Startup Life
Technology. Startups. Venture Capital. My Life.
Business Models
The Importance of Customer Acquisition Costs for Startups
Mar 8th
I recently came across the blog of David Skok of Matrix Partners and was inspired to write this post by an article on customer acquisition costs. If you have not yet read through his blog’s vast resources for entrepreneurs, I suggest you do so – particularly if you plan to pitch your startup to VCs anytime soon.
After being pitched countless times by startups, as a VC I’d like to identify a common misconception that web-based startups often have about their own growth potential and the costs associated with their plans. Management of web services companies, SaaS companies and mobile (web-based) applications commonly believe that because they are situated online, customers will come across their service, submit a purchase order (or subscribe) and notify friends or other companies to use the service as well. Although this may happen from time to time, it is very rare for any company to experience sustained viral growth.
Many companies don’t understand the difference between viral marketing and viral growth. Viral marketing is essentially “word of mouth” or “person-to-person distribution” and is the latest buzzword. Viral growth implies a K-factor greater than 1 (i.e. for each new person who tries a product/service, they will each invite more than 1 registered user of the product on average). Since true viral growth is so hard to achieve in practice, many companies miscalculate the actual costs it will incur to acquire customers. As David points out in his article, the majority of startup pitches lack detail/emphasis on how much it will cost to acquire customers. I second this statement entirely.
Business Model Viability
For a business to be profitable on each new customer, startups must balance two variables: (1) Cost to Acquire Customers (CAC); and (2) Lifetime Value of a Customer (LTV).
CAC can be calculated by taking the business’s entire cost of sales and marketing over a given period (including salaries and other employee expenses) and divide it by the number of customers that the business acquired in that period.
LTV can be calculated by looking at the Average Revenue Per User/Customer (ARPU) over the lifetime of a business’s relationship with a customer.
As Steve Blank mentioned in his recent post, an early indication that a business has found the right business model is when the cost of acquiring customers becomes less than the revenues generated from the customer. “For web startups, this is when the cost of customer acquisition is less than the lifetime value of that customer. For biotech startups, it’s when the cost of the R&D required to find and clinically test a drug is less than the market demand for that drug.”
Credit: David Skok.
Zynga is a great example of a company that has managed to decipher the business model of online social gaming. After thousands of A/B tests and experiments, Zynga finally found a business model where CAC was less than LTV. Once they cracked the nut, the company spent so much on customer acquisition that it was rumored that they accounted for upwards of 30% of Facebook’s revenue in 2009 though its aggressive social ad buying strategies. Similar business models and opportunities exist in virtual worlds, massively multiplayer online games (MMOGs) and many other online businesses. Many social games, such as those created by Zynga, leverage virtual currency, micro-transactions, emotional response mechanisms and social influence to promote the sale of decorative and functional virtual goods.
Before investing in a web-centric startup, good VCs will look deep into a company’s business model and know to look for CAC and LTV metrics. In fact, Trident Capital recently held a meeting with their online advertising and ecommerce companies to help exchange best practices for customer acquisition and improving LTV. My advice to startups: prove out your business model and you will have a much better shot at raising VC dollars. Skok suggests that two key equations be followed by web startups:
- CAC < LTV (3x appears to be a rough minimum for SaaS businesses)
- CAC should be recovered in < 12 months (for subscription businesses)
Startups, if you’ve already figured out your business model and how to make CAC < LTV, stay very quiet and add as much fuel to the fire as you can afford. Your competitors will likely try to hone-in on your tactics and fight back for their share of the market.
Credit: Steve Blank.
Leverage Startup Metrics
Startups are different from larger companies and therefore need different metrics than larger companies. Metrics will give startups a lens into how well the search for the business model is going and help to identify when to scale the company. Besides CAC and LTV, some essential metrics that startups should be familiar with include Viral Coefficient (K-factor) and Customer Lifecycle. Dave McClure from Founders Fund recently updated his Startup Metrics for Pirates presentation for web sales pipelines. Take a look!
Questions to my Readers
Please consider the following questions and share your perspectives with my other readers and the tech community at large.
- What metrics do you consider the most valuable?
- Do you use any tools to help measure specific metrics for your business?
- What mistakes have you made (and corrected) that can help others succeed?
The Future of Contextual Mobile Commerce
Feb 23rd
In the early days of the gold rush to create location aware and contextually relevant mobile applications for smartphones, I was constantly bombarded with business plans that showed revenue models driven from advertising. Although advertising is a plausible way of earning revenue, there is a high level of inherent risk since those businesses are largely at the mercy of market rate CPMs/eCPMs and available ad inventory (unless you have a rockstar in-house ad sales team). Ad inventories are beginning to improve as advertisers are becoming more and more aware of the high interaction and engagement rates of mobile ads. However, for startups looking to differentiate in their niche, monetizing solely through ads is a risky road to travel. That being said, I believe that ads are still relevant for *lite* versions of apps that supplement a paid model of some form and for monetizing certain consumers that would not otherwise become a paying customer.
Tim O’Reilly wrote a short article last week on the convergence of Advertising and E-commerce and I thought he hit the nail right on the head. He says that “E-commerce is the killer app of the phone world. Anyone whose business is now based on advertising had better be prepared to link payment and fulfillment directly to search, making buying anything in the world into a one-click purchase. Real time payment from the phone is in your future.” I completely agree. Square is a great example of real-time point-of-sale (POS) coming to iPhone.
In the article, O’Reilly arrives at this conclusion by making a few theories about what can be expected from the marketplace based on some recent announcements and common sense:
- Google, Apple, and Microsoft will announce e-commerce programs akin to AdSense, in which retailers will register with “app stores” to allow physical goods and services to be bought as easily as apps
- We can expect announcements of partnerships between phone providers and Amazon or Wal-Mart to fulfill mobile e-commerce requests
There are a number of mobile apps that are positioned well to capitalize on some of these trends such as foursquare and other mashups of local and geocoded information. IMHO, there is a more exciting category that is only starting to gain excitement. Companies like Layar, Tonchidot (Sekai Camera), Mobilizy (Wikitude) and TAT (Recognizr) are creating augmented reality browsers and applications that use location data and combine it with image recognition technology to recognize specific people or places in the physical world and allow the application user to interact with them in some capacity. I strongly believe that these are some of the fundamental technologies that will make this category of future applications possible. By linking interaction of location-aware data through to payment and fulfillment functions, one can point a phone at a local pizza restaurant and order a pizza to their home en route. Another example may be pointing a phone at a friend and performing a money transfer with only a few clicks.
What killer apps can you think of that combine hyperlocal, e-commerce and fulfillment?
Does Eliminate Pro Violate Apple’s Developer Agreement?
Nov 5th
As an after thought to my last post on virtual goods, I published a comment discussing Eliminate Pro’s innovative play (or “experiment” says MTV Interactive) on Apple’s changes to the App Store to allow for in-app billing on certain items. It’s been a successful experiment. As of yesterday, the game has been downloaded 500,000 times so far at a rate of about 25,000 an hour, currently making it the top free app in iTunes (via TechCrunch).
After some successful digging, playing the game and reviewing Apple’s Developer Agreement. Some red flags were raised…
Eliminate Pro, a game developed by ng:moco, is an action-packed first person shooter (FPS) game that progresses very slowly. The game uses this tactic to charge impatient users to play and progress through the game at a faster pace. The game allows users to buy more battery packs or cases (Power Cells) through the In-App billing system. This allows users to recharge faster, compete to earn more “credits” so that they can upgrade their fighter’s armor, weapons and other items (virtual goods). Power cells are the currency of the game.
What I want to know is where Apple is drawing the line in the sand in terms of what is considered a virtual currency and what isn’t. As per Apple’s iPhone Developer Program License Agreement (the “Agreement”), Apple states:
Additional Restrictions 2.1 You may not use the In App Purchase API to enable an end user to set up a pre-paid account to be used for subsequent purchases of content, functionality, or services, or otherwise create balances or credits that end users can redeem or use to make purchases at a later time. 2.2 You may not enable end users to purchase Currency of any kind through the In App Purchase API, including but not limited to any Currency for exchange, gifting, redemption, transfer, trading or use in purchasing or obtaining anything within or outside of Your Application. "Currency" means any form of currency, point, credits, resources, content or other items or units recognized by a group of individuals or entities as representing a particular value and that can be transferred or circulated as a medium of exchange.
Specifically, item 2.2 of ‘Additional Restrictions’ within ‘Attachment 2′ of the Agreement raises some obvious questions about how Eliminate Pro got approved. Eliminate Pro uses Power Cells (the virtual good that they sell) to buy additional energy (a resource) that they can use in a game to earn credits, which are redeemable for weapons, armor and other inventory items.
This seems to be in direct violation to the Agreement. Unless, however, Apple is okay with allowing “indirect” forms of currencies to work (Buy Energy > Spend Energy for Time > Use Time to gain Credits > Use Credits to buy Virtual Goods (weapons, etc…)). Some clarity please?
It would be great if some people (Apple execs, developers, anyone) could weigh-in on this matter. What types of “economies” or “currencies” can be established while still being compliant with Apple’s policies?
Please share your perspective below.
Virtual Goods: Market, Types, User Psychology
Oct 30th
Virtual Goods have begun to penetrate social networks like Facebook and mobile applications like Tap Tap Revenge (by Tapulous) and I Am T-Pain (by Smule). They have spread like wildfire, with game developers itching to better understand the economics of virtual goods and the psychology of gamers. This post will explore the rapid market growth, types of virtual goods, user psychology and steps to launching virtual goods in your application or game.
Market Growth
The estimated market size has gone from a nascent space in 2008 to approximately $500 million (Aug. 2009; Source: Viximo) to over $1 billion by end 2009 (Oct. 2009; VentureBeat) only 2 months later. If you are at all surprised by this vast market size, you should know that the Asian virtual goods market is seven times bigger than US (estimated at $7 billion for 2009).
Zynga, one of the leading social games companies, launched a game called Farmville in June 2009, and has already become the most popular game application on Facebook with 62.4 million active users as of October 29, 2009 and will easily break through $150 million in 2009 revenue.
Types of Virtual Goods
Developers are very creative. So far, the types of virtual goods can largely be placed into 2 buckets:
- Decorative Goods: Do not affect game statistics / game play (e.g. avatars)
- Functional Goods: Affect game statistics / game play (e.g. Farmville tractors — did you know users bought 800,000 of them yesterday)
Since functional goods affect game play activities, game developers should give users the ability to either earn these items/goods through game play or provide a shortcut in acquiring them with a virtual currency. Functional goods can be managed to have low or high value price points; generally, the value of these functional goods can be set by carefully managing and understanding scarcity. Ensure to have some items that are very common (Developers: ensure to “prime the pump” by getting users familiar with using some free and low-cost items), and some that are very rare and expensive.
While A/B testing how much users will pay for items, understand that as the aggregate number of social interactions per user increases within an application, each rare item’s value will proportionately increase for those users. Another consideration while establishing demand for your virtual goods is whether or not you need a secondary market where users can sell, trade or profit from their virtual goods (See more from Bill Grosso’s presentation on Managing a Virtual Economy).
There are many reasons why a user would pay more for certain items. Let’s try to better understand game user psychology.
Psychology of Purchasing Virtual Goods
Users will buy virtual goods for many different reasons. Buying decisions will be based on a number of factors including user motivation, several forms of influence, boredom and competitiveness. If you’re a developer, think carefully about users of your applications: Why would they want to buy a virtual good within your application? What added value would they receive? Which other people would see they bought this good, and could they benefit as well? Below, I outline a number of different reasons why users choose to purchase virtual goods:
- People are impatient (time = money) and want to advance through game play more quickly
- People are competitive and want to get ahead (of friends, peers, the world)
- People want to express themselves in unique ways (akin to the culture of decorating cell phones in Japan)
- People want to feel good about themselves (donating to charity and publicizing)
- Gifting allows people to foster and maintain existing relationships with others in an increasingly electronic world
- Gifting allows people to create new relationships
- People will return gifts due to the rule of reciprocation (influence), which prompts us to repay what someone has given us
- Provenance (e.g. did a famous user own this item in the past?)
- Branding (virtual goods branded by real-world companies)
- Rarity (scarcity)
5 Key Steps for Launching Virtual Goods
In a presentation by Amy Jo Kim, CEO of Shufflebrain, about why and how virtual goods work, she outlined 5 steps for launching virtual goods.
- Create meaningful content
- Prime the pump with free goods or currency
- Create demand for premium content
- Offer fresh content at a range of price points
- Make it easy to purchase currency
There are many different companies that offer solutions to help with your virtual currency. If you’re looking for good vendors, try: PayPal, Gambit, boku, Zorg or $uperRewards.
Why are your users buying your goods? How did you generate interest or scarcity in your application? Please share your story and learnings about user psychology and buying decisions in the comments area below.