In a previous post, we provided a primer for the ModernMSP on the Cost of Customer Acquisition, or COC (often referred to as COA by executives and investors in recurring revenue businesses). In that post, we talked about why COC is such a critical part of a ModernMSP's growth plan. We believe that COC is the single most important factor to measure and control when scaling a cloud/managed services business and maximizing its valuation either for an upcoming investment round or for an M&A event. In this post will take the COC concept one step further and explain the nature of its impact on both short-term and long-term profitability for a ModernMSP business.
To help make this explanation as clear as possible, we have created a diagram to illustrate COC in action. Take a few moments and study the diagram below—it will help you to visualize the critical role that COC plays in scaling your ModernMSP business. The diagram shows the customer acquisition ramp for a hypothetical business that is launching a new cloud/managed service. Each newly acquired customer is represented by a row of colored squares from left to right with each square representing the Monthly Recurring Revenue (MRR) collected from the customer. Every month, the business acquires a new customer and, as a result, a new and incremental revenue stream is set in motion one customer at a time.
The colored squares are divided in half with one part colored red to represent cost, and another part colored green to represent the profit realized during the term of the cloud/managed services contract. For each new customer, the colored squares in the early months are red on both top and bottom. This illustrates the fact that you must incur a cost to acquire the customer. And you must also incur a cost to deliver services to them (these are very separate and distinct cost elements). The cost of acquisition is represented by the top red half of the revenue square and the cost of service delivery is the bottom red half of the square. After some number of months, the cost of acquisition is recovered. The COC is paid back by the gross margin dollars remaining after all service delivery costs are met. In the example above, you will notice that it takes nine months of gross margin to pay back the cost of customer acquisition for each new customer acquired. Then beginning in the tenth month, the customer becomes profitable and stays that way for the life of the contract, or multiple contract terms assuming the ModernMSP maintains a low churn and strong contract renewal rate.
After you study the diagram for a few minutes, you will begin to see the importance of managing COC on both your short-term as well as your long term profitability. There are many insights to be gleaned from this diagram. Each one is significant so let’s cover them one at a time.
- First of all, notice the compounding effect of a recurring revenue business. It’s much like saving for retirement. If one new customer with an MRR of $2,000 is added each month (equal to 20 users at $100 per user per month), then after four years you will have a million-dollar recurring revenue business. That means your recurring revenue business will generate a million dollars per year for as long as your customers renew, and you would never have to add another customer to keep that million-dollar revenue run rate going. Isn’t recurring revenue a beautiful thing? How can you consistently add a new customer every month? All you need is a consistent customer acquisition strategy, where your sales and marketing functions operate according to an effective and efficient execution model. It’s very achievable, but it won’t happen by chance—and it must be managed.
- Next, you will notice that during the first year of customer acquisition, your ModernMSP business will not be very profitable. That’s because you have not reached critical mass in your customer base—the majority of your customers are still within their first nine months of acquisition and have not generated enough margin dollars to pay back their acquisition cost. They are in the “Acquisition Cost Recovery Zone”, and as long as you are acquiring customers, that unprofitable zone will always be a fact of life. But you will also notice that during the second year, the profitability picture changes dramatically. In Year 1, only a few of the squares (monthly recurring revenue) are profitable. In fact, in this scenario, less than 10% of the first year revenues are profitable. However, in the second year, more than half of the MRR squares become profitable. If your customer acquisition rate stays constant, then each year the proportion of profitable squares to unprofitable squares will increase and your overall business profitability will rise accordingly. So much so that by Year 4, 90% of your MRR will be profitable revenue and only 10% of your revenue (i.e., new acquired customers) will be unprofitable. In other words, over time, the profitability picture flips from a very unprofitable situation to an extremely profitable one.
- How can you minimize the number of red (unprofitable) squares and maximize the green (profitable) squares? The answer is to manage your cost of acquisition to the lowest possible level so that the time to recover COC is reduced and the path to profitability is accelerated. How can you reduce your COC? You must find the inefficiencies in your sales and marketing functions, and continuously improve them. Where are they? Well, that depends. Excess COC could be in your sales compensation plan, or your pipeline close ratio, or unusually long sales cycles. In the marketing area, your COC might be too high because of your cost per lead, or your lead qualification rate or maybe your overall lead volume is not sufficient to consistently drive sales activity. With the right sales and marketing metrics in place, you can find these inefficiencies and then you can identify and implement strategies to correct them.
- Finally, let’s look at the actual numbers implied by the diagram above and use this COC metric in a real-world scenario. We have already pointed out that, in this diagram, the COC cost recovery time is nine months. If your average MRR is $2,000 per customer, and your gross margin is 50% (we are using round numbers here for simplicity), then each month you will generate $1,000 in margin dollars to recoup the cost of customer acquisition. So a nine month COC implies a $9,000 cost to acquire each customer. Where did that $9,000 go, anyway? Let’s start with selling expenses. If we ballpark your cost per sales rep at $100k per year (including salary, commissions, overhead, T&E), then each month a sales rep accounts for more than $8,000 in selling expenses. So the next question is how many deals at $2,000 MRR does a sales rep close in a month? If the answer is only one deal per month, then most of your $9,000 COC has been spent on selling expenses alone.
Now let’s look at marketing expenses. If you spend $200 per lead and you qualify one third of your leads into the sales pipeline, and then you convert one third of the pipeline into customers, then you have just spent $1,800 on lead generation ($200/30%/30%) to acquire each new customer. Are there any marketing staff or sales support staff not already counted? If so, then add them in, too. Now add in all other sales and marketing expenses for creative services, PR, trade associations, demo equipment, literature, etc. COC is your total cost of customer acquisition, including all fixed and variable sales and marketing expenses.If you currently have a high COA (e.g., the time it takes to recover your COC is greater than 12 months), then your goal should be to move to a low COC model as soon as possible. Otherwise you are burning margin dollars unnecessarily, and undermining the profitability of your business. Which of the diagrams below do you think looks more like your COC efficiency?
A low COC model will enable you to acquire the most customers in the shortest time frame at the lowest impact on your operating margins. But the question becomes how to make the move from a high COC model to a low COC model. The only way to manage a process with so many variables is to create a Go-To-Market plan, and then execute against that plan. Then you must measure your COC performance constantly and improve it over time. With an efficient, consistent and scalable Go-To-Market model and customer acquisition program, you will build up your customer base, maximize top-line revenue growth and maximize your bottom-line profitability all at the same time. Here is a summary of the steps we recommend to move from a high COC model to a low COC model.
The chart above summarizes the factors that increase COC and the steps you can take to improve your COC efficiency. You may only need to address one or two of these factors to optimize your COC…or you may find that you need to take all five steps to address them all. In any case, you owe it to yourself and your business to take a hard look at your cost of acquisition and then take the necessary steps to optimize it. Just ask any serious investor in recurring revenue companies: mastering your COC is not only the key to increasing your profitability, it is also the key to maximizing the valuation of your ModernMSP business.