Let’s Talk About Customer Retention
It turns out, almost everyone agrees that it’s better to have a customer who sticks with you for a long period of time than one who buys two LoneStar tallboys and disappears off into the sunset, never to be profited from again. But lately finance departments, investors, and college kids hoping to invent the next Match.com have become obsessed with the idea of customer retention. What’s up with that?
It’s the subscription economy, mannnn. One of the hottest new trends in the business world today. It’s hard to say what exactly has caused this – the technological advances that make it viable, the ever-increasing amount of options that consumers and business alike are presented with, or perhaps the business schools just ran out of new things to teach – but regardless, it’s definitely here to stay.
What is the Subscription Economy?
For those of you who aren’t particularly familiar with the latest buzzwords, like subscription economy, all it really means is that where companies used to sell you something for a large, up-front fee – say a Microsoft Office license or a DVD – they now want to sell you a recurring subscription to that thing, where you make smaller payments each month in perpetuity and get access to upgrades, support, and other add-ons included – e.g. Microsoft Office 365 and Netflix. While this has been popular amongst software and entertainment companies for a while, it’s quickly expanding to include everything from razors (Dollar Shave Club) to office space (WeWork) to dog toys (BarkBox).
This shift means that companies are often spending more money to acquire a new customer – commonly measured as Customer Acquisition Cost (CAC) – than they receive in payments from that customer initially. Let’s say a company spends $100 in sales and marketing expenses to get you as a customer and $3/month for ongoing support, but the subscription you sign up for only costs you $15/month. If you cancel your subscription 3 months in, not only have they not made a profit, but the company has actually lost $61 [ (15*3) – (3*3) – 100 ]. So do you know anyone who went into business to lose money? Me either. In this particular example, the company would need to keep you as a customer for at least 9 months to make any money. This metric – 9 months – is referred to as Months to Recover CAC. This is shown on the graph below where we cross the x-axis and is simply the breakeven point measured in units of time instead of quantity (as with traditional businesses selling widgets).
Don’t get me wrong, the subscription model isn’t just an opportunity to spend more money than you make. If it were, no one would have adopted it and in fact the reality is quite the opposite. While companies often incur large upfront costs, the ongoing expense to support and retain a customer is often quite small compared to their subscription price. Because these ongoing costs are relatively low the company actually makes more and more money from that customer as time goes on. In the graph below, we see the same example from above extrapolated over a five year period and it quickly becomes apparent why so many companies are adopting this model.
Unfortunately, many of the traditional metrics used to analyze how well a company is doing are ill-suited for subscription businesses. For example, looking simply at Net Income can be very misleading, particularly early on in winner-take-all markets. In these situations, is it common to reinvest all earnings back into the company in order to scale aggressively and acquire the greatest market share. However, when you are doing that, and your upfront costs are greater than your revenue in the initial period, traditional financial measures show that you are losing money. That makes it seem like the company is performing poorly, either not having enough growth in sales or operating very inefficiently at great expense. In reality though, neither of those may be true.
For this reason, it’s important to take other Key Performance Indicators (KPIs) into consideration when evaluating the value of a subscription business. One of the most common subscription profitability metrics is known as the LTV:CAC ratio. This is defined as the average Lifetime Value of a customer divided by the average Customer Acquisition Cost. Ultimately we’re still looking at how much money is coming in vs. how much money is going out, but with two key differences.
First, we’re not looking at a specific time period, such as a month, which could get skewed heavily due to timing differences of revenue and expense. Instead we’re looking at the entire lifetime of the customer, which is really the average lifetime of a customer when done in aggregate. Second, the cost component isn’t focused on what it takes to create the product, as gross margin does by including direct costs but excluding SG&A, but instead is focused on what the incremental cost of acquiring additional customers is, typically thought of as sales and marketing expenses.
These differences paint a much more accurate picture of a subscription business’ performance. It is not uncommon in high-growth subscription businesses (SaaS companies in particular) to have a healthy LTV:CAC ratio (> 3.0) but show a loss on the Income Statement. Ironically, the faster a subscription company tries to grow, the bigger the initial losses and the more cash that’s required to support the growth. This is another reason why it is very common for these companies to turn to venture capital funding in order to support their growth early on.
Coming full circle, what is all the fuss about customer retention? It’s really pretty simple: it costs a lot of money to get new customers, so you don’t want to lose them after investing so much in acquiring them in the first place. To take a metric-based look at the problem, the longer you can retain a customer, the higher their lifetime value is and subsequently the higher their LTV:CAC ratio is, meaning ultimately the more profitable that customer is for the business.
If you’re interested in geeking out even more on this topic, there’s a great article which goes into far greater depth than I have, which you can find here.