A framework for startups to help understanding how much money you should spend on advertising.

How much should you spend on advertising?

I get this question a lot.  My quick answer is a very annoying two-word phrase . . . “it depends.”

This is usually followed by an eye roll.

Today, I’m going to help you determine how much money you should spend on ads.  We’ll breakdown the following frameworks to determine two things (1) how to approach your ad budget and (2) how much should you spend per month.

We’re going to approach it from the following perspectives:

1. Ad Spend Based on Your CAC Ratio
2. Ad Spend Based on Your Sales
3. Ad Spend Based on CAC Payback Time
4. Ad Spend Based on Burn Rate
5. Ad Spend Based on “Validation Experiments”

But first, I think that it’s fitting that we get on the same page with CAC (Customer Acquisition Cost), LTV (Lifetime value) and some other fundamentals of running an ad budget.  To do so, I’m going to leverage blurbs from some of my favorite blogs and articles.

What is CAC

According to Search Customer Experience, here is the definition of CAC:

“Customer acquisition cost is the fee associated with convincing a consumer to buy your product or service, including research, marketing and advertising costs. An important business metric, customer acquisition cost should be considered along with other data, especially the value of the customer to the company and the resulting return on investment (ROI) of acquisition. The calculation of customer valuation helps a company decide how much of its resources can be profitably spent on a particular customer.”

How to Calculate CAC

According to Search Customer Experience, here is how to calculate CAC:

“The first step in calculating customer acquisition cost is to determine the reporting period. Businesses typically calculate customer acquisition cost on a monthly, quarterly or annual basis. The formula for customer acquisition cost is:

(Sum total of all sales and marketing expenses) / (Number of customers acquired)

The values in the numerator and denominator determined must use the same reporting period.

For example, if the total of sales and marketing expenses in a month is $15,000 and a business acquired 150 customers that same month, the customer acquisition cost is $100.”

As a bonus, I strongly recommend looking to Brain Balfour and Andrew Chen on the best way to actually calculate CAC depending on your business model. 

What is LTV?

According to Hubspot, here is the definition of LTV:

“Customer lifetime value is the metric that indicates the total revenue a business can reasonably expect from a single customer account. It considers a customer’s revenue value, and compares that number to the company’s predicted customer lifespan. Businesses use this metric to identify significant customer segments that are the most valuable to the company.”

How do you calculate LTV?

According to Shopify, here is the best way to calculate LTV:

“CLV = average value of a purchase X number of times the customer will buy each year X average length of the customer relationship (in years)

So a marathon runner who regularly buys shoes from your shoe store might be worth:

$100 per pair of shoes X 4 pairs per year X 8 years = $100x4x8=$3,200

And the mom of a toddler might be worth:

$20 per pair X 5 pairs per year X 3 years = $20x5x3 = $300”

Alright, now that we’re on the same page with the fundamentals of CAC and LTV lets dive into how you should approach spending your ad dollars.  Here we go: 

Based on Your CAC Ratio

You CAC Ratio is calculated as your LTV (lifetime value) over your CAC, the cost to acquire a customer.  An ideal LTV:CAC ratio should be over 3:1. The value of a customer should be three times more than the cost of acquiring them. If the ratio is close i.e.1:1, you are spending too much.

Based on Sales

With more established companies, they look at ad spend as a percentage of sales.  Companies aim to have this number around 10%.  If a company is in growth mode then this number can go up to 12% of 15%.  If you’re slowing your spend or have other channels (SEO) that are working then this might come down to 5-7%. 

Based on CAC Payback Time

This is especially important for subscription businesses and SaaS (Software as a Service) companies.  The payback period is the amount of time it takes for your company to recover the cost of acquiring one customer. As time increases, a customer pays back more of their customer acquisition cost (CAC) through their incremental subscription payments.

Based on Burn Rate

For startups, the reality is that you’re dealing with a monthly burn rate based on the amount of money you’ve raised.  Your ad spend will be directly impacted by how much money you have leftover after paying for other important line items like rent, salaries, ping pong tables, etc. Then it is a strategic question of how much to spend without increasing your burn rate while working to profitability or funding.  More on that in the next section . . . 

Based on “Validation Experiments”

With startups that are just getting started with ads, I call this the validation process.  This is when you earmark a certain amount of money for ads per month (anywhere from $2k to $10k) and the goal is to validate that social ads and/or Google ads can be ROI positive.  This can take anywhere from 2 months to 6 months depending on your product. The total number is dependent on your total burn rate. Pioneer Square labs, a startup studio in Seattle, has a validation team.  Their #1 goal is to quickly validate or kill an idea with marketing experiments. 

Hope this helps as you try and navigate how much you’re spending on Facebook ads, Google ads and other platforms each month.

Summary of How Much to Spend On Ads 

Your ad budget should be 100% dependent on the stage of your business, your growth goals and your current capital structure.  Once you’ve determined those key pillars of your business then you should have a clearer picture of how much to spend on ads. Need help spending money on ads? Schedule a time to chat and learn more about working with our growth marketing agency.