Thursday, July 21, 2011

COA 102: The Impact of Customer Acquisition Cost on MSP Profitability

In our last blog post (titled “COA 101:  A Primer for the MSP on the Cost of Customer Acquisition”) we provided an introduction to the concept of “COA” (the acronym for Cost of Acquisition used by many executives and investors in recurring revenue businesses) and we talked about why COA is such a critical part of an MSP’s growth plan. At MSPexcellence, we believe that COA is the single most important factor to measure and control when scaling a managed services business and maximizing its valuation either for an upcoming investment round or for an M&A event.  So in this post we are going to take the COA concept one step further and explain the nature of its impact on both short term and long term profitability for an MSP business. To help make this explanation as clear as possible, we have created a diagram to illustrate COA in action.  After all, a picture is worth a thousand words and COA can be a difficult concept to grasp with only a written definition and a formula for calculating its value.  

So take a few moments and study the diagram below. It will help you to visualize the critical role that COA plays in scaling your MSP business. The diagram shows the customer acquisition ramp for a hypothetical MSP business that is launching a new managed service.  Each newly acquired customer is represented by a row of colored squares from left to right with each square representing the Monthly Recurring Revenue (MRR) collected from the customer. Every month, the MSP business acquires a new customer and, as a result, a new and incremental revenue stream is set in motion one customer at a time.

The colored squares are divided in half with one part colored red to represent cost and another part colored green to represent the profit realized during the term of the managed services contract. For each new customer, the colored squares in the early months are red on both top and bottom. This illustrates the fact that you must incur a cost to acquire the customer and you must also incur a cost to deliver services to them – these are very separate and distinct cost elements. The cost of acquisition is represented by the top red half of the revenue square and the cost of service delivery is the bottom red half of the square. After some number of months, the cost of acquisition is recovered. The COA is paid back by the gross margin dollars remaining after all service delivery costs are met.  In the example above, you will notice that it takes 9 months of gross margin to pay back the cost of customer acquisition for each new customer acquired. Then beginning in the 10th month, the customer becomes profitable and stays that way for the life of the contract, or multiple contract terms assuming the MSP maintains a low churn and strong contract renewal rate.

After you study the diagram for a few minutes, you will begin to see the importance of managing COA on both your short term as well as your long term profitability. There are many insights to be gleaned from this diagram and each one is significant so let’s cover them one at a time.

1.   First of all, notice the compounding effect of a recurring revenue business. It’s much like saving for retirement. If one new customer with an MRR of $2,000 is added each month (equal to 20 users at $100 per user per month) then after four years you will have a million dollar recurring revenue business. That means your recurring revenue business will generate a million dollars per year for as long as your customers renew and you would never have to add another customer to keep that million dollar revenue run rate going. Isn’t recurring revenue is a beautiful thing? How can you consistently add a new customer every month? All you need is a consistent customer acquisition strategy where your sales and marketing functions operate according to an effective and efficient execution model. It’s very achievable, but it won’t happen by chance – and it must be managed.

2.   Next you will notice that during the first year of customer acquisition, your MSP business will not be very profitable. That’s because you have not reached critical mass in your customer base – the majority of your customers are still within their first 9 months of acquisition and have not generated enough margin dollars to pay back their acquisition cost. They are in the “Acquisition Cost Recovery Zone” and as long as you are acquiring customers, that unprofitable zone will always be a fact of life. But you will also notice that during the second year the profitability picture changes dramatically. In year 1 only a few of the squares (monthly recurring revenue) are profitable. In fact, in this scenario, less than 10% of the first year revenues are profitable. However, in the second year more than half of the MRR squares become profitable. If your customer acquisition rate stays constant, then each year the proportion of profitable squares to unprofitable squares will increase and your overall business profitability will rise accordingly. So much so that by year 4, 90% of your MRR will be profitable revenue and only 10% of your revenue (i.e., new acquired customers) will be unprofitable. In other words, the profitability picture flips from a very unprofitable situation to an extremely profitable one over time.

3.   How can you minimize the number of red (unprofitable) squares and maximize the green (profitable) squares? The answer is to manage your cost of acquisition to the lowest possible level so that the time to recover COA is reduced and the path to profitability is accelerated. How can you reduce your COA?  You must find the inefficiencies in your sales and marketing functions and continuously improve them.  Where are they? Well, that depends.  Excess COA could be in your sales compensation plan, or your pipeline close ratio, or unusually long sales cycles. In the marketing area, your COA might be too high because of your cost per lead, or your lead qualification rate or maybe your overall lead volume is not sufficient to consistently drive sales activity. With the right sales and marketing metrics in place, you can find these inefficiencies and then you can identify and implement strategies to correct them.  

4.   Finally, let’s look at the actual numbers implied by the diagram above and use this COA metric in a real world scenario. We have already pointed out that in this diagram the COA cost recovery time is 9 months. If your average MRR is $2,000 per customer and your gross margin is 50% (we are using round numbers here for simplicity) then each month you will generate $1,000 of margin dollars to recoup the cost of customer acquisition. So a 9 month COA implies a $9,000 cost to acquire each customer. Where did that $9,000 go anyway?  Let’s start with selling expenses. If we ballpark your cost per sales rep at $100k per year (including salary, commissions, overhead, T&E) then each month a sales rep accounts for more than $8,000 in selling expenses.  So the next question is how many deals at $2,000 MRR does a sales rep close in a month? If the answer is only one deal per month, then most of your $9,000 COA has been spent on selling expenses alone.

Now let’s look at marketing expenses.  If you spend $200 per lead and you qualify 1/3rd of your leads into the sales pipeline and then you convert 1/3rd of the pipeline into customers, then you have just spent $1,800 on lead generation ($200 / 30% / 30%) to acquire each new customer.  Are there any marketing staff or sales support staff not already counted?  If so, then add them in too. Now add in all other sales and marketing expenses for creative services, PR, trade associations, demo equipment, literature, etc.  COA is your total cost of customer acquisition including all fixed and variable sales and marketing expenses.
If you currently have a high COA (e.g., the time it takes to recover your COA is greater than 12 months), then your goal should be to move to a low COA model as soon as possible. Otherwise you are burning margin dollars unnecessarily and undermining the profitability of your business. Which of the diagrams below do you think looks more like your COA efficiency?

A low COA model will enable you to acquire the most customers in the shortest time frame at the lowest impact on your operating margins. But the question becomes how to make the move from a high COA model to a low COA model. The only way to manage a process with so many variables is to create a Go-To-Market plan and then execute against that plan. Then you must measure your COA performance constantly and improve it over time.  With an efficient, consistent and scalable go-to-market model and customer acquisition program you will build up your customer base, maximize top line revenue growth and maximize your bottom line profitability all at the same time. Here is a summary of the steps we recommend to move from a high COA model to a low COA model.
The chart above summarizes the factors that increase COA and the steps you can take to improve your COA efficiency. You may only need to address one or two of these factors to optimize your COA…or you may find that you need to take all five steps to address them all. In any case, you owe it to yourself and your business to take a hard look at your cost of acquisition and then take the necessary steps to optimize it.  Just ask any serious investor in recurring revenue companies ... Mastering your COA is not only the key to increasing your profitability it is also the key to maximizing the valuation of your MSP business.

Friday, July 1, 2011

COA 101: A Primer for the MSP on the Cost of Customer Acquisition

As business people, we are all familiar with the age-old concept that acquiring new customers is many times more expensive than retaining existing customers (by some reports 5 to 7 times more expensive). In a managed services business, the value of customer retention and the contribution of add-on business from an installed base cannot be overstated.  However, the fact remains that new customer acquisition is essential to accelerating the growth of a managed services business. If you are an MSP just starting out, or transforming from a VAR model to an MSP model, then each new managed services customer is critical to growing recurring revenue, building customer references and gaining industry knowledge in your target market segments. Each new customer brings with it a long-term revenue stream that adds stability to your business. Most important, as you add profitable customers using an efficient sales and marketing process, you will be increasing your profitability and that directly impacts the valuation investors will assign to your company. If you are an established MSP, you may be looking for growth capital to fund expansion or planning for the day when you sell your business and cash out. When that day comes, your valuation becomes the ultimate report card that determines your financing terms or the purchase price your business will command.  

How can you maximize profitability and the valuation of your MSP business?
There are two kinds of profitability to consider - gross profit and net profit.  Gross profit is simply the amount of money generated by your managed service fees after subtracting the cost of service delivery.  Over the years, MSPs have spent a ton of time and effort maximizing their gross margins by wringing as much cost out of service delivery as possible. However, many MSPs make a big mistake … they believe that by maximizing their gross margins, they have maximized their profitability. The problem is that gross margin improvement is only half the battle. In order to truly increase the valuation of your business you need maximize your net profits – the amount of money left over after you subtract all of your operating expenses from gross profit. Operating expenses include sales, marketing and administrative expenses and must be funded by gross margin dollars. Generating a high gross profit only to give it back with high operating expenses is an exercise in futility. If your MSP business produces high gross margins but you are still unable to realize healthy net margins then you are probably suffering from a high cost of customer acquisition.  But don’t worry… this is a curable condition.

What is the cure for a high customer acquisition cost?
Before you can cure a high customer acquisition cost, you first have to know how to measure it. After you learn how to measure it, you must monitor it. Then, and only then, can you manage your COA to a more reasonable cost level. Here’s how to measure your Cost of Acquisition:

COA = (Total Selling Expense + Total Marketing Expense)/Gross Margin from New Customers
This calculation provides a standard metric for COA that divides the total monthly cost of acquiring new customers by the gross margin dollars generated by those new customers. Your Total Selling Expense includes the salaries, commissions, overhead and departmental expenses for your outside sales reps, inside sales reps and any other headcount in your sales organization. Total Marketing Expense includes the salaries, bonuses and overhead for the marketing staff as well as the program expenses for lead generation, branding, public relations and producing sales enablement materials. Add up all of these expenses, determine the gross margin dollars from new customers produced during the same period, convert them to a monthly value and input them into the formula above.

The result is a number that represents the number of months it will take to pay back your customer acquisition cost with gross margin dollars. The payback time should be in the range of 6 to 12 months. Sounds simple doesn’t it? Nevertheless, it is surprising how few MSPs actually calculate their COA. Do you calculate your COA? If so, what is the value of your COA? Is it within the range of 6 to 12 months? How often do you measure it? Is it trending up or down? What are the major cost elements?  Are you taking steps to reduce those costs? Knowing how to measure COA is just the first step in maximizing your valuation. The second step is to monitor your COA on a regular basis as one of the key performance metrics for your business. The third step (this is the hard part) is to manage your COA to a minimum value by creating an efficient and repeatable go-to-market model.  Then you must faithfully implement this model to scale up your business.

What is your repeatable COA strategy?

If company valuation is the final report card for your business, then COA is the final exam. So the question becomes, what kind of homework should you be doing now to pass your final exam? Your homework starts with marketing and ends with sales. Your marketing homework is to implement a very efficient lead generation process. Start by measuring your cost per lead and your lead conversion rates.  Use these conversion rates to track the percentage of unqualified leads that become qualified leads feeding the sales opportunity pipeline and the percentage of sales opportunities that are closed and become new customers. Then put a process in place to continuously improve these metrics. While this is not a hard process to put in place, few MSPs proactively manage their lead funnel in this way. Your sales homework is to implement an efficient sales process for tracking the movement of deals through the pipeline in order to compare the performance of each sales rep against a baseline for sales cycle time and close ratio. This approach allows you to manage your sales team by focusing on the deals that need attention and forecasting the deals that are following a normal progression through the pipeline.  Sales pipeline management is not hard either, but it’s not a natural or intuitive process for most MSP entrepreneurs who are cut from a technical bolt of cloth.  

Developing a repeatable and scalable COA strategy means building a comprehensive go-to-market plan for your managed services that includes these five building blocks:

o A Formal Strategic Plan
Define your MSP marketing strategy including your target markets, ideal customer profile and differentiated customer value proposition
o A Profitable Business Model
Determine your pricing strategy, service bundling and an economic model for profitable service delivery to a typical customer
o An Effective Marketing Machine
Create compelling content and execute efficient lead generation programs to drive the right volume of qualified leads into the pipeline
o Manage a Predictable Sales Process
Establish a process for hiring, enabling and managing an MSP sales function that efficiently and consistently produces results
o Continuously Measure Success
Develop key metrics for measuring sales and marketing effectiveness including the cost of customer acquisition and monitor them continuously
Now ask yourself if you have all five of these areas covered to the best of your ability. If the answer is yes and your COA is within the target range, then you are well positioned to scale your MSP business into a high valuation company.  If the answer is no, then you still have more homework to do. Measuring COA is not hard.  Implementing a repeatable and low cost COA strategy is harder – but no harder than managing your cost of service delivery. If you can do one, you can certainly do the other. Check back and we will cover ways to reduce your COA by maximizing the effectiveness and efficiency of your sales and marketing operation. If you do your homework, you will pass that COA exam with flying colors.