There's a reason that Netflix and Terminix have grown to become the dominant players in their respective industries: they've figured out how to turn their businesses into streams of predictable recurring revenue.

But the secret to their sustained success goes even deeper into the area of customer acquisition costs. In other words, they have learned how much they can spend on acquiring new customers to fuel their continued growth without running out of cash. This - along with customer retention - is the secret to any recurring revenue business.

Let me explain.

By now, it's no secret that firms that create recurring revenue streams are valued far more highly than companies that rely on more transactional revenue events. But if you run a software business that charges a monthly fee instead of a big one-time fee, it's possible that you can spend too much money to acquire new customer.   This means you'll never get a payback on that investment, no matter how long they stay as a customer.

Since your revenue is deferred into the future, recurring revenue businesses need to be well capitalized.  But this becomes a huge problem when you're growing fast and you find yourself spending more than you're earning to land new customers.  No one wants to go raise capital with tough results like that.

While that might not be an issue for some companies, it might be wise to consider an alternative approach when it comes to designing your customer acquisition strategy. In short, if you want to take a lesson from Netflix and Terminix, you need to think about the lifetime value of that customer. You can calculate this figure by multiplying the amount of monthly recurring revenue each client generates by the number of months they remain a customer. No matter what the project lifetime of customer might be, you shouldn't go more than 3 years - 36 months.

The rule of thumb when it comes to how much you should spend to acquire a new customer is that you shouldn't spend more than 25% of the lifetime value of that customer. If you average customer stays with you for, say, three years, that might mean you can spend up to six months worth of their potential revenue to acquire them, with nine months as a maxiumum. If you can stay within that ratio, then you should be able to rapidly grow your business without having to always return to the market for more capital.

An example of this is a wine subscriptions service with good margins and a $50 monthly cost.  Their lifetime value of a customer is $50 x 36 months = $1,800.  But to maintain their cash position and grow, they shouldn't spend more than $50 x 6 = $300 to acquire a customer -  with $450 as an absolute maximum (25%). You might be able to go a bit higher for a very high margin product like software.

We've seen examples across all kinds of industries like software-as-a-service, home services, and other subscription businesses who have perfected this model. On the other hand, companies that see their ratio balloon out of the 25% range will always struggle to sustain their growth.

If your customer acquisition cost ratio is too high, there are a couple of strategies you can consider as remedies.

One strategy is to improve the efficiency and yields from of your sales and marketing processes where you find ways to generate more returns for every dollar you spend.

A second way to think about improving your acquisition ratio is to revamp your customer retention strategies. If you can keep your customers longer, say by increasing their tenure from three to four years, you can get your ratio in check.

Finally, a third strategy you can employ is to simply increase your prices. You can accomplish this either by raising the amount you charge each month or you can charge a sign-up or installation fee for new customers as a way to offset their acquisition cost. Even a nominal fee here can help tip the balance to help you get your ratio under 25%. 

So, take a look at your business model and do the math to determine how much you are spending to acquire your customer relative to how much they are worth to your business. If the ratio is higher than 25%, you might have some work to do.

Published on: Dec 12, 2017
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.