Optimizing your Customer Acquisition Funnel

This blog post focuses on how B2B companies can optimize their customer acquisition funnels using a customer-centric methodology to analyze and remove blockage points.

Acquiring customers in the B2B world involves using a variety of marketing and sales steps with the goal of converting prospective customers into paying customers. The process is often thought of as a funnel (see diagram above) where you pour in suspects at the top, and various steps in the process, some percentage of prospects successfully convert to the next stage, making the funnel narrower as the process evolves.

No matter how large or successful your business is, you will have at least one place that is a blockage point in your customer acquisition funnel. This is the point where the conversion rates from one stage to the next are not satisfactory, or the point where you have a scaling problem, (i.e. you cannot profitably increase the number of people coming out of that part of the funnel because you have maxed out the capability of one marketing or sales technique). If you solve that blockage point, usually it will cause another to appear somewhere else in the funnel.

As an example, you may have too few visitors coming to your web site, which you see as the top of your funnel. Or you might have plenty of visitors to your website, but too few of them signing up for your trial.

In this blog post, I will talk about a method that I have found to be highly effective at removing blockage points. There is enormous power in this exercise, as removing blockage points will increase conversion rates in your funnel. Readers of my prior blog posts on the importance of lowering the cost of customer acquisition (CAC), will know that increased conversion rates have a huge impact on increasing sales and lowering the cost of customer acquisition.

Identifying Blockage Points

The easiest way to identify your blockage point is to ask the question: “What is stopping us from increasing sales by 5x?”. Common answers to this might include:

We don’t have enough leads coming in the top of the funnel.
We have plenty of visitors to our web site, but not enough are converting to registered users.
We have plenty of users signing up for our freemium product (or free trial), but not enough are converting to paid users.
We can’t get meetings with the key decision makers.
We’re doing OK getting people to sign up as customers, but there is not enough growth in the account after the first sale.

The Most Common Causes of Blockage Points

Product/Market Fit

If you are a new startup just going to market, one of the greatest causes of problems in your customer acquisition funnel is that you have not yet found product/market fit. It is important to diagnose if that is the case, as the wrong diagnosis will likely lead to management wasting a lot of money on sales and marketing for a product that is not right. The correct course of action if this is the case, is to focus all your energy and attention on solving product/market fit. While you are doing this, you should limit your spending on sales and marketing to just the minimum level required to have adequate amounts of customer interaction to determine where your customers have the highest levels of pain and urgency, in an area that you can provide a solution. You will need to conserve your cash to continue to pay for product development to evolve a product that does fit the market need.

Solving for product/market fit is a topic that has been widely discussed elsewhere on the web, with great contributions coming from Steve Blank, and Eric Ries with the Lean Startup concept. This primary topic of this post is aimed at companies that are confident about their product/market fit, and who are now working on the next problem that should be addressed: optimizing their customer acquisition funnels.

Beyond Product/Market Fit

After many years of helping to diagnose problems in different companies’ customer acquisition funnels, I have observed that there is a common cause of blockage points:

For example, you may be hoping your prospects will come to your web site in droves. However you may not have solved the problem of how to make them aware of your site, and secondly of providing a motivation or reason for them to want to visit it. (A quick look at your web site might reveal that it is entirely sales oriented, and contains no content of interest to them.) Alternatively, you may be hoping that your prospects complete your on-line registration form and give you their email address, but they will find that step annoying, and be concerned that you will spam them in the future.

This happens because most companies design their customer acquisition process around their own view of the world, instead of first taking the time to understand the customer’s buying process, and their concerns at each stage.

Readers of my other article, Building a Sales and Marketing Machine, will know that I recommend designing sales processes from the outside in. i.e from the customer’s point of view. This involves mapping out the customer’s buying cycle first, and then designing a process to fit that. However since most companies have already got a sales process in place, that advice is less helpful to them. For those startups, the technique I will describe below will be more helpful as it will focus on fixing what is most broken in their current funnel.

Solving Blockage Points

Once you have identified your blockage points, the best way to start to solve them is to get inside your customers head and study their concerns at this particular stage of the sales process:

These concerns represent the friction in your sales process. Mapping these out clearly in a written form will give you the basis for the next step, which involves studying the possible things that you could use to motivate them to take the step or action that you want them to take:

Think of the concerns as being the friction in the process, and the motivations as being the forward pulling forces that you can use to overcome the friction.

The art is finding the right motivation that is great enough to overcome their concerns, and have them move forward in the sales process. This is where you need to muster your brightest and most creative thinkers to brainstorm the issue. Since customers have such an aversion to being sold to, and now have real control over the buying process, the old ways of moving them through a conversion funnel will usually have mediocre results. Getting superb results requires thinking outside the box and creativity.

Below I will walk you through a few examples to help illustrate how this works.

Problem: Driving Traffic to your Web Site

One of the most common blockage points for startups is right at the very top of the funnel: i.e. how to get found on the web. If you can’t even start a dialog with a prospective customer, then you have no opportunity to sell them.

A very common misperception amongst first time entrepreneurs is “If you build it, they will come”. Given the huge pressures of today’s always-on lifestyle with iPhones, BlackBerries, instant messaging, SMS, Twitter, social networks, etc., the average buyer is suffering from severe information overload. Their most scarce and valuable commodity is rapidly becoming their time and attention. Getting their attention by simply creating a web site and hoping for viral spread will not work in this environment.

Lets start by writing down their concerns and motivations:

Concerns

Don’t want to waste time on anything that is not immediately valuable and directly relevant to me
Hate being sold to
If it doesn’t come up in the first page of Google search results, I can’t be bothered to look further
Concern about whether they have found the best product/service for this category. (i.e. is there a better product out there that I haven’t yet found?)
Concern about whether this is the best deal (price) they can find for this product category
etc. (please add more in the comments section)

Motivations

I do have a problem to solve, and would love to find a solution to it.
If my friends recommend this product then I’ll want to check it out, and will be favorably disposed towards it
If I can get something for free, and it will help me with my life/work, then that is valuable to me
I am really interested in learning about XYZ (where XYZ may be totally unrelated to your product area)
I trust this review site/individual/consulting firm/etc. as an expert in this area, and would like to know what they have to say about the topic, and which products they rate as the best
I like to hang out on Web sites that entertain and educate me on areas that I am passionate about
etc. (please add your own thoughts in the comments section)

To get them to pay attention to you, you will want to think about giving them something valuable to earn their attention.

Example 1: Use a Free Product (HubSpot’s WebSite Grader)

A good example of using a free product/service as a motivator to drive traffic to your web site is HubSpot’s WebSite Grader tool. HubSpot is a company that sells a SaaS product aimed at helping small and medium size businesses implement Inbound Marketing. The components of their product include blogging, SEO, social media, etc. (In full disclosure, I am an investor in HubSpot.)

HubSpot’s two most powerful tools for driving traffic to their web site are a) their blog, which is full of valuable educational material on Inbound Marketing, and b) the free products, WebSiteGrader, AlertsGrader, TwitterGrader, etc. The first of these, WebSiteGrader, gives customers a way to find out how well their web site will perform in Google searches (SEO), and what can be improved to make it perform better. This leverages the third motivation in our list above: “If I can get something for free, and it will help me with my life/work, then that is valuable to me”:

There are several powerful lessons to take from WebSiteGrader in how it works to drive customer motivations to pull them through their sales funnel:

It is a free tool that offers customers a lot of value. Because of that, bloggers will recommend the product and users will tweet about it, spreading the word. (High value, low cost.)
It requires a very small amount of non-private information to get going (just a web site URL), and gives back a lot of value from that small amount of input. (Low customer effort.)
It offers a rating (score out of 100) which takes advantage of the competitive nature of humans. They want to get the best score, so if their score is low, they will likely want to improve it, and if that’s the case, HubSpot has the answer. (Leverages customer’s competitive instincts.)
It positions HubSpot as an expert in the SEO space, and it shows their ability to use technology to perform a task that is normally done by highly paid SEO-experts. (Leverages the respect accorded to experts.)
It builds trust between the customer and HubSpot, by creating a value for the customer (Trust is key to making sales.)
It has minimum sales pitch, and yet has a clear call to action at the end (see below). The two calls to action are carefully pitched in such a way as to offer more value for free to the customer. (The connection to the next step is obvious an natural.)

Contrast HubSpot’s approach to driving traffic and and providing value for free with the worst types of website that require you to give them an email address before they will allow you watch a marketing video that will tell you about their product. If you’re like me, this will drive you mad, and make you immediately dislike the vendor.

The key to success is to provide value first, which builds trust. Then at an appropriate time the customer will be more willing to offer their email address.

Using Engineering for Marketing

HubSpot’s WebSiteGrader tool is a great example of another idea that is really powerful: using engineering resources for marketing. The power of your engineers is that they can build things that can be used by your customers and provide value to them. These are powerful motivators to overcome friction.

These tools can also be hugely scalable. Compared to the traditional spend that you might put into marketing programs, this can frequently be a far better investment, and be more effective at building the right kind of relationship with your prospective customers.

The power of Education as a selling tool

If you are wondering what to offer to your customers to provide value, I have a suggestion to make: think Education. HubSpot’s highly trafficked blog is a great example of this in action.

Get inside your customers head, and understand what area they are most interested in learning about, and offer educational material in that area. It helps if this is in the same area as your product/service, but it is not essential. There is an interesting thing that happens when someone learns from material that is well put together and intelligent: They develop respect and trust for the person that is educating them, and will listen to suggestions that come from that person, including for products and service. Think of the following situation: you attend a course on social media marketing, and really like the material and the teacher. At the end of the course, they tell you that the product they use to manage their Tweets and other social interactions is XYZ. You are highly likely to go out an buy XYZ for that job.

You may have heard of consultative selling. In that role, the consultant places themselves at the same level as the customer. In the educational model, the teacher who does great work is automatically placed into a superior role to the person that is doing the learning. This is an important insight, and can be used as powerful tool.

Important note: most companies that I talk to think that they are doing this well, but a quick review of their materials reveals that what they think are educational materials are just thinly disguised sales collateral. This will not work, and will actually turn customers off. To do this well, you may need to hire a dedicated writer who is measured on the quality of material, traffic, and positive comments they generate.

Example 2: Using Data to drive customers to your website

Many companies collect interesting data as part of their business. Frequently it is possible to use insights gained from that data to create interesting articles or services that can be used to drive traffic to your website.

One good example of this is a company called Sysomos (recently acquired by Marketwire). Sysomos provides a SaaS service to help enterprises monitor the conversations going on in blogs and social media that might affect their company. The backbone of the service is a series of crawlers feeding data in to a huge and constantly expanding database. Sysomos uses the data that they have to search for interesting insights on any current topic, and then publish blog posts. Topics they have covered include insights on Twitter usage, social media and the Iranian election, the oil spill, Facebook, etc. Since the topics they look at are of high interest, these blog posts often get picked up by national media, such as The New York Times, and many other bloggers. These published articles and blog posts have led to major traffic increases for Sysomos’s main web site, which they convert to free trials, and then closed customers.

If you don’t have your own data, then collect it from customers

After reading the above, you might be wondering how you could do something similar, but realizing you are held back by not having a data source. Don’t let this hold you back. There are several examples of companies that decided to issue surveys to get collect that data, promising people that participated that the would have access to the results. Amongst businesses there is a strong desire to learn how they stack up relative to the peers and the best in the industry.

One example of a firm doing this is PriceWaterhouseCoopers, who collect data on venture funding, and publish a report called the MoneyTree. This helps them get the attention of VCs and venture backed companies who are their prospective customers.

Another example of this is a Dutch SaaS business intelligence company called Mirror42. Mirror42 has created an on-line KPI repository that tracks the Key Performance Indicators (KPIs) that are used in various different vertical industries. They have over 200,000 users signed up to use and contribute to the database. Customers can also compare their performance in this KPIs to industry benchmarks, which is highly valuable. Mirror42 then uses these customer relationships to market their SaaS offering.

Top of the Funnel: Harvesting Demand versus Creating Demand

A important note for those readers considering the concerns and motivations of people that they are wanting to attract to the top of their funnel: there are two actually two different classes of customers that you will be dealing with:

Type A: Those that are aware that they want a solution where your product fits the bill
Type B: Those that are not aware of your product category, and aren’t aware that it could benefit them

For Type A customers, you need to Harvest Demand. For Type B customers you will need to Create Demand.

For Type A customers, the most likely starting point for an interaction will be a Google Search, since they are likely looking for a product to solve a particular need. For Type B customers, the problem is much harder, and will likely cost you more effort and money. You will have to reach them in some other way, and get them to hear about your product. The very best method is having them hear about you from a trusted source such as a friend, respected blogger, main stream press, etc.

These two audiences require different marketing programs, and have different motivations.

2nd Problem: Getting Customers to Register

Another frequent problem are in conversion funnels is the point where you want your visitors to register and provide you with their email address or other contact information.

Let’s look at their likely concerns and motivations:

Concerns

Don’t like to give their email addresses, as they hate getting spam emails from vendors
Distrust vendors with my email. Not sure how they may abuse this in the future. You need to earn my trust that you won’t abuse this.
That information is personal, and the time it takes for me to deal with your future emails has considerable value. You need to earn the right to ask for that.
You are asking me to put my valuable time and effort in to trying out your product. I have concerns about whether it will be easy to use, fast to evaluate, and effective at meeting my needs.
etc. (please add your own thoughts in the comments section)

Motivations

I have a problem, and would like to find a solution. I have seen enough about this product/service in your intro video/content, that I believe it will work and take away my pain.
This site seems to have enough positive feedback in comments from users, and reviews from the press that I feel it is likely a good product, and worth my time to try
I care a lot about being amongst the best in my industry. These guys have data that will allow me to benchmark myself against my peers. That is valuable. (If I find out I am below the industry top performer group, or not following best practices, I will want to improve.)
I’d like to impress my boss/co-workers with my ability to come up with clever ideas and solutions to problems that we have
I am passionate about XYZ and like to learn more about things in that area
I have heard about this from my friends, which means I believe that it is very likely to be good, and worth my time
etc. (please add more in the comments section)

Example 3: Move gratification upfront

Many of the good marketers that I have worked with talk about the time to Wow!. That is how long it takes before your customer gets to the point of Wow! (i.e. experiencing some gratification from use of the product). The conventional approach to registration is to make the customer register before they can get to experience the Wow! moment and get some gratification.

If you are doing this, you may want to try a different approach, and place the Wow! moment before you ask them to register.

Examples of companies that have done this well are:

uberVU (www.ubervu.com), a social media monitoring service which allows you to enter your website’s URL and see a partial version of their reporting before signing up for a free trial (which requires registration).
Posterous (www.Posterous.com), a blogging site which doesn’t require you to sign up to start using it. You simply email them your first post, and it get’s your registration information from your email address (pretty clever!).

Example 4: JBoss

JBoss, the Open Source Java middleware company, leveraged two powerful customer insights to create a very high growth business. The first was that giving the product away completely free would create immediate interest and viral growth. This worked extremely well: the free product was downloaded over 5 million times.

However that first insight created the next bottleneck in the funnel to solve: the millions of users that had downloaded the product for free had not registered, as JBoss felt that putting a registration in front of the download would greatly reduce download volume. In order to market paid services to that user base, JBoss needed to get the contact information for these users. At the time that we did the brainstorming session to apply this methodology, they were charging money for the documentation, which was bringing in a very nice steady revenue stream of $27,000 every month. The solution to the blockage point was to offer the documentation for free, and use that as an incentive to get them to give us their email address. Because of the significant revenue hit this entailed, it took a while to get everyone’s buy-in, but once implemented, the process generated 10,000 leads per month, which grew over time to 16,000. (The full story behind JBoss’s success can be found here.)

Example 5: Getting a meeting with a Decision Maker

The second company that I started in 1986 was called International Software, which later became the European branch of Corporate Software. 1986 was the time when PCs were just starting to be adopted by enterprises. Before International Software, the typical way you purchased a PC and associated software was through a store like ComputerLand, or BusinessLand. However the problem with these stores is that they primarily focused on the hardware, and didn’t stock more than 5-6 software titles, and certainly didn’t know how to demo them or support them. We spotted an opportunity, create a new channel that only sold software, and focused on the needs of enterprise buyers. We would stock a huge range of products, and provide excellent consulting advice on which products to use, as well as great support.

When I first started the business, I purchased a copy of the Times 1,000 top companies in the UK, and started at the top, dialing the biggest companies, trying to reach their PC buyers. Not too surprisingly, I would get to voicemail, leave a message, and not get a call back. This was a frustrating blockage point, and there was clearly lots of buyer friction at this stage in the sales funnel.

I started brainstorming for a solution: One of the key parts of our service was content. We published The International Software Guide, a 600 page book that reviewed almost all the software products available for the PC at that time. The book was given to our customers as part of our service if they purchased their software from us. It was highly impressive (see below).

My insight was that if I sent them a free copy of the book first, and then asked them for a meeting, I might provide them with proof that we were different, and capable of providing more value to them than all the other vendors calling on them. The results were spectacular: I went from a 2-3% success rate in getting meetings to around 90%!

(Once in the meeting, our value proposition was so compelling that we converted approx. 50% to customers within a month of the first meeting. The company grew to $100m in sales in four years, and was incredibly capital efficient.)

In today’s world we have the web, and print media like that book are a thing of the past. Using compelling high value content on the web is the modern equivalent of the above story, and is exactly how companies using Inbound Marketing are driving web traffic.

Example 6: Getting to Executive Decision Makers

One of my portfolio companies, Enservio, sells high value products and services to Insurance companies. As part of their sales process, they need to get to senior executives in the insurance industry that are capable of making decisions. Not surprisingly, the average sales person will struggle if they simply try to cold call those executives.

While sitting in the audience of a TechCrunch 50 presentation, the CEO, Jon McNeil, had the brilliant idea to hold a similar conference for executives in the insurance industry, bringing together the very best startup companies that were innovating in the insurance industry. They put together an annual Claims Innovation Summit, and pulled in prestigious speakers from highly respected analyst and consulting firms, and invited speakers from within the industry to add valuable content around the startup presentations.

The net result was a great success, attracting executives that their sales people could never get to. Not only did they get hard-to-reach executives to the event, but due to the incredibly professional way in which they managed the event, they built trust with those executives, which is a key requirement before a sale can be completed. (A key part of that professionalism was to avoid the temptation to use the event as a selling platform, and to stick to valuable educational content.)

The other benefit of getting executives to an event like this is the amount of time that was available for relationship building. This worked far better than a typical short meeting in an office setting.

Example 6: Applying the technique to Web Site Design

Most web sites represent a mini-funnel in a marketing process where you’d like to move your customer from through a series of steps/pages to the point where they will sign up to purchase your product, download your trial, etc.

The great thing about web sites is that we can get precise analytics that tell us where the bottlenecks are occurring. To improve the conversion rates at these bottlenecks, I have found it highly valuable to apply this same technique: i.e. document the customer concerns and brainstorm the possible motivations that could be used to help get them to move through the bottlenecks.

One of the other powerful techniques I highly recommend for this purpose is A/B testing. When coming up with new ideas for content on pages, split the traffic so that one half goes through the new page and the other half goes through the old page. Or try two variations of the new page with different wording to optimize the conversion rate. Once you have found the winner, repeat until it’s clear which messaging is having the best effect.

Take a look at the Posterous screen shot below. It has some great examples of how to address customer concerns:

You have to like how they put a redline through Step 1: Create and account, highlighting the fact that you don’t need to register to set up a Posterous blog.
Use a quote from a well known name, in this case Leo Laporte, to reinforce the fact that it really is easy to get going.
Make them feel comfortable that thousands of other customers are using the site, so they can feel comfortable that others like the site, so they probably will, and the risks of anything going wrong with their personal information are likely to be low.
The “Who is it for?” provides a nice way to allow each user type to get comfortable that this site has features that make it well suited to their needs. Without this, there is a risk that a power user could see the site as too simple for them, given all the focus on simplicity in the messaging.

One thing missing from the above screen that might add value to lesser known sites is some quotes from reviews that say positive things about the product. (I also personally like to see a video demonstrating any new product right on the front page, as it is the easiest way for me to see how a web service works.)

Brainstorming

It is important point to realize that all sales and marketing funnels have blockage points. As soon as you remove one blockage point, another one will appear elsewhere in the funnel. This means that there is always room to improve. I recommend using quarterly brainstorming sessions where the key execs including the CEO, heads of sales, marketing, and product, get together to work on coming up with creative ways to address the latest blockage point using the technique described in this post: Analyze the customer’s concerns and seeing if it is possible to come up with a motivation that will overcome those concerns.

When running these sessions it is highly valuable to have a flow chart diagram of your sales and marketing funnel process as one of the starting places for discussion. Without this diagram, you are unlikely to find that all the players have the same picture of what is going on.

I also recommend that the customer concerns, and possible off-setting motivations, are written down on a white board or similar during the meeting.

Assigning a person to become the customer

In my own startups, I found that I naturally gravitated into the role of being the person who tried to think like the customer, and represented their point of view to the rest of the group. In other companies, it is not always going to be clear which executive has the best natural tendencies to play that role. I recommend that you choose one person from the executive team to play that role, and encourage them to become intimately familiar with how your customers think. This will only happen as a result of them spending time with a lot of customers listening and and asking questions. Then in the quarterly brainstorming meetings their job will be to ensure that the voice of the customer is heard loud and clear.

The importance of Metrics

Elsewhere in this blog, I have talked a lot about the importance of metrics (here and here). If you don’t measure your funnel’s performance, you have very little chance of understanding how to improve it. also when designing any of these creative solutions, you will likely want to understand how effective your solution is, and whether is providing a good return in the investment you made. They key metrics you need are shown in the diagram below:

You will want to measure the number of prospects going into each stage, and the conversion rate to the next stage. You will also care about the overall conversion rate of prospects from the top of funnel to closed deal, and the average deal size.

The shape of your funnel will likely vary for each different lead source. e.g. a leads from Facebook ads may not convert well into trials, but those that do convert to trials may have a higher conversion rate to closed deals than normal web traffic, and the deal sizes may be larger. That means you will need to track the funnel metrics separately by lead source.

These metrics will show you your funnel blockage points, and help you understand whether your actions to improve funnel flow are working.

Summary

All sales and marketing funnels have blockage points, and as soon as you remove one, the blockage will move to another place.
Blockages are frequently caused because you are hoping your customer will take a step in your process where they are not adequately motivated to do that step.
By analyzing their concerns, and brainstorming with creative thinking executives, it is often possible to figure out customer motivations that can be used to offset their concerns, and get them to willingly take that step.
The best solutions often require out-of-the-box thinking.
Free products, educational content, and insights based on data that you may possess or collect are examples of tools that can be used as motivations for your prospective customers.
Removing blockage points increases conversion rates in your funnel, which is one the most important things you can do to increase revenues and profitability. (A small improvement in conversion rates can dramatically lower your cost of customer acquisition.)
I recommend setting up quarterly brainstorming sessions to focus on removing blockage points, which could also be referred to as increasing conversion rates.
I also recommend choosing one executive to become the voice of the customer, and setting them the task of getting inside your customers’ heads to understand how they think and react to all stages of your sales and marketing process.

Posted in Startup Help.

Tagged with freemium, Harvesting demand versus creating demand, Hubspot, Inbound Marketing, JBoss, Lean startup, Mirror42, Optimize customer acquisition funnel, Remove blockage points in sales funnel, Sales funnel, sales process optimization, Sysomos.

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By David Skok – July 15, 2010

What drives great entrepreneurs

If any of you read one of my blog posts entitled “Six Things VCs look for in an Investment,” you may remember that the first entry on the list is “An Extraordinary Entrepreneur with Unique Insight.”

I recently watched an outstanding presentation called “How great leaders inspire action” by Simon Sinek (embedded at the bottom of this post). It inspired me to write about my own experiences as an entrepreneur that relate to his message:

I meet with a lot of would-be entrepreneurs and executives that are looking to get into the world of startups. During those meetings I can often detect which people are truly cut out for this world, and those that are really looking to get in with the hopes of making some fast money. For the latter, I always tell a story about a life changing event that happened to me:

My first and second startups were driven because I was doing something that I was truly passionate about. It was what I believed in. (In Simon Sinkek’s terms, I was doing this “because of the Why”.) After I got married, I mistakenly felt a need to make money, and so I looked around for a situation where I could make money quickly. I found a turnaround, which was a bankrupt hardware company (Xionics). I did care about the industry that they were in, but rapidly found that I personally had no passion the hardware business. I hated it, because as the hardware vendor, I was reliant on the software vendors to drive the innovation that could sell the solutions that would drag through our hardware. The problem was that the software vendors were all old school, and not building anything innovative. This became one of the most unhappy times of my life. Eventually I became so unhappy with the situation, that I created an internal startup software project, that we later spun out as a separate company (Watermark Software). I did this so that I could take charge of my own destiny and become the innovator.

I remained a major shareholder and board member in the hardware company, Xionics, and the board hired a great entrepreneurial CEO who developed a new mission for Xionics that he was passionate about. This led to both companies becoming successful. The hardware company went public, and was eventually acquired at a great price. And the software company was acquired for a 5x return within two and half years.

The big lesson I learned was that, in the startup world, if your primary focus is on making money, you usually won’t make money. When you work because you are passionate about your work, I believe you will maximize your chances of making money. Usually it will happen in a way that is totally unexpected. And it will likely happen at a time that is unexpected.

In my case, my passion in life at that time was building truly great products that would delight customers and change their lives for the better. (Later on, when I became a VC, my passion changed to helping other entrepreneurs.)

Why building a company for an exit usually won’t work

As a VC, I often hear entrepreneurs making pitches where some part of the presentation focuses on how they are going to exit from their companies. I personally find this to be a turn off. I realize that this viewpoint is unusual for a VC, as many VCs see this as an important attribute of a good investment. I am far more interested in finding entrepreneurs that have no thoughts of exit, and who would love to see their company become a leader in its field, and stay with it as it undergoes that journey. Those are the kinds of entrepreneurs that have the ability to be great leaders. Their passion will inspire their employees and drive customer loyalty.

Whenever you see a company being built for an exit, you will see short term decision making. You will find people thinking about how various moves will be perceived by potential acquirers, or what will get the company to an IPO where they can cash out their shares. That leads to short term decisions that are often in conflict with what makes for great companies, which is a maniacal focus on building spectacular products that delight customers.

It is also important to note that if you are hoping to sell your company, you don’t control that process or decision. As is often repeated in the startup world: companies are bought, not sold. i.e. the acquiring company has to make the decision that they want to buy before there can be an acquisition.

When you talk to the acquiring companies and ask them what they are looking for in businesses that they want to acquire, they will tell you that they are looking for companies that have been built to remain independent. Those are the businesses that have the loyal and dedicated employees that are passionate about what they do. Those are the employees that they want to have on staff.

They will also tell you that they can usually smell companies that have been set up for a quick sale a mile off, and they usually run away from them. Or at best, they will pay a low price to acquire them as they know the employees are tired and not likely to stay and be excited about the next phase of the company’s life after acquisition.

Why great startups are often started in bad recessions

Around the years 1999 and 2000, the startup world was invaded by a range of newcomers that were attracted by the prospect of making a fast buck. They had seen all sorts of dot com companies with crazy business plans go public and get amazing valuations. In my opinion these newcomers were not really true entrepreneurs. They were not motivated by a powerful inner drive and passion to build something wonderful. They were motivated mostly by money. The net result were some of the worst startups we have seen.

When things changed in 2001 and the IPOs vanished, the startup world became a very tough survival environment. The visitors disappeared back to other jobs where they thought they could make more money. However the true entrepreneurs stayed. They battled the harsh funding environment even though they realized the chances of making money were slim. They did this because they were passionate about their ideas. Most had to live on substantial pay cuts. Not surprisingly many of the best startups were started in this kind of environment.

So if you are attracted to the world of startups, ask yourself this question: are you here because you are passionate about what you will be doing? Or are you here because you think this is a great way to make money? If it is the latter, I believe your motivations will have the effect of leading you to disappointment.

The best employees are attracted to a big vision

The other lesson that I learned from my own startup experience was that there were two types of employees: the one type saw a startup as just another job, and put in just the right amount of work. The other type bought into the vision, and dedicated most of their waking hours to finding creative ways to make the vision come true. Clearly the second type were the more valuable even if they had less experience than the first.

It wouldn’t be uncommon to find the first type asking questions about how long would it be before the company exited. But the second type would be far more focused on the vision, and the bigger and bolder the vision, the more interesting and exciting were the types of people that would be attracted to join. To hire this level of individual requires a founder and CEO that are able to convey passion for their mission in a way that is credible with smart people who will question whether it is achievable.

What Simon Sinek’s presentation can teach startups

As soon as you watch the presentation below, it will become immediately clear that startups need to be focus energy on selling the Why, and not the What. You all started your businesses because you were passionate about what your product could do to change the world. Don’t be scared to tell the world what your grand vision for change is about.

For a good example of a company that does this very well, take a look at this video: HubSpot acceptance speech after winning Best Place to Work in Boston 2010. You can see Brian Halligan, HubSpot’s CEO clearly express their grand vision for how they want to change the world, and how that has led to a highly motivated workforce that believes in the mission and loves their work.

Let me not steal from Simon’s message. Instead I strongly encourage you to watch him tell this fascinating story.

Posted in Startup Help.

Tagged with Entrepreneur motivation, Hubspot, Leadership, startup business plan exit, Startup exit, What makes a good entreprenuer, Why startups are started in recessions, Xionics.

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By David Skok – June 12, 2010

Two Excellent Startup Presentations

Readers of this blog will likely really enjoy the following two presentations that discuss lessons learned by the founders of both DropBox and Xobni. There are lots of great lessons to be learned here.

Dropbox Startup Lessons Learned

From Zero to a Million Users – Dropbox and Xobni lessons learned

Posted in Startup Help.

Tagged with DropBox, lean startup principles, lessons learned by entrepreneurs, When is the best time to launch a startup?, Xobni.

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By David Skok – May 17, 2010

How Sales Complexity impacts your Startup’s Viability

There is no question that success for the entrepreneur starts with a breakthrough (or at the very least great) product or service. Yet too often, entrepreneurs fall into the “field of dreams” mentality (in the words of Terence Mann, AKA James Earl Jones: “build it and they’ll come”). But the truth is that defining the product is just the beginning. Entrepreneurs must spend significant time thinking about the complexity of their sales process and the cost of customer acquisition, as these factors will strongly impact a company’s ability to make money and attract investors.

An obvious requirement for a successful startup is that they are able to make more money from a customer than they spend for a customer, i.e. Lifetime value (LTV) should be greater than cost of customer acquisition (CAC) (see my prior blog post, Startup Killer: the Cost of Customer Acquisition). In this post, we’ll focus on the complexity of the sales cycle for various different types of B2B software and hardware products, and looking at how that impacts the viablity of startup business models by increasing CAC. And I will introduce a “zone system” that entrepreneurs can use to help evaluate different start up sales models.(Note: This post is primarily about B2B technology companies. Some of the concepts may apply to B2C internet, or to other industries, but it was not written with them in mind.)

Understanding Sales Cycle Complexity

Let’s start by looking at the sales cycle spectrum. Some products/services are easy to sell, and buyers will feel comfortable buying them online the first time they visit a web site, while other products and services require complex sales cycles with multiple on-site visits, meeting with various decision-makers, a protracted proof-of-concept trial of the product, etc.

The following diagram attempts to portray the spectrum that exists from the simple to the complex:

(Note: The categories shown are not hard and fast ways to define sales complexity, but are designed to provide a framework for discussion. For simplicity, I have also left out channel sales at this stage.)

Freemium

In this model, some version of the product or service is given away, with the goal of up-selling or cross-selling over time. Think Open Source products like JBoss, MySQL, and Asterisk, and web services such as DropBox and SugarSync. (Note that only some portion of the free customers will likely convert into paying customers.)

No Touch Self-Service

Here you drive traffic to the web site using SEM/Pay per Click ads, SEO, Inbound Marketing, Freemium, etc. Visitors convert to paying customers without any need for salespeople. The product needs to be simple to understand, and have a compelling value proposition.

Light Touch Inside Sales

In this model, you might provide some light level of human touch such as email exchange to answer questions and provide customer support. A slightly higher level of touch might involve a phone call with an inside sales person.

High Touch Inside Sales

Here you still sell your product/service over the phone, but the amount of work in closing the deal requires several phone calls, sales engineers, and/or web-based demos.

Field Sales, and Field Sales with SE’s

Now you require an on-site visit using a field sales organization. You might also need multiple on-site visits, selling to several decision-makers, use of SE’s (sales engineers), and perhaps on-site proof-of-concept installations that take considerable SE time.

Impact of Sales Complexity on Customer Acquisition Costs (CAC)

If you are like me, you would expect the Cost of Customer Acquisition (CAC) to rise as sales complexity increases. So the first time I talked about this topic, I drew the following simple graph:

However, when I looked a little deeper into the costs, a very different picture emerged. The diagram below shows rough estimates of how CAC increases with the complexity of the sales process. (For a look at the spreadsheets that support these estimates, take a look at the embedded spreadsheets in Startup Killer: the Cost of Customer Acquisition.)

Now let’s create a more accurate graph with these estimated numbers:

What we see above is something quite surprising: using the rough numbers that I had estimated for these different categories, CAC appears to increase exponentially as Sales Complexity increases.

To help understand this phenomenon further, I looked at the estimated numbers against a logarithmic scale:

The above diagram illustrates the same phenomenon in different way: using my estimated numbers, the cost of customer acquisition (CAC) jumps by about 10x as you move between these different sales models.

A warning about the data and the graph

Readers should be aware that there can be substantial variation in CAC for different real world companies from my estimates. The key driver of variation is the conversion rates and time taken at various stages in the sales cycle. However, despite that, I believe the diagram is a good indicator of the correlation between Sales Complexity and CAC, indicating a major rise in CAC as additional human touch is added into the process.

Reducing CAC by reducing Sales Complexity

The numbers indicate that it is possible to reduce CAC by very significant amounts if you could change your sales model from:

Inside Sales –> No Touch
Direct Field Sales –> Inside Sales

This is obviously much easier said than done. But the impact is so powerful, that it bears serious thought and brainstorming.

What causes Sales Complexity?

To understand if we can reduce sales complexity, we need to understand its causes. Here is a quick list of things that will make a product or service have high sales complexity:

Complex to understand and/or evaluate, install, configure
Requires multiple people to get a purchasing decision (frequently caused by a high price)
Mission critical
Has high cost if it fails (e.g. data loss, significant financial impact), and the risks of failure are high
Expensive – high cost to the purchaser, and/or takes a long time to get an ROI
Affects many other IT systems, people or departments
Requires significant change to the way people work
Requires the purchase of other elements, or integration/development work to make a complete solution
No customer references that have the same usage needs as the buyer
Pricing complexity, where the buyer can’t easily figure out the right configuration, etc.
Custom contracts need to be negotiated

The list is probably incomplete, so please add your own thoughts via comments.

There are two other factors relating to your buyer that can make it harder to sell a product:

Where there is low customer pain
Where there is no sense of urgency

If you are an entrepreneur looking at your next startup, the following sections will help you understand the impact on your business of a product or service that has the specific sales complexity properties.

Customer Monetization (LTV) must exceed CAC

As stated in the introduction, for a profitable business the money that you make from your customers must exceed the cost that it takes to acquire them. i.e. LTV must be > CAC. (This topic is covered at length in Startup Killer: the Cost of Customer Acquisition.)

As Sales Complexity and CAC increase, this means that businesses need to find a way to charge their customers more money for their product/service to remain profitable.

To get a customer to pay for a much higher priced product in today’s tough economic environment, I believe there are three driving forces that need to be in place:

Value: the customer needs to perceive that they are getting good value for the money they are paying
Pain: the customer needs to be experiencing some significant pain that they need to see resolved
Urgency: there needs to be a sense of urgency to get the problem resolved

The combination of these three factors could be said to equate to your ability to monetize the customer (Lifetime Value of the Customer, or LTV).

Lets look at what happens when we plot Value/Pain/Urgency with a logarithmic scale against Sales Complexity:

Startups that fall below the line are likely to be in the Unprofitable Zone where their buyers will not be willing to pay them enough money to cover just their sales and marketing costs. See diagram below:

A Zone System for evaluating Startup Sales Models

Using the above chart, it is now possible to group startups into a series of interesting zones based on the complexity of their sales process. Lets start with the Red Zone.

Red Zone 1 (Field Sales)

As you might imagine, the color red signifies danger. Startups in Red Zone 1 usually have high priced sales people selling direct to the customer. Given a typical number of deals that those people can work on at any time, this will drive a high CAC number. (For the spreadsheet showing how sales productivity in terms of deals closed per sales person affects CAC, see Startup Killer: the Cost of Customer Acquisition.)

The only way to cover the high CAC number is to close high priced deals. In a strange twist of fate, charging your customers more money has the unfortunate effect of increasing sales complexity (because it lowers the perceived value for money; involves more people in the decision making process; and potentially introduces budgeting issues).

There is also another fundamental problem: buyers see high risk in purchasing from startups as there is a perceived high risk that those startups may not be around in the long term. This is the so-called “Safe Choice” problem, which adds to the sales complexity, and makes an already tough problem considerably harder.

Other problems that are likely to affect companies using direct sales forces are:

Lumpy deal flow that makes revenue forecasting difficult and unpredictable
Deals tend to close at the end of the quarter, which can make life uncomfortable for executives and the salesforce

Despite how difficult it is to be successful with a direct sales force, it is possible to be very successful in this area provided your product/service gets a high score on the Value/Pain/Urgency axis, allowing you to charge enough money to cover the high cost of customer acquisition. If you are an entrepreneur thinking about an idea in this area, I would caution you to remove the rose colored glasses, and ask yourself some very hard questions about your value/pain/urgency score, to make sure you don’t end up in the failure zone, like so many other venture backed companies. Given my own experiences in this area, I have seen only a small percentage of these make it into Blue Zone 1.

Despite the difficulties, good companies can successfully make it to Blue Zone 1. Matrix Partners has done very well investing in this area, and will continue to seek out good ideas in this space. Examples of successes in the Portfolio include:

Netezza (IPO-ed in 2007) with an average initial deal size of around $1m
Starent (recently acquired by Cisco for $2.9Bn) that successfully sold wireless data infrastructure equipment to wireless carriers. Very high LTV per customer.
Aruba (IPO-ed in 2007), sold wireless infrastructure to enterprises. High LTV per customer.
Airvana (IPO-ed in 2007), sold infrastructure to wireless carriers for 3G data services. Very high LTV per customer.

Using Strategic Partners

There is one very good strategy that companies in Red Zone 1 can follow which will move them into Blue Zone 2, and that is to sign up strategic partners like IBM, HP, Oracle, etc. to resell their products for them. These companies have built successful direct sales organizations and have the credibility with customers to get around the “safe choice” problem. A couple of my porfolio companies that were very successful at doing this were AppIQ (acquired by HP) who leveraged relationships with HP, Sun and HDS; and Diligent (acquired by IBM) who leveraged a relationship with HDS. To play this game right, ideally the partner should sell a platform version of the product, leaving open the opportunity for the startup to go back to those customers and up-sell them additional modules, thereby establishing its own customer relationships. Companies that only sell through one or two OEM channels and have no direct customer control are valued far lower than those with a broad set of customer relationships.

Another option is to try to move to selling through a VAR channel, but this move needs to be done early in the company’s life to get the culture right, otherwise it can be very difficult to change later.

Red Zone 2 (Channel Sales)

Channel Sales is complex category that is not easy to represent on this chart. It could span a range of complexity/CAC values depending on whether the channel management program is human intensive or not.

For simplicity sake, I chose to show channel in a zone between inside sales and field sales. I also chose to place this in the Red Zone, as it can be very hard to get a channel started and working well. Entrepreneurs and startups tend to underestimate just how hard this can be, and how long it will take. Success requires a deep commitment to channel partner recruitment, training, support, and sales & marketing assistance. It may also require field sales people working alongside the channel if there is no existing demand in the market, as channel partners are not good at creating new markets or evangelizing a major new concept.

In this model, it is often more about your ability to successfully build a network for partners than it is about the uniqueness or marketability of your product.

The Amber Zones

The Amber Zones are a less dangerous place to find yourself as a startup, as your cost of customer acquisition can be low enough, that your primary problem is solving how to provide enough value to your customer in an area where they have adequate pain and urgency.

Amber Zone 1 (Freemium): this zone is for companies that have used a free product to acquire non-paying customers, e.g. Open Source. The challenge for these companies is to figure out how to monetize their customer base without damaging the growth of the free product. A good example of this kind of company is one of my portfolio companies, Digium, which produces Asterisk, the Open Source telephony server (most frequently used as a PBX). Asterisk is downloaded approximately 4,000 times every day. Digium has several strategies for monetizing its market position, including offering support, and a premium version of the product, Switchvox, that turns Asterisk into an easy-to-use, and bulletproof, PBX.

Why Amber and not Red?

There are two reasons why I prefer to use Amber as a color to indicate less danger than Red for these zones:

CAC is low enough here, that the challenge of figuring out how to increase value to move to the Green Zone is not as hard as it is for companies with higher CAC numbers.
Companies in the Amber Zone are likely to have the ability to leverage the transformational effects of the Internet on sales and marketing. See later section entitled: Make full use of the Web for Sales and Marketing for more details.

The Green Zones

The Green Zones represent a great place to make money. These are areas where I am particularly focused on finding investments.

Green Zone 1 (Freemium) can work well where the free version of the product is highly attractive to customers and drives considerable numbers of people, and when the conversion rate to paying customers is high.

Usually there is some additional selling work to do to convert the non-paying customers into paying customers. (e.g. JBoss used an inside sales organization, and Digium uses both inside sales and a channel to convert its customers to paying). Hence the arrow in the diagram above.

Green Zone 2 (No Touch Self-Service): One of the most powerful B2B business models. These companies in this zone have found a way to create very clear value propositions for their products/services that can be easily understood just by visiting their web sites. Having a touchless conversion from website visitor to buying customer means that all your focus should be on maximizing visitor traffic to your web site, provided you can do that and keep CAC at a reasonable level below your LTV (the lifetime value of your customer).

Green Zone 3: (Inside Sales): An attractive business model provided that you are able to appropriately monetize the value that you are providing to your customers. If your business is in this zone, it makes sense to ask questions about how to further simplify your sales complexity, and even ask if it might be possible to move some set of customers into a touchless conversion. There is the possibility of a very significant reduction in CAC if you are able to do this.

Winning by reducing your Sales Complexity

Product / Service Design plays a crucial role in Sales Complexity

A big question that this whole blog post raises is whether it is possible to take a product/service that has the properties described above in the section called What Causes Sales Complexity, and change them so that can use a less complex sales model. It is my current belief that the primary way to do that is to redesign the product/service to eliminate the issues.

SaaS example

By moving from a an on-premise, enterprise software product to a SaaS model, a company changes the following elements that contribute to Sales Complexity:

Eliminates the need to involve IT in the decision making process
Makes it easy for the customer to try the product
Eliminates the need for any on-site installation, or new equipment purchases
Greatly reduces the initial size of the $’s that have to be allocated to purchase
Moves the expenditure from CapEx to OpEx which is usually an easier decision
Greatly reduces risk for buyers, as if it doesn’t work, they can cancel and stop paying

This has the following effect on the diagram:

Freemium

Freemium offerings can aim to reduce sales complexity by doing the following:

Making it easy for the customer to try to the product
Eliminating risk for buyers, as they don’t pay for other services or upgrades until they have seen some results from the free version

The best Freemium offerings are like DropBox. They provide the full functionality of the product for free, but find a measurement that the customer will likely exceed that draws them into paying. By the time the customer reaches this threshold, they are likely very happy with the product and inclined to pay without too much difficulty, and also hooked by its sticky features (i.e. they have a lot of files on the system that are being shared with others that would be hard to move elsewhere.)

Free Trials

In a similar way, free trials reduce sales complexity by:

Providing a very powerful way for your customers to ensure that your product will solve their problem
Greatly reduce the risk for the customer when purchasing.

These are both important steps to allowing your customers to sell themselves.

Open Source

Open Source software has a similar transformative effect on Sales Complexity. By making your software free and Open Source, you change the following:

Make it easy for the customer to try the product
Eliminate risk for the buyer, as they don’t pay for other services or upgrades until they have seen some results from the Open Source version
Greatly reducing the $’s that have to be allocated to purchase versus Enterprise software
Lower customer risk if the vendor fails as you have a community that can support you

Leverage the Transformative Power of the Web for Sales and Marketing

The wide new range of tools available including SEO, SEM, the Social Web, Inbound Marketing, viral techniques, etc. all combine to provide a savvy marketer with great ways to generate low cost web traffic. Then once you have those visitors, other web tools allow the use of rich interactive media, videos, free trials, etc. to answer buyers’ key questions, and handle their objections. Businesses that are expert in this area have a huge cost and business model edge over those stuck using human touch which is expensive and doesn’t scale easily.

Leverage Engineering to solve Sales and Marketing problems

There are a few ways that engineering resources can be used to help with sales cycle complexity. In particular Engineering needs to adopt the cultural mindset of designing and building the product so it is far easier to evaluate during the buying cycle.

Sometimes, doing this well might involve building a separate version of the product just for evaluation. A good example of the latter is CloudSwitch, which produced a free Express version of its product that has a greatly simplified user interface from the Enterprise edition.

Leverage Channel Partners to do more of the Human Touch

To the extent that your company is doing the human touching, it is very expensive from a CAC perspective. When channels are engaged, CAC to some degree migrates to more of a variable cost model in that there is some ongoing expense associated with training and managing the channel, but once a channel is trained and productive, that burden lessens. Subsequently, “others” are spending their dollars on CAC, and the manufacturer pays for success on a variable basis through margin to the partner.

The Internet Divide

One of the more interesting developments in the software industry is the emergence of a new breed of companies that have leveraged the revolutionary effects of the Internet together with either a touchless sale or inside sales model. That combination has created a far lower cost of sale than was previously possible for selling complex software. Pioneers in this area include JBoss, SolarWinds, Acronis, and HubSpot. These companies have developed new techniques and scientific approaches to lead generation, marketing automation, and inside sales, and used those advances to sell software in high volumes at low prices. This is in stark contrast to the old way of selling enterprise software which is very human intensive, and expensive.

The divide between the two approaches is illustrated on the diagram below:

For want of a better name to describe this new approach, I refer to it as the Low Cost Sales Model.

Disrupting the Enterprise Software world

The Low Cost Sales Model has the power to disrupt the industry as companies using the Low Cost Sales Model can disrupt players using the older enterprise sales model. As an example, JBoss used the Low Cost Sales Model to disrupt BEA and IBM that were selling the same solution for dramatically higher prices. BEA and IBM could not respond as they were stuck with a business model that would not be profitable at the lower price point.

Selling to SMBs (Small and Medium sized Businesses)

Sales and marketing costs are now low enough that it is finally possible to profitably sell sophisticated software to the SMB market. Previously it was simply too expensive to try to reach this market for anything but the simplest software. Since most SMB’s don’t have IT staffs, Software as a Service (SaaS) provides the perfect delivery mechanism. HubSpot is a great example of a company using the Low Cost Sales Model to sell software as a service to SMBs very successfully.

Extreme Profitability

Companies like SolarWinds are leveraging the power of the Low Cost Sales model to deliver extraordinary levels of profitability. In 2009, it reported EBITDA profits of $52m on revenues of $116m. That means its operating profit margins were 52%, placing it in rarified territory.

Conclusions

The most fascinating new insight that I discovered while writing this post, was how CAC grew at a roughly exponential rate as sales complexity forced higher levels of human touch into the sales process.

Given this, I recommend that B2B Entrepreneurs gain a clear understanding of the sales complexity of their proposed new business, and carefully contrast this with the associated customer value / pain / urgency levels. This comparison should help them understand if they have what it takes to make a viable business model. (A viable business model requires that you are able to monetize your customers at a higher level than it costs you to acquire them – i.e. LTV>CAC.)

The data also shows that it is extremely important to consider ways to redesign your product/service and resultant go-to-market models to minimize the amount of human touch involved in the sales process. It is not enough to simply want to use a lower touch sales channel. The product/service has to be simple enough to evaluate and purchase for it to work in that channel.

If you have an existing business, my recommendation is that the CEO should be leading brainstorming sessions with his or her VPs of Products, Sales and Marketing to see if it is possible to move from one tier of sales complexity to a lower tier.

Key Takeaways

Understand the sales complexity of your business. Figure out your LTV and CAC, and make sure that your LTV>CAC so that you have a viable business model.
Look for ways to decrease your sales complexity, which might involve redesigning your product and leveraging engineering resources to eliminate issues in the sales process.
Realize that reducing sales complexity is an achievable goal, and should be an ongoing process that merits a significant investment.

Brainstorming suggestions:

Do you have a clear documented picture of the issues in your buyers’ mind in each step of the sales cycle that have to be resolved before they can make a purchasing decision? (This needs to be in hard copy form for the brainstorming group to be effective. It is rare that I find this step has been properly completed.) For more details, refer to Building a Sales and Marketing Machine.
What attributes of your product/service are causing it to require a complex sales cycle? Can these be changed?
What would be required to allow your company to use the next step down in sales model (e.g. to move from Field Sales to Inside Sales, or from Inside Sales to No Touch Self-Service)?
Are you using all the latest techniques for leveraging the web including Inbound Marketing, lead scoring and lead nurturing, marketing automation, SEO, SEM, social media, web video, etc. Those interested in pursuing the Low Cost Sales Model would do well to study the techniques and behaviors pioneered by the leading companies like SolarWinds, Acronis, HubSpot, ConstantContact, etc.
Does your Web site answer all the questions and issues that arise in your buyers’ minds during their purchasing process?
Are you making it easy for the customer to sell themselves, including providing a free trial?
Is your pricing causing you problems by increasing sales complexity? Could you reduce entry level pricing to the point where only a single individual is required to make a buying decision?
Can you use a free product to help acquire customers that you can later up-sell or cross-sell?

Important Final Note

It would be wrong to read this article and conclude that any business with high sales complexity is a bad business. There is nothing wrong with having high sales complexity provided you are able to get large enough orders, in a reasonable time period, to cover your cost of sales. That is a very viable business model.

The opposite situation is also worth stating: any business that has low sales complexity but inadequate value provided to a customer is very unlikely to be successful.

Acknowledgements

I would like to thank the following people for their highly valued input to this article: Dharmesh Shah of HubSpot; Danny Windham and Steve Harvey of Digium; Tim Barrows, Antonio Rodriguez and Nick Beim of Matrix.

Posted in Startup Help.

Tagged with B2B sales complexity, Customer Acquisition Costs (CAC), freemium, simplifying software sales cycle, simplifying startup sales complexity, startup sales complexity, startup sales process.

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By David Skok – April 1, 2010

SaaS Metrics – A Guide to Measuring and Improving What Matters

This blog post looks at the high level goals of a SaaS business and drills down layer by layer to expose the key metrics that will help drive success. Metrics for metric’s sake are not very useful. Instead the goal is to provide a detailed look at what management must focus on to drive a successful SaaS business. For each metric, we will also look at what is actionable.

Before going any further, I would like to thank the management team at HubSpot, and Gail Goodman of Constant Contact, who sits on the HubSpot board. A huge part of the material that I write about below comes my experiences working with them. In particular HubSpot’s management team is comprised of a group of very bright individuals that are all very metrics driven, and they have been clear thought leaders in developing the appropriate tools to drive their business. I’d also like to thank John Clancy, who until recently was President of Iron Mountain Digital, a $230m SaaS business, and Alastair Mitchell, CEO and founder of Huddle.

Let’s start by looking at the high level goals, and then drill down from there:

Key SaaS Goals

Profitability: needs no further explanation.
- MRR Monthly Recurring Revenue: In a SaaS business, one of the most important numbers to watch is MRR. It is likely a key contributor to Profitability.
Cash: very critical to watch in a SaaS business, as there can be a high upfront cash outlay to acquire a customer, while the cash payments from the customer come in small increments over a long period of time. This problem can be somewhat alleviated by using longer term contracts with advance payments.
- Months to recover CAC: one of the best ways to look at the capital efficiency of your SaaS business is to look at how many months of revenue from a customer are required to recover your cost of acquiring that customer(CAC). In businesses such as banking and wireless carriers, where capital is cheap and abundant, they can afford a long payback period before they recover their investment to acquire a customer (typically greater than one year). In the startup world where capital is scarce and expensive, you will need to do better. My own rule says that startups need to recover their cost of customer acquisition in less than 12 months.
  (Note: there are other web sites and blogs that talk about the CAC ratio, with a complex formula to calculate it. This is effectively a more complicated way of saying the same thing. However I have found that most people cannot relate well to the notion of a CAC ratio, but they can easily relate to the idea of how many months of revenue it will take to recover their investment to acquire a customer. Hence my preference for the term Months to Recover CAC.)
Growth: usually a critical success factor to gaining market leadership. There is clear evidence that once one company starts to emerge as a market leader, there is a cycle of positive reinforcement, as customers prefer to buy from the market leader, and the market leader gets the most discussion in the press, blogosphere, and social media.

Two Key Guidelines for SaaS startups

The above guidelines are not hard and fast rules. They are what I have observed to be needed by looking at a wide variety of SaaS startups. As a business moves past the startup stage, these guidelines may be relaxed.

In the next sections, we will drill down on the high level SaaS Goals to get to the components that drive each of these.

Three ways to look at Profitability

Micro-Economics (per customer profitability): Micro-economics is the term used to describe looking at the economics of your business on a single customer level. Most business models (with a few exceptions such as marketplaces) are based around a simple principle: acquire customers and then monetize them. Micro-economics is about measuring the numbers behind these two essential ingredients of a customer interaction. The goal is to make sure the fundamental underpinnings of your business are sound: how much it cost to acquire your customers, and how much you can monetize them. i.e. CAC and LTV (cost of acquiring a customer, and lifetime value of the customer). In a SaaS business, you have a great business if LTV is significantly greater than CAC. My rule of thumb is that LTV must be at least 3x greater than CAC. (As mentioned elsewhere in this blog, your startup will die if your long term number for CAC is higher than your LTV. See Startup Killer: The cost of acquiring customers.)
Overall profitability (standard accounting method): This looks a the standard accounting way of deriving profitability: revenue – COGS – Expenses. The diagram also notes that Revenue is made up of MRR + Services Revenue. Since MRR is such a critical element, there will be a deeper drill down to understand the key component drivers.
Profitability per Employee: it can be useful to look at the factors contributing to profitability on a per employee basis, and benchmark your company against the rest of the industry. Expenses per Employee is usually around $180-200k annually for businesses with all their employees in the US. (To calculate the number take the total of all expenses, not just salaraies, and divide by the number of employees.) Clearly to be profitable in the long term, you will want to see revenue per employee climb to be higher than expenses, taking into account your gross margin %.

Drill down on MRR

MRR is computed by multiplying the total number of paying customers by the average amount that they pay you each month (ARPU).

Total Customers: a key metric for any SaaS company. This increases with new additions coming out the bottom of the sales funnel, and decreases by the number of customers that churn. Both of these are key metrics, and we will drill down into them later.
ARPU – average monthly revenue per customer: (The term ARPU comes from the wireless carriers where U stands for user.) This is another extremely imporant variable that can be tweaked in the SaaS model. If you read my blog post on the JBoss story, you will see that one of the key ways that we grew that business was to take the average annual deal size from $10k, to $50k. Given that the other parts of the pipeline worked with the same numbers and conversion rates, this grew the business by 5x. We will drill down into how you can do the same thing a little further on.

Drill down on Micro-Economics (Per Customer Profitability)

Our goal is to see a graph that looks like the following:

To achieve this, lets look at the component parts of each line, to see what variables we can use to drive the curves:

As mentioned earlier, customer profitability = LTV – CAC.

Drill down on LTV

Drilling down into the factors affecting LTV, we see the following:

LTV = ARPU x Average Lifetime of a Customer – the Cost to Serve them (COGS)

It turns out that the Average Lifetime of a Customer is computed by 1/Churn Rate. As an example, if a you have a 50% churn rate, your average customer lifetime will be 1 divided by 50%, or 2 months. In most companies that I work with, they ignore tracking the average lifetime, but instead track the monthly churn rate religiously.

The importance of a low churn rate cannot be overstated. If your churn rate is high, then it is a clear indication of a problem with customer satisfaction. We will drill down later into how you can measure the factors contributing to Churn Rate, and talk about how you can improve them.

Drill down on CAC

The formula to compute CAC is:

CAC = Total cost of Sales & Marketing / No of Deals closed

It turns out that we are actually interested in two CAC numbers. One that looks purely at marketing program costs, and one that also takes into consideration the people and other expenses associated with running the sales and marketing organization. The first of these gives us an idea of how well we could do if we have a low touch, or touchless sales model, where the human costs won’t rise dramatically over time as we grow the lead flow. The second number is more important for sales models that require more human touch to close the deal. In those situations the human costs will contribute greatly to CAC, and need to be taken into consideration to understand the true micro-economics.

I am often asked when it is possible to start measuring this and get a realistic number. Clearly there is no point in measuring this in the very early days of a startup, when you are still trying to refine product/market fit. However as you get to the point of having a repeatable sales model, this number becomes important, as that is the time when you will usually want to hit the accelerator pedal. It would be wrong to hit the accelerator pedal on a business that has unprofitable micro-economics. (When you are computing the costs for a very young company, it would be fair to remove the costs for people like the VP of Sales and VP of Marketing, as you will not hire more of these as you scale the company.)

When we look at how to lower CAC, there are a number of important variables that can be tweaked:

Sales Funnel Conversion rates: a funnel that takes the same number of leads and converts them at twice the rate, will not only result in 2x more closed customers, but will also lower CAC by half. This is a very important place to focus energy, and a large part of this web site is dedicated to talking about how to do that. We will drill down into the Sales Funnel conversion rates next.
Marketing Program Costs: driving leads into the top of your sales funnel will usually involve a number of marketing programs. These could vary from pay per click advertising, to email campaigns, radio ads, tradeshows, etc. We will drill down into how to measure and control these costs later.
Level of Touch Required: a key factor that affects CAC is the amount of human sales touch required to convert a lead into a sale. Businesses that have a touchless conversion have spectacular economics: you can scale the number of leads being poured into the top of the funnel, and not worry about growing a sales organization, and the associated costs. Sadly most SaaS companies that I work with don’t have a touchless conversion. However it is a valuable goal to consider. What can you do to simplify both your product and your sales process to lower the amount of touch involved? This topic is covered at the bottom of a prior blog post: Startup Killer: the cost of acquiring customers.
Personnel costs: this is directly related to the level of touch required. To see if you are improving both of these, you may find it useful to measure your Personnel costs as a % of CAC over time.

Drill down on Sales Funnel Conversion Rates

The metrics that matter for each sales funnel, vary from one company to the next depending on the steps involved in the funnel. However there is a common way to measure each step, and the overall funnel, regardless of your sales process. That involves measuring two things for each step: the number of leads that went into the top of that step, and the conversion rate to the next step in the funnel (see below).

You will also want to measure the overall funnel effectiveness by measuring the number of leads that go into the top of the funnel, and the conversion rate for the entire funnel process to signed customers.

The funnel diagram above shows a very simple process for a SaaS company with a touchless conversion. If you have a conversion process involving a sales organization, you will want to add those steps to the funnel process to get insights into the performance of your sales organization. For example, your inside sales process might look like the following:

Here if we look at the closed deals and overall conversion rates by sales rep, we will have a good idea of who our best reps are. For lower performing reps, it is useful to look at the intermediate conversion rates, as someone that is doing a poor job of, say, converting demos to closed deals could be an indication that they need demo training from people that have high conversion rates for demos. (Or, as Mark Roberge, VP of Sales at HubSpot, pointed out, it could also mean that they did a poor job of qualifying people that they put into the Demo stage.)

These metrics give you the insight you need into your sales and marketing machine, and those insights give you a roadmap for what actions you need to take to improve conversion rates.

Using Funnel Metrics in forward planning

Another key value of having these conversion rates is the ability to understand the implications of future forecasts. For example, lets say your company wants to do $4m in the next quarter. You can work backwards to figure out how many demos/trials that means, and given the sales productivity numbers – how many salespeople are required, and going back a stage earlier, how many leads are going to be required. These are crucial planning numbers that can change staffing levels, marketing program spend levels, etc.

Drill down by Customer Type

If you have different customer types, you will want to look at all the CAC and LTV metrics for each different customer type, to understand the profitability by customer type. Often times this can lead you to a decision to focus more energy on the most profitable customer type.

Drill down into ROI per Marketing Program

My experiences with SaaS startups indicate that they usually start with a couple of lead generation programs such as Pay Per Click Google Ad-words, radio ads, etc. What I have found is that each of these lead sources tends to saturate over time, and produce less leads for more dollars invested. As a result, SaaS companies will need to be constantly evaluating new lead sources that they can layer in on top of the old to keep growing.

Since the conversion rates and costs per lead vary quite considerably, it is important to also measure the overall ROI by lead source:

Growing leads fast enough to feed the front end of the funnel is one of the perennial challenges for any SaaS company, and is likely to be one of the greatest limiting factors to growth. If you are facing that situation, the most powerful advice I can give you is to start investing in Inbound Marketing techniques (see Get Found using Inbound Marketing). This will take time to ramp up, but if you can do it well, will lead to far lower lead costs, and greater scaling than other paid techniques. Additionally the typical SaaS buyer is clearly web-savvy, and therefore very likely to embrace inbound marketing content and touchless selling techniques.

From Alistair Mitchell, CEO of Huddle: “Just calculating CAC can be extremely complicated, given the numerous ways in which people find out about your service. To stop getting too bogged down in the detail, its best to start with a blended rate that just takes your total spend on marketing (people, pr, acquisition etc) and split this across all your customers, regardless of type or source. Then, once you’ve got comfortable with that, you can start to break CAC down by the different customer types and elements of your inbound funnel, and start measuring specific campaigns for their contribution to each customer type.”

Drill down into Churn Rate

As described in the section on LTV, Churn Rate has a direct effect on LTV. If you can halve your churn rate, it will double your LTV. It is an enormously important variable in a SaaS business. Churn can usually be attributed to low customer satisfaction. We can measure customer satisfaction using customer surveys, and in particular, the Net Promoter Score.

If you are using longer term contracts, another key metric to focus on is renewals. From John Clancy, ex-President of Iron Mountain Digital: “

Non-renewals add to churn, but they can have different drivers. We spent a lot of time examining our renewal rates and found that a single digit improvement made a huge difference. Often times the driver on a non-renewal is economic – the internal IT department has mounted a campaign to bring the solution back in house. SaaS businesses need to identify renewal dates and treat the renewal as a sales cycle (it’s much easier and less expensive than a new sale, but it deserves the same level of attention) Many SaaS businesses make the mistake of taking renewals for granted.”

A good predictor of when a customer is about to churn is their product usage pattern. Low levels of usage indicate a lack of commitment to the product. It can be a good idea to instrument the product to measure this, looking for particular features our usage patterns that are correlated with stickiness, or a likelihood to churn.

Another measurement tool that can be very useful in understanding churn is to look at a Cohort Analysis. The term cohort refers to a group of customers that started in the same month. The reason for doing this is that churn varies over time, and using a single churn number for all customers will mask this. Cohort analysis shows:

How churn varies over time (the green call out below).
How churn rates are changing with newer cohorts, (the red call out below) For example in the early days of your SaaS company, you may have serious product problems and lose a lot of customers in the first month. Over time your product gets better, and the first month churn rate will drop.

Cohort analysis will show this, instead of mixing all the churn rates into single number.

Here’s a comment on Cohort Analysis from Alastair Mitchell, CEO of Huddle: “I actually think this is more important than churn, for the simple fact that churn varies over the lifetime of a customer cohort, and just looking at monthly churn can be very misleading. Also, given the importance of payback in a year – you really want to look at churn over the course of a 12 months cohort. For instance, in the first 3 months of a monthly paying customer you will see high churn (3 is a recurring ‘magic’ number in all of retail), then reduced churn (sometimes even positive churn) over the next 3 months less and then probably more stable spend over the next 6 months. The number you really care about is the % of customers spending after 12 months (not necessarily on a monthly basis) as that’s what matters for your CAC payback calculations.”

Two variables that really matter

As we saw above, there are two variables that have a huge effect on a SaaS business: funnel conversion rate, and churn, and it is not a bad idea to graph them as shown below.

Drill down into ARPU (Average Revenue per Customer)

ARPU is often different for different customer categories, and should be measured separately for each category. It can usually be driven up by focusing on:

Product Mix: adding products to the range, and using bundles, and cross-sell and up-sell
Scalable Pricing: there are always some customers that are willing to pay more for your product than others. The trick is developing a multi-dimensional pricing matrix that allows you to scale pricing for larger customers that derive more value from the product. This could be pricing by the seat used (Salesforce.com), or by some other metric such as number of individuals mailed in email campaigns (Eloqua).
If you are using scalable pricing, it will be valuable to measure what the distribution is of customers along the various axes. You could imagine taking an action to do after more seats inside of existing customers as a way to drive more revenue. etc.

Drill down into Cash

We already discussed Months to recover CAC as a key variable. There is another way to affect Cash: which is using longer term contracts and incenting your customers to pay for 6, 12, 24, or even 36 months up front in advance. This can mean the difference between needing to raise tons of venture capital and giving away ownership, or being able to grow the business in a self-funded manner. Given the cost of capital, you can often calculate what discount makes sense. (If capital is cheap and freely available, it doesn’t make sense to give much discount.)

If you do use longer term contracts, it will be important to measure “Discretionary Churn”. Since some of your customers are locked in and cannot churn, they could artificially lower your overall churn numbers. The way to understand what is really going on is to look at the discretionary churn, which is the churn rate for all customers that are at the point where they have the option to churn, removing those whose contracts would have prevented them from churning.

Cash Management and forecasting

Cash is one of the most important items to get right in any startup. Run out of cash, and your business will come grinding to a halt regardless of how good any of your other metrics may be. One of the most important ways to run a SaaS company is to look at CashFlow profitability (not recognized revenue profitability). What is the difference: If your business only gets paid month by month, there will be no difference, but if you get longer term contracts, and get paid in advance, you will receive more cash upfront than you can recognize as revenue, so your cash flow profitability will look better than your revenue profitability, and is a more realistic view of whether you can survive day to day on the money coming in the door.

Here is another comment from Alastair Mitchell of Huddle on this topic: “SaaS companies tuning their model should think not just in terms of the months to recover CAC, but also the topline amount of cash required to get to cashflow profitability (or the next funding round). This is probably the single biggest mistake I see in early stage companies. They don’t look ahead, using these metrics, to figure out that if the time to repay CAC is 12 months, then in aggregate they are going to need 12 months of CAC spend PLUS the number of months required of further growth to cover their operating costs (mostly engineering) BEFORE they are even cashflow positive (let alone revenue profitability). Most businesses I see fundamentally miss this and end up short; frequently through under-estimating the time to recover CAC, and churn. The readers of this blog should be focused on cashflow profitability, not revenue profitability. (Hence why your point about annual/upfront contracts is so important)”

Drill down into Growth

Focusing on Growth as a separate parameter can be highly valuable. It is the nature of a SaaS business to grow MRR month on month, even if you only added the same number of customers every month. However your goal should be to grow the number of new customers that you sign up every month. You can do this by focusing on:

Improvement in the overall funnel conversion rate
Lead Generation Growth
Growth in Funnel Capacity

The first two have been covered already. The last bullet: Growth in Funnel Capacity is an often overlooked metric that can bite you unexpectedly if you don’t pay attention to it. In my second startup, I had a situation where sales growth stalled after growing extremely rapidly for a couple of years. The problem, as it turned out, was that we had stopped hiring new sales people after reaching 20 people, a number that felt very large to me, and had maxed out on sales capacity. We started sales hiring again, and a couple of years later the business hit a $100m run rate. I witnessed a similar phenomenon at Solidworks, when after 2-3 years of phenomenal growth, their growth slowed. It turned out that their channel sales capacity had stopped growing. Solidworks started measuring and managing something that would later turn out to be a critical metric: channel capacity in terms of the number of FTE (Full Time Equivalent) sales people in their channel, and the average productivity per FTE. This has helped propel them to over $400m in annual revenues.

Another great way to grow your business is by adding new products that can be up-sold, or product features that can lead to a higher price point. Since you already have a billable contract, it is extremely easy to increase the amount being charged, and this can often be done with a touchless sale.

Other Metrics

There are a series of less important metrics that can still be useful to be aware of. I have listed some of these in the diagrams below:

After posting the above, I received a note from Gail Goodman of Constant Contact, noting that they include the cost of on-boarding a customer in CAC, not LTV as I have shown. Given that they are a public company with significant accounting scrutiny, this is likely the right way to do things.

Conclusions

If you have kept reading this long, it likely means that you are likely an executive in a SaaS company, and truly have a reason to care about this depth of analysis. I would very much like to hear from you in the comments section below to see if I have missed out on metrics that you think are important.

The main conclusion to draw from this article, is that a SaaS business can be optimized in many ways. This article aims to help you understand what the levers are, and how they can affect the key goals of Profitability, Cash, Growth, and market share. To pull those levers requires that you first measure the variables, and watch them as they change over time.

It also requires that you implement a very metrics driven culture, which can only be done from the top. The CEO needs to use these metrics in her staff meetings, and those execs need to use them with their staff, etc. Human nature is such that if you show someone a metric, they will automatically work to try to improve it. That kind of a culture will lead to true operational excellence, and hopefully great success.

Posted in Building for Success, Startup Help.

Tagged with Average Monthly Revenue per Customer, Constant Contact, cost effectively acquire customers, Customer Acquisition Costs (CAC), Hubspot, Huddle, Iron Mountain Digital, Lifetime Value of a Customer, Metrics, metrics for SaaS companies, profitability per employee, SaaS.