Why Knowing Accounting Made Me Sh*t at Understanding CAC
In my previous life I was an investment banker building models day in day out to value companies. Now working in analytics at Eucalyptus, I help our team decide where we spend money by building tools to understand what our customers cost, and what we earn from them.
I’ve realized that the way I was taught to value companies in more traditional finance is a red herring when it comes to valuing customers.
Accounting provides a rigid framework to understand how businesses interact with their customers. Unfortunately it’s not well suited as a tool to understand modern ecommerce businesses.
The main difference comes down to, what does it mean to invest in a customer relationship vs. just spending a lot on marketing. First we should try and understand the accounting view.
Investing vs. Spending
When companies invest in things like machinery or real estate these are referred to as “Assets”. Assets are by Investopedia (and accounting) defined as
“A resource with economic value that an individual…owns or controls with the expectation … [of] future benefit.”
This means they show up on what’s called the ‘balance sheet’ of the business, which is one of the key financial documents provided to investors. An example of an asset might be the machine a widget factory uses to produce widgets.
Owners of the business can point to this machine and say ‘Look, we have this machine, and at the very least our company should be valued at the machine’s market value — because if this business blows up, we still have our widget machine that we can sell!’
Other things that a business spends money on are called “Expenses” and again from Investopedia are
‘The cost of operations that a company incurs to generate revenue’
Examples of these include general day-to-day business expenses, company headcount and marketing. Once the money is spent, a business in traditional valuation has no way to show that there can be value from these dollars out. Once you pay someone’s salary, print a bunch of brochures, or sponsor a conference, there’s nowhere on the financial statements where assumed income related to this expenditure shows up.
How does this relate to CAC?
CAC would traditionally be hidden inside a catch-all marketing expense line, which would imply that we have received the full value of the customer in the period in which the money was spent.
More investors are aware of the relationship between Lifetime Value when it comes to SaaS businesses because these companies have contractual recurring revenue streams with low costs and high margins. These revenue streams are highly valued (who doesn’t like ‘for certain’ dollars in the bank each month), and so have been the catalyst for deeper interrogation of how companies spend and make money.
However, across a long enough time horizon, a large volume of customers acquired for a B2C ecommerce businesses can begin to trace familiar retention profiles, this means, similar to our investment case for the hypothetical widget machine, we can reliably say that a good relationship with a customer can produce or have the expectation to produce future benefit in the form of revenue, outside the period in which the marketing dollars were spent.
While investors generally seem to hold the right view that they should be obsessed with CAC it’s only really telling one part of the story.
Historically, brand loyalty have been captured under the bucket of ‘goodwill’, while customer contracts, can appear on balance sheets, but only upon acquisition and are generally only recognised pro-rata as the revenue is earned. This makes sense as until now there have been less ways to categorise and follow customer relationships — and less technological ability to do so.
Suddenly with the ability to more closely track customers to our businesses the categorisation of marketing as an expense within the financial year, makes much less sense
Where it all falls down
The post-covid recovery/bull/animal spirit run has eclipsed the need for interrogation at this level, and has seen Australian publicly listed companies with any ecommerce offering priced aggressively (with what looks like little relative nuance within their peer sets). There is difference between ecommerce businesses that can have good long term experience with their customers, and market places or online retailers, who may have transactional relationships with customers. (mispriced or otherwise, most investors are probably just getting in while the getting is good)
The take away for me here is that it doesn’t really matter what traditional accounting’s view of CAC and marketing spend is that an acquired customer, and the cost to do so should be considered an investment.
There are two ways to think about this, the first is
Existing Customers
The first and maybe less familiar is what mechanism do we have to understand how customers relate to companies and the services they provide. This is the intersection of brand and experience and how a customer feels when using a product or talking to a customer service team.
We don’t have a way to fully quantify it so people will generally ask, “what stops someone else doing what you’re doing?”
This isn’t captured anywhere in financial statements and will be far less intuitive to public equity analysts, but can be found with other adjacent analysis or inspection such as public customer reviews, customer interviews and retention profiles as the lagging indicators of business who are able to capture effectively monetise their customer relationships
The second is
New Customers
In thinking about acquiring these new customer ‘relationships’ (through online or offline channels) we should be using the same corporate finance principles in use for other asset classes. Examples of these are acceptable return hurdles relative and ROI both between the channels themselves, and taking a portfolio approach to the channels as a whole.
The implications for thinking about CAC as an investment, at least hypothetically then changes the way we think about spending money on market for those customers. Capital allocation under this model is what I will cover next.
Conclusion
Whether or not great relationships with your customers are an asset under an accounting framework is actually mostly irrelevant. You just need to make sure in practice you treat it that way — and the same with any investment, investors ask, now that you’ve paid for it, what can you do with it?