Spending money to make money in online advertising

Main illustration: Henrique j. Tramontina

Word of mouth can only take a startup so far, which means advertising is an inevitable investment. So how do you advertise profitably? It begins with metrics.

A long time ago, I spent about $10,000 on a Google AdWords campaign and a couple of weeks later looked at the results: 200 leads. With much excitement I grabbed my boss, told him the news and expected a high five, but instead got a glare and a question:

“How many customers did you get?”

My answer: “One.”

People had clicked through to our website and begun to check it out, but I had no idea if they were a good fit for the product.

Advertising is about customers, not leads

Looking at how many leads I got, rather than how many customers I acquired, was the wrong approach.

Nobody likes bad leads. My boss didn’t. Our sales team for sure didn’t because they had to spend time and energy sifting through leads that weren’t ready to do more than window shop.

Just because it took five leads to get one customer last month doesn’t mean the same will happen next time. Small samples sizes are unpredictable. Looking at leads alone means you won’t reliably bring in customers, and not bringing in customers means you’re making a tight budget even tighter. To get to the right side of profitability you instead need to focus on a different set of metrics.

The three metrics you need to know

Let’s say that you run and manage paid ad strategy for a project management startup called ProjectStash.io, an up-and-comer that TechCrunch has said is the next Basecamp.

A hot new seed venture firm called Investment.io was so impressed by Project Stash’s monthly recurring revenue business – you charge customers $100 a month and your customers stick around exactly for one year – that they invested $100K.

Thrilled, Project Stash’s founders Jill and Jack ask you to spend 20% of the seed money on advertising and to do so profitably. To make sure that you’re setting yourself up to do this successfully, what metrics would you look at first, and how would you go about calculating them?

There are three numbers you need to know. To illustrate some common errors startups can make, and how they can be addressed, we’ll simplify their calculation here.

First, you need to figure out how much Project Stash’s customers are worth on average. If you charge customers $100 a month and on average they stick around for 12 months, your Customer Lifetime Value is $1,200.
Customer lifetime value formula
You also need to know how much you’re spending for each customer.
Cost per customer formula
If you marry these two numbers, you get an efficiency metric, Profit Ratio. If that ratio is below one, you’re losing money. If it’s at one, you’re breaking even. If it’s above, you’re making a profit.
Profit Ratio formula
Below is an example in action. Every campaign you run will always fit into one of three categories: campaigns that are bleeding cash, campaigns that are breaking even, and campaigns that are making money.
Types of campaigns

How Profit Ratio works

Fast forward a few weeks. You ran three ad campaigns for Project Stash and have enough data to call whether or not they’re successful. These are your campaigns:

  1. A very creative right-brained campaign that you’ve christened The Oddball. You’re testing “help your minions work better, together” as a campaign theme.
  2. An Educational Campaign that tells people how to use your software.
  3. An aggressive campaign that highlights the benefits and features of your product and asks people to try out your product today. We’ll call this one Big Money.

To figure out which of your campaigns actually made money for you, here’s how you should approach each of them with Profit Ratio.

By the way, the principles we’re using to analyze the campaigns are universal across all advertising channels, regardless of whether you’re using Facebook Ads, Google AdWords, LinkedIn, etc.

1. The Oddball Campaign

Not profitable example
You spent $4,000 to acquire two customers worth $1,200 each, which means that you spent $4,000 to make $2,400 on this campaign. You’re making only $0.60 on the dollar. This campaign’s clearly unprofitable as it’s losing $0.40 for every dollar spent. Again, the easy way to look at it is this:
Oddball profit ratio
In hindsight, based on your analysis, the oddball verbiage and half-baked humor of this campaign didn’t resonate with most folks, but some of it did work. One of the ads was close to break-even at a 0.8 Profit Ratio. You might consider revisiting this particular ad in the future, making the language appropriate by changing the theme from “help your minions work better” to “help your teammates work better”, and running a new experiment that could be profitable.

2. The Educational Campaign

Break even campaign
Let’s say that you spent $6K on this ad campaign that tells people how they could use Project Stash’s software, and it got you five customers.

You spent $1.2K for each customer. Since your average Customer Lifetime Value is also $1.2K, your Profit Ratio is 1 so you’ve broken even.

With this data, you know that you’re so close to making money on this campaign. Here are a few optimizations that you’d consider to cross that bridge:

  • Decrease your maximum bid, which is how much you’re willing to pay for each click. This will get you fewer customers, but the ones you do get will be cheaper. If you pull this low-effort lever, you should get to profit pretty easily.
  • If you could get more people to click on your ads, your advertising channel’s bid algorithm will see this and make clicks cheaper. For Project Stash, your new ads could more directly ask these folks to try your product. If this was Google AdWords, for instance, introduce a call-to-action such as “Try It Today!” in your ad copy, like this:

3. The “Big Money” campaign

Profitable campaign example
You spent $10K on the “Big Money” campaign and acquired 17 new customers. Your Cost Per Customer is under $600 whereas your Customer Lifetime Value is $1.2K. In one year through the customer lifecycle you’ll make two-plus times more than you invested in this ad campaign. It’s clearly profitable.

Here’s one idea you could consider to get even more customers and get them faster, but at slightly lower efficiency:

  • If you increase bids, you’ll pay a little more to get each new customer, but you’ll also get more customers. At most you’d only want to increase bids to the point of breaking-even. You wouldn’t want to increase bids to the point where the campaigns are not profitable, so tread carefully.

Instead of making more than $2 for every $1 you put in, by increasing bids, you could make $1.50 but get a lot more customers.

Profitable ads are crucial to the bigger picture of your startup, so be sure to focus on Profit Ratio when measuring the success or failure of your campaigns. The sooner you can figure out how profitable a particular advertising channel can be, the faster you’ll know if you can scale the channel, and ultimately turbocharge your company’s growth.