Can a Growing Company Grow Faster While Spending Less? (Part 1)

May 9, 2012 by

customer acquisition cost

Image provided by: DeeganMarie

A lot of growing businesses face a common issue as they advance past the early stages of their development:

How can they accelerate growth while concurrently improving distribution efficiencies? In other words, how can they build a business with capital efficiency? Or, better yet, what kinds of things does an expanding company need to do to grow profitably?

I bring up this issue because one of the portfolio companies I work with is undergoing that evolution right now. It’s an exciting time for the business, and the CEO has proven exceptionally skilled at focusing his senior management team around driving higher growth, while also improving distribution economics.

That can be a tricky balance to strike, which is why I thought it might be helpful to walk you through this company’s experience, highlighting a few of the key decisions that its CEO has made to better align with that goal.

Let’s start with some background information.

This company (we’ll call it ACME, Inc.) sells a SaaS solution to enterprises that addresses a fairly common pain point within a target market. But the product also requires its customers to change the way their employees work in order to best use its features.

The target market is defined as departments within medium to large enterprises, and the sales model is direct, primarily through inside sales (with some field sales sprinkled in). Marketing is primarily delivered through SEM/SEO, email, and other forms of outbound prospecting. The product is delivered as a service and requires anywhere from two to 10 days of professional services to onboard and train customers to implement and use it.

OK, now that we have that out of the way, here are some operational metrics to provide additional context:

  1. The company has grown at about 30 percent year-over-year and is aiming for 50 percent.
  2. Licensing drives recurring revenue, with an average sale price of $10,000.
  3. It takes $15,000 in sales and marketing to acquire a new customer.
  4. First year booking is invoiced and paid upfront.
  5. Renewals are running at 70 percent; with upselling that number goes up to 80 percent.
  6. Expenses are greater than first year bookings by 6 percent (which is an indication of negative cash flow).
  7. Professional services account for 25 percent of revenue, with a 20 percent gross margin.

So what’s the problem, you ask?

Well, here’s a question for you: Should ACME be raising more money, allowing it to direct a larger amount toward sales and marketing and growing the company faster? That might seem like a simple question to answer, but it’s actually pretty complex.

Yes, ACME is showing decent growth for a B2B recurring revenue business, especially considering its revenues exceed a $30 million run rate. But that growth isn’t spectacular. In fact, a 50 percent growth rate is certainly achievable given the company’s differentiated solution in a big market. The issue, however, is that higher growth almost always requires more money. Unless, of course, ACME focused instead on improving operating efficiencies to fund that higher growth… 

That’s exactly what it’s done. Today, the company is working hard to improve distribution economics and fend off the symptoms of poor efficiencies.

One of those symptoms involves relatively simple math: If it takes more than a dollar to generate a dollar in new customer bookings (for ACME, that’s $15,000 to generate $10,000), that’s not a good sign. Why? Because it means that new customer acquisition is expensive and that growth can’t be funded organically.

In ACME’s case, the good news is that customers pay the first year booking upfront, rather than through monthly subscriptions like other SaaS companies. So, all ACME needs to do is focus on things that will help bridge its $5,000 customer acquisition cost (CAC) gap.

How can growing companies do that? 

Here are some ideas for improving CAC ratio:

1. Focus your acquisition efforts on a more specific and targeted customer segment. The sharper you are at identifying a specific pain point, the easier it is to market your solution. In other words, the more defined your target prospect is, the more efficient your targeting will be.

In the case of ACME, it historically sold to several segments within the broader enterprise market. This year, it has chosen two specific market segments (one is an industry segment, the other is a functional segment), making it easier for ACME to target those segments and lower CAC (for more on segmentation, click here).

2. Become a thought leader through online content marketing. This will allow you to generate leads without having to spend money on traditional marketing channels like email and events (Note: We’ve covered content marketing pretty extensively on our OpenView Labs site. Click here for more).

3. Break up your sales team into specialized units. Specialization creates focus and increased expertise. In most cases, growing companies need to build an inbound lead qualification team, an outbound opportunity generation team, an inside sales team, a field sales team, and an account management team (for upselling into existing accounts). In the case of ACME, the company made those hires and then divided its teams among specific segments and target customer groups.

4. Invest in better product marketing. Develop collateral and training that is specific to each target segment. Train and retrain the sales team about their specific targeting responsibilities. Move more lead qualification responsibilities to marketing (which will help you avoid sending unqualified leads to the sales team) and move opportunity qualification away from the sales team and into the website (giving visitors more relevant information before they engage with a sales rep).

5. Invest in better product management and user experience design. Focus your product development and design on the needs or pains of the specific one or two segments you’re targeting. Remember, its not about what your software can do, it’s about how customers use it.

6. Leverage your best customers as evangelists. Have an annual customer meeting where customers can share their best practice use of your product with prospects. Market videos where customers share their experiences and leverage social networks to give your evangelists more exposure.

The bottom line is that unless your CAC ratio is positive, spending more money to acquire more customers won’t make you more profitable. In fact, counterintuitive as it may sound, spending less (by improving distribution economics and efficiencies) sometimes leads to faster, better growth.

In my next post, I’ll maintain this theme, but focus on renewals and upsells, sharing some advice for how to improve their efficiencies.

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Discussion

  • Hendrix Bodden

    Your customer acquisition costs far exceed revenues. If I were you I would find another example to support your points…which are good. You lose total credibility with the $10k – $15k customer example.

    • http://bit.ly/1Gu8Ha Firas Raouf

      Hendrix, not sure how I lose credibility with a real example. These are not made up numbers. And they are precisely why I wrote the post. Such a scenario is typical in a SaaS company with subscription licensing. 

      The initial customer acquisition cost is not the only element with which to judge the viability and value of a SaaS company. Nor should the CAC should be compare only with the first year revenue generated from the customer. CAC should be compared against:
      1.  The life time value of the customer: to determine if that customer is worth acquiring. In essence, it would be comparing the cost of capital against the IRR of customer net revenue.
      2. The breakeven point: how many months/years of revenue does it take to recover the CAC. This is an indication of what it will take in capital to fund the acquisition of the next set of customers.
      3. Churn: determines the life time in year of new customers acquired.
      4. ASP: the average sale price multiplied by the life time gives the life time value. 

      Here’s a place to go if you want to dive deeper into this topic http://www.forentrepreneurs.com/saas-economics-1/

      The reason that this company has been able to thrive with a breakeven point of 18 months is because its existing customers are funding the delta between the cost of acquisition and the first year revenue. When the company first started, it had a more capital efficient distribution model (CAC breakeven less than a year), which allowed it to acquire lots of customers without having to raise capital.  In these early startup years, it had the advantage of acquiring early adopter prospects who are much easier to convert into customers. 

      As the company grew and started to reach out to later stage adopters, the cost of acquisition started to go up. 

      So back to my question… What would you do with this company?  Would you throttle down the growth in order to conserve capital?  Or would you raise more money, hit the accelerator to go for growth, and hope that the valuation of the company upon exit will return the capital and then some?

      What I’m suggesting is a strategy of growth, coupled with extreme focus on optimizing the distribution economics in the process. 

    • Alfonso de la Nuez

      That depends on the company’s mid-long term strategy, right? If they would like to increase the number of accounts (growth), this CAC sounds reasonable to me. If they are looking at increasing profitability, then they should improve that ratio, yes, but it’s still more or less ok to me. It’s a SaaS business with a 70% renewal rate, which means the CLV (customer lifetime value) is what matters (more than the CAC). If account managers are able to upsell in the 2nd year (they claim 80% upsells), then they’ll be fine.

      • http://bit.ly/1Gu8Ha Firas Raouf

        Precisely. The beauty is that they have lots of options in fine tuning the distribution economics. More to come in the next post about churn and upsell.

  • http://blog.kwiqly.com/ James Ferguson @kWIQly

    Point One is brilliant and simple but not obvious – we learned it by accident.

    We ran out of money! Nobody does that on purpose, but fortunately we were lean enough that we could survive hand-to-mouth to get to a trade show for a last ditch attempt.

    This meant reduction of every aspect of what we do to a single core proposition.
    It meant turning away clients in wider segments. It meant finding out exactly what our core client base were looking for. It meant reducing our marketing collateral to things we could produce ourselves. 

    Fortunately – these core clients are our resellers and understand our proposition – they don’t need to be sold because – they don’t want our service, but they do  want to offer it as added value to their otherwise “commodity buying” client base to improve client retention.

    The bizarre implication, our clients only want what we have indirectly.

    Energy companies who want to sell energy savings – It even sounds weird.

    So my “value-add” to this article is look for channel partners who are already selling into your target markets and see if you can help them sweeten their proposition, it may help you focus yours !

    • http://bit.ly/1Gu8Ha Firas Raouf

      Great point James. Channel partners can be helpful in extending a vendor’s distribution channel, and relieving some of the need for direct sales people and marketing.  But building indirect channels is hard and can consume a lot of bandwidth before they ramp up to make a significant impact.  It very much depends on whether your target market is better served by and reached through channel partners… and depends on whether the target customers prefers to deal with the partner than the vendor directly.  At the very least, channel partners that have the trust of the target customer can be a reference conduit. 

      Good point.

      • http://blog.kwiqly.com/ James Ferguson @kWIQly

        Firas – Again a very helpful observation. Indirect channels is easier if you have a track record in the industry / branch. In our case we offer energy savings, and work with utilities who must offer Carbon reductions as compliance but also to differentiate their service. We have offered consultancy through them for a while – so our scalable automated “own-itch-scratching” sevrice is a logical extension.

        Hope you don’t mind but I’m adding your article to http://www.rebelmouse.com/kWIQly/ which looks like a nice social dashboard app I thought I would try

  • http://abdallahalhakim.tumblr.com/ Abdallah Al-Hakim

    Great post Firas and definitely contains many excellent points.

    My understanding about SaaS is that controlling chrun rate is critical for the sucess and one way to achieve negative churn would be to expand the revenue capacity of existing customers. I think this is where companies can become innovative in coming up with business models that increase ARPU.

    There was a recent post by David Skok where he discussed the importance of churn rate and it goes well with your post – http://www.forentrepreneurs.com/why-churn-is-critical-in-saas/

  • Jason Healey

    Great post! I have a question on CAC. What if there’s a poor sales & marketing strategy based on an assumption that the market a company is targeting is substantially larger than it really is. For example, ABC Company bases their salesforce hiring on the assumption there’s 80,000 companies in their target segment. Then, the marketing strategy is based on this 80,000 number which drives up costs through too many event sponsorships, added list purchases, direct mail costs, etc. After two years with the 80,000 number, they run out of lists to call, over hire possibly 20 cold callers with very little effectiveness, over hire 8 sales reps while revenue and new customer acquisition stays flat. The Senior Management, after two years, realizes the market is more around 10,000. My question, wouldn’t the traditional method of finding CAC be highly erroneous in this scenario because spending was increased on grossly inaccurate target market numbers from senior management?