Managing a business is a little bit like flying an airplane. Keep your eyes on the speed, altitude, drag, and fuel and you’ll get to your destination fast. Try flying blind and you’ll crash and burn.
Who Should Read This
Startup founders, marketing managers, and growth hackers who are new to the growth game. Anyone who’d like to understand basic business metrics tech startups use. Here is why you might care:
- You’d like to grow your business faster and understand the highest-leverage areas to focus on
- You’d like to evaluate the performance of your marketing
- You’re raising a new round and want to be ready for the questions VCs are going to ask
So, let’s dive right in.
What We’ll Cover
First, we’ll focus on user growth. Here we’ll look into acquisition, retention, and virality metrics, as well as interactions among these three.
Second, we’ll focus on the monetary value associated with users. Here we’ll look into customer lifetime value and customer acquisition cost.
Summary (TL;DR)
- There are multiple variables that will define business growth dynamics
- Main ones are acquisition rate, retention rate, and virality coefficient
- At any given time you might choose to prioritize some of these metrics over others
- This decision will depend on the business strategy, available resources, customer feedback, stage of the product lifecycle, and hundreds of other factors
- Models like the one shown here can assist you in making better decisions by letting you see where your business will be at in the future under different scenarios
Basic Metrics: Acquisition, Retention, and Virality
- Acquisition = the number of users you acquire during a certain time period
- Retention rate = the percentage of users that you retain during a certain time period
- Churn rate = the percentage of users that churn during a certain time period = 100% minus retention rate
- Virality coefficient = how many additional users you acquire for free via word of mouth per one user acquired
You may have an intuitive understanding that you want to acquire as many users as you can, retain as many users as you can, and have the highest possible virality coefficient. What you might not be so sure about is the relative importance of these three factors. So to address the former issue, let’s model several scenarios and visualize the results.
Growth Model
Here is the spreadsheet I built to illustrate the growth dynamics. Feel free to download it or save a copy to Google Drive and play with it. Of course, the reality is much more complex than this oversimplified model but it will suffice for our purposes of illustrating key patterns.
Let’s run a few scenarios to get an intuitive grasp of the interplay of these metrics.
Example #1: Acquire 100 users each week and retain all of them
Let’s start with the simplest scenario and assume that we can only acquire 100 users per week. This limitation might be due to our budget constraints or the number of friends we have.
Let’s also assume that our product is not viral at all, i.e., virality coefficient = 0. In other words, nobody recommends our product or nobody sufficiently trusts these recommendations to sign-up.
Now, let’s analyze churn. The first scenario is ideal: we retain 100% of the users we acquire. This is how our ½-year growth chart looks:
We end up with 2,600 users by week 26. Not quite a hockey stick, but a solid linear growth rate.
Example #2: Acquire 100 users per week and retain 80%
Now, let’s suppose that our weekly churn rate is 20%. In other words, we lose 20% of our users each week and retain the remaining 80%. With this type of churn, we will only have 399 users by the end of week 26 instead of 2,600, even though we acquire them at the same rate:
Example #3: Acquire 100 users per week and retain 90%
What if we could improve our churn rate? Let’s say we can get it down to 10%. In other words, we will still lose 10% of users each week but will retain 90%. In this case, we will end up with 842 users by the end of week 26. It’s much better than 100 but nowhere close to 2,600:
Example #4: Acquire 100 users per week and retain 80% with a virality coef. of 0.4
How about viral growth? You might have read stories about Facebook, Twitter, and Hotmail growing this way. So let’s see how this variable can impact our growth prospects.
Let’s still assume that we lose 10% of our users. But let’s also assume a virality coefficient of 0.4. This means that when we acquire 100 users via our regular customer acquisition efforts, we get additional 40 more through the viral loop.
Under this scenario, we will have 1,395 users by the end of week 26:
Example #5: Acquire 100 users per week and retain 80% with a virality coef. of 1.0
Now, what if we could create a truly remarkable product experience leading to a virality coefficient of 1.0? In other words, for each acquired user, we would get another one “for free”.
Whoa, we’ll have 15,823 users by the end of week 26 with the same acquisition rate of 100 users per week and with the same churn rate of 10%!
Example #6: Acquire 100 users per week and retain 80% with a virality coef. of 1.2
What if we could get our virality coefficient above 1? Let’s say we could achieve 1.2. Here is how it might work: each user sends an email to five friends and, on average, 1.2 out of five sign up.
Still assuming the same churn rate of 10%, we will end up with 201,730 users by the end of week 26.
Now, this is much more exciting, isn’t it?
Marketing professionals have been talking about “word-of-mouth marketing” for decades to refer to marketing that your customers do for you. In a way, the “viral loop” is simply re-branded “word-of-mouth marketing” with more emphasis on deliberately designed product features that reinforce virality.
Of course, achieving this type of virality would require an outstanding product and remarkable marketing. In fact, very few companies were able to achieve this kind of growth.
The practical takeaway is that product experience and marketing and highly interrelated. When users love the product, marketing campaigns become much more effective as acquired users stick around and bring even more users in.
Setting The Right Goals
How do we decide on which metrics to focus on? One way to do it is to benchmark our metrics against market-averages.
Here is just one example. Let’s say we find ourselves in this situation:
| Our company | Estimated market averages | |
| Acquisition | 3,500 per week | 2,200 per week |
| Retention rate | 70% (churn = 30%) | 90% (churn = 10%) |
| Virality coef. | 0.2 | 0.2 |
As you can see our retention is lagging behind the competition. Let’s estimate how it impacts our business by plugging these numbers into the spreadsheet.
An average competitor can expect 23,105 users by week 26.
We can expect only 10,207 even though we acquire users at a higher rate.
What if we could improve our retention rate from 70% to the industry standard of 90% while keeping all other metrics at the same levels?
In this case, we could expect 36,758 users – more than 3x the original number.
So would we be able to confidently set the goal of improving retention rate in this case?
This, of course, depends on the context. Here are some questions you might ask:
- What’s the root cause of the low retention rate? E.g. the product itself, the quality of onboarding materials and customer support, the pricing strategy, or marketing effectiveness.
- What exactly are customers unhappy about?
- How much investment is required to improve retention?
- How is the market evolving – will this still be important in the future?
Practical Takeaways
Improving retention and virality coefficients can have a substantial effect on growth, independent of customer acquisition. But it doesn’t mean that acquisition numbers are irrelevant. On the contrary, the rate at which you acquire users will often be the number one factor determining future success.
How so? Here are some possibilities:
- Certain companies might be unable to improve the churn rate in the short-term because of certain fundamental issues with the product that would take months to address.
- Certain teams can substantially improve the acquisition rate but be limited in how much they can affect churn rates and virality.
In other words, the answer is “it depends”. So, the most important takeaway is that modeling your specific situation will allow you to make much better decisions.
What We Learned
- There are multiple variables that will define business growth dynamics
- Main ones are acquisition rate, retention rate, and virality coefficient
- At any given time you might choose to prioritize some of these metrics over others
- This decision will depend on the business strategy, available resources, customer feedback, stage of the product lifecycle, and hundreds of other factors
- Models like the one shown here can assist you in making better decisions by letting you see where your business will be at in the future under different scenarios
What’s Next
Today we discussed how changes in acquisition, retention, and virality metrics impact the number of active users. Next time, we’ll assess the dollar impact one user makes on our business. To do it, we’ll learn to calculate and use another metric: customer lifetime value. Keep reading.
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