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This Is Not Your CAC

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In my brief time thus far as a VC, I’ve seen entrepreneurs repeatedly screw up one key metric again and again: customer acquisition cost (CAC).

Along with lifetime value (LTV), CAC is one of the most important metrics consumer-facing businesses need to watch. But so many of them get it wrong and do so in a very dangerous way.

The entrepreneurs who get it wrong calculate CAC as follows:

CAC = Advertising Spend / Total New Customers

Instead of:

CAC = Advertising Spend / Total New Customers Attributable to Paid Advertising

Counting all your customers in your CAC metric – rather than just those acquired through paid marketing – is playing with fire. As an entrepreneur, I learned that the worst possible result of a test is a false positive: a result that incorrectly makes a hypothesis look correct when it actually doesn’t work. False positives will waste time, money and precious focus.

Calculating your CAC as a “blend” of all customers is just asking to be on the receiving end of a false positive. Your paid campaigns could very well be unprofitable, but you are making them appear profitable by blending in customers who found your product through organic channels – referral, word-of-mouth, organic search, or social, to name a few.

This is a huge problem since traffic from those organic channels doesn’t scale linearly with traffic from paid channels as a paid advertising budget increases. If you are spending (say) $1,000 on paid marketing and getting 20 new customers per day, it does not follow that your CAC is $50. 5 of those customers may be from paid marketing campaigns while the other 15 are from organic sources, so your CAC is actually $200. When you scale your paid budget to $2,000, you won’t be getting 40 customers per day – only 25 at best. And that’s assuming that CAC stays constant as your budget increases, which is a very optimistic assumption.

Using “blended CAC” in a presentation is a very quick way to get me to pass on an investment. When I hear a pitch, I care less about whether or not a company’s initial paid marketing tests were profitable or not. There are numerous factors that can drive campaign profitability, and there are a lot of ways to acquire customers these days. Rather, I care about how an entrepreneur uses data and thinks about key metrics. Showing a blended CAC means an entrepreneur is loose with the numbers at best and deceptive at worst. And as a company grows and the numbers get bigger, either of those are very bad things.

Written by Brad Hargreaves

March 15th, 2015 at 6:48 am