TAKING A STANCE ON VALUE
All of us are out to build sustainable businesses and household brand names. But when I look across many emerging product companies, I keep seeing an over focus on customer acquisition in expensive online channels. There are several unhealthy side effects to this. Here are a few of them.
THE BEST BRANDS ARE BUILT THROUGH GOOD OLD FASHIONED WORD OF MOUTH DISCOVERY AND THIS TAKES PATIENCE
Paid customers are worth less than organically acquired ones. At Stance, there’s a dramatic difference in repeat purchase rates between naturally acquired and paid or persuaded customers.
When people discover a great brand, product or service, they enjoy sharing it with those closest to them. They generally explain why they perceive your value proposition to be good and add their testimonials. This is very powerful and a hallmark of nearly every brand we admire today. The problem is these one-to-one endorsements tend to happen slowly for most brands (with an exception occurring when the product or service is incredibly disruptive such as Uber, Skype or Spotify).
The opposite of this is when a company solicits and persuades a new customer to do business with them through an advertisement—and often through a discount offer—thus robbing them of the eventual personal discovery experience they would have had through one of their friends or family. You effectively trade off a personal one-to-one endorsement in the future in exchange for a persuaded customer available from advertising today.
This isn’t to say that customer acquisition can’t play a role in your growth or that you can’t create conditions to enable natural word of mouth marketing. But too often, I see emerging companies using Google, Facebook, podcasts and the like to buy customers, seemingly as the extent of their strategies.
Their presentations are full of cohort data. They feel validated when they show high top-line growth, which, in turn, attracts investors. They may even show what appears to be great LTV data.
But great investor slides often lead to more venture capital to spend on customer acquisition. Building brands and insanely great products take time and I argue that introducing customers to your brand exclusively through direct response ads will have dangerous long-term side effects in the form of unsustainable economics and ultimately customer churn. It may take several years to manifest, but eventually competitive pressures, changing capital markets, or your own balance sheet will reveal that this growth strategy was fool’s gold.
PAID ACQUISITION ADDICTION
I’m not the first person to observe this, but, as common sense isn’t always common practice, I’ll continue. I saw a presentation by Bill Gurley at the Benchmark portfolio conference in 2006 where he effectively compared AdWords to a highly addictive drug. This was over 10 years ago!
Companies become addicted to paid customer acquisition because no one ever turns off revenue—unless they run out of cash for acquisition. You might as well move the expense from OPEX to COGS, because it’s never going away. At best, it’s a significant, permanent expense that will likely go up over time because media is a commodity that goes up in price as more advertisers join the network. At worst, it was a mirage and your CAC/LTV model was wrong because it was based on a short history and you didn’t factor in decay.
So why do companies do it? Well, paid acquisition is formulaic and therefore relatively easy. Creating a brand that resonates with customers, designing great products and finding organic ways to introduce customers to your company are all very difficult.
LOW GROSS MARGINS AND HIGHER OPERATING EXPENSES AS A PERCENT OF REVENUE
A quick study of publicly traded consumer brands such as Nike, Lululemon, Michael Kors and Under Armour reveals that their gross margins and operating expenses all fall within fairly narrow ranges. These businesses are at scale and therefore different than a startup. At the same time, every consumer product startup will eventually need to have their numbers in similar ranges in order to make a profit.
Unfortunately, another common trait I see is that many emerging product companies have much lower gross margins (and much higher operating expenses) than the public group. By low, I mean gross margins less than 45%, which is lower than nearly the entire public comp group.
Real gross margin includes duties, freight and a margin for distressed inventory. Unless the business has an unfair advantage that will eventually allow for exceptionally low OPEX (less than 35%), low gross margin signals a business with little future value, because low gross margin businesses struggle to produce real cash flow.
As we all know, eventually every business is valued on expected future cash production. Unfortunately, up until very recently, today’s venture capital market has been typified by huge rounds at high valuations into unprofitable companies with high growth rates—which, again, are often due to large paid acquisition budgets.
It’s a cycle that allows companies to become very large without ever fundamentally validating their businesses.
I don’t like to pick on any company, especially one where I wasn’t in the board meetings. But since they’re gone, Fab appears to be the quintessential example. Hundreds of millions of dollars were transferred from venture capitalists to Fab and from Fab to Google and Facebook. Yes there was a payroll and rent, but the acquisition spend was historic for a startup. The resulting growth obscured what was happening in that business and whether it had a durable model.
Except in the most competitive and clearly lucrative market opportunities, I prefer a different approach: grow organically and profitably until the value proposition is proven and then accelerate.
As an entrepreneur time is the most valuable thing I have. I want to know as soon as possible if the value proposition works. If it doesn’t, I need to pivot or shut down and try another idea. The worst situation is a startup that confuses a repeatable value proposition with validation from a CAC/LTV model or a venture capitalist.
As the entrepreneur, you could spend years building a business that’s never going to work. I maintain that when startups build paid acquisition as their first channel, the company’s real value proposition—and its ability to produce cash flow—remain unproven. Don’t be deceived: As my friend Bob Kagle likes to say, “It’s easier to raise venture capital than get money from a full price customer.”