Monday, December 12, 2016

Lesson #252: Marketing ROI--The Metric That Matters Most

Posted By: George Deeb - 12/12/2016


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For all you entrepreneurs trying to attract investment capital, this post will be the most important one you read.  If you cannot answer the following customer acquisition related questions for your target investors, your fund raising process is over, before it even started.  Below will walk you through the inputs required to calculate the most important marketing metric for investors:  your return on marketing investment ("ROMI").


Your average transaction size will significantly vary based on your product and target consumer.  An ecommerce company selling arts and crafts supplies may have a $50 average order size, and an enterprise software company may have a $250,000 average order size.  For purposes of this post, I am going to focus on the consumer facing businesses.  Average order size is calculated by taking your total revenues in the period, and dividing it by the number of transactions in the period.  So, if you did $1,000,000 in revenues with 10,000 orders last year, your average transaction size is $100.


It is hard enough to acquire new customers, so it is important you don't lose your old customers.  You always need to be figuring out what percent of your current year transactions came from prior year customers (and improving that metric over time).  So, if you did 10,000 orders in total in the period, and 5,000 came from customers acquired in prior years, you have approximately a 50% repeat customer mix (where some customers may have made their second transaction with you, and others may have made their fifth transaction with you).  You can calculate this based on unique customer identifiers, like client numbers or email addresses in your system.  Anything north of 33% is acceptable, and if anything less, you may have a customer retention problem on your hands (which may spook investors).


If your average transaction size is $100, and your average repeat customer rate is 50%, on average, one customer will drive $100 in year one, $50 in year two, $25 in year three, $12.50 in year four and $6.25 in year five.  So, that is a lifetime value of revenues (often abbreviated LTV) of around $194.  Understanding, the one customer that made five orders in five years, most likely spent $500, but they are the minority, and made up for the majority of the customers that only spent $100 for one order in five years.


Your cost of customer acquisition (often abbreviated CAC), is the total marketing investment required to bring in one customer.  Let's say you spend around 10% of your $1,000,000 in revenues on advertising; so, you spent $100,000 to generate 5,000 new customers in this example.  So, your CAC is $20 per new customer acquired.  Notice, I did not divide the marketing cost by total customers in the year, I only divided it by NEW customers in the year, as I wanted to get a clean look at my acquisition costs without it being benefited by free customers generated from repeat sales or word of mouth.  Those items are the gravy, if they end up happening.


And, now, what you have all been waiting for, the key metric that matters most to investors:  your ROMI.  This is calculated by taking your  LTV of $194 and dividing it by your $20 CAC, in this example.  So, your ROMI is almost 10x in this case study.  If you are doing 10x that is pretty terrific.  Most average companies are doing around 5x.  And, companies that can't exceed 3x typically lose money, after subtracting their cost of sales and operating expenses.  If you want to edit this calculation, don't use revenues, use gross profit as your numerator and shoot for a 5x return, understanding most companies will be around 2.5x with a 50% gross margin.


If your marketing investment does not drive a healthy return (5-10x on a revenues basis, or 2.5-5x on a gross profit basis), and does not have a quick payback period for investors (from the first transaction, in this example), you are going to have a really hard time of attracting investors.  And, know going in, consumer marketing for brand new companies, is going to be expensive and less efficient than established companies (e.g., one-third as effective, on average).  So, the sooner you start testing and optimizing your marketing efforts, to start illustrating healthy marketing returns, the sooner investors will start flocking to your business.

Don't forgot, as I have said many times in the past, your proof of concept is more important than your product when talking to investors.  And, having a solid ROMI is one of the key metrics they are going to be focusing on, in determining if you have passed your proof-of-concept threshold. This will make or break your fundraising efforts, so don't reach out to investors until you have identified, tested and optimized scalable marketing techniques which can be accelerated with the use of proceeds from your raise.  Investors prefer to pour gasoline on an established fire; they don't like to start the fire.

For future posts, please follow me on Twitter at: @georgedeeb.

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