site installation by a sales engineer, which sends costs skyrocketing. Consider every possible way to minimise this. For example:
- Create demo videos that answer every likely sales question.
- List the common sales objections that come up in the sales cycle, and provide answers to these on the web site.
- Try using customer references to avoid the need for a trial
- If customers are going to make comparisons to the competition as part of their process, consider doing this for them, with a section of your site that has a comparison matrix with appropriate check marks.
- Consider setting yourself the goal of a “Touchless Conversion” by getting rid of, or minimising the touch required to close the sale. As shown in the model, this has a huge impact on cost of customer acquisition.
Understand that the customer acquisition strategy may be the toughest part of your business. You may have built the world’s best product with the world’s best team, but if nobody knows about you or cares…you’re going to have major problems.
From a funding standpoint, it is useful to know that the ability to raise capital will dramatically improve as soon as a viable business model has been proven. Always apply the two basic rule of thumb equations:
- CAC < LTV (3x appears to be a rough minimum)
- CAC should be recovered in < 12 months
Once the business model has been proven, hit the accelerator pedal, and invest as much as is affordable. Grow the business as fast as possible before a competitor realises what has been achieved and tries to steal valuable first-mover market share!
When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens