It’s quite easy to build a business that generates $1 billion in yearly revenue. In fact, I can do it right now on the spot. Just look for a commodity like gold, buy $1 billion worth of that commodity and sell it immediately on the market below the spot price. For commodities with a lot of liquidity you can probably move it within the day. I don’t need to explain to you why that would be a very bad idea. It would be fundamentally unprofitable and there would be no perspective on how this could possibly change in the future. Yet in venture capital, we often see deals where massive funding rounds get allocated to startups that are operating at a negative gross margin. In VC there is a trade-off that needs to be made between growth on one hand and financial sustainability on the other hand. Policies of central banks worldwide that flooded the markets with cheap money have tipped this balance to the extreme of ‘growth at all costs’ while completely disregarding financial sustainability. This is not always the wrong approach. For example when customer stickiness is high and a couple of startups with a similar value proposition are battling for market share, it makes sense to disregard sustainability for a while and just aggressively acquire customers. However, it can only make sense when keeping in mind that at some point you need to drastically increase prices again. When you have a shot at establishing a monopoly, or when switching costs for the consumer are really high, you can go down this road.
However, the current Covid-19 crisis is highly likely to cause a decrease in available capital to be deployed and will rebalance the trade-off back to financial sustainability. That’s okay, the trends in VC move like a pendulum between these two extremes. As a founder you just need to be aware that you will be assessed based on dollar-efficiency. Basically, the ultimate metric to guide VC’s here is your LTV/CAC ratio. It’s simply the total profits a customer generates on average for your startup in his entire lifecycle, divided by the total costs associated with acquiring him. I will list the obvious strategies to optimize this ratio below:
1) Increase acquisition efficiency
This one is obvious. If you bring down the average acquisition cost per user, your LTV/CAC metric will improve. You can do this in 5 ways: 1) find the right audience for your product or service, 2) target them via the right channels, 3) optimize your marketing strategy, 4) launch referral campaigns and 5) remove all frictions to signup.
It has never been easier to do this. Point 1 to 3 can be optimized by applying growth hacking strategies in your digital marketing. Especially if you’re a consumer startup, test all possible channels and target difference audiences. It’s easy to set up different marketing campaigns across all channels. You can segment based on demographics and check where you get most signups from. Once you know your best audience, just try out different campaigns and keep track of your metrics to determine where your ad spent per customer won is the lowest. Point 4 and 5 can be tackled by testing your landing page. Add a referral program and keep track of the points where you experience a drop-off in customers. The key is to have a data-driven approach and pivot fast. The faster you can implement changes, the faster you can get feedback and adapt. The faster you can iterate, the bigger your advantage over your customer.
2) Decrease churn
Your churn is the % of customers you lose, often measured on a monthly basis (the basis should be the basis you bill your clients on). Obviously, it’s cheaper to keep an existing customer than it is to convince a new one. Your churn is an important metric that is often used by VC’s to determine whether you have product-market fit (we’ll write about this later). When it comes to minimizing churn, all strategies are fair game. If you’re a monopolist it’s very easy since customers have nowhere to go. If not, your pricing is an important aspect. However, try not to go too far in undercutting your competitors since this will decrease your LTV as well. You can increase switching costs, whether by doing this contractually or by making it very inconvenient. The champion of high switching costs is Hubspot. Want to use a different CRM? Say goodbye to all your data. There is a reason you can start using it at a 95% discount. They practically make it free so you start putting in data and at one point you find yourself locked in for the lifetime of your company. The easiest -and arguably the most customer-centric- way to decrease churn is to obsessively track customer satisfaction. Amazon is an example of a company that does this and I heard they are doing pretty well.
3) Up-sell or cross-sell
Increasing the amount of profit a customer generates can also be achieved by up-selling or cross-selling. Up-selling is when a customer upgrades to a better -more expensive- plan. Cross-selling is when you sell a complementary product or service. It’s closely related to customer satisfaction, but also to understanding what your customers need or want and their willingness-to-pay.
4) Increase usage
This one is closely related to up-selling and works when you charge on a pay-per-use basis. Again, it’s related to your customer satisfaction. I listed this separately because it’s an important one because it directly impacts a different metric that is often used to assess a startup and that is based on your CAC: the CAC payback period. This one is relevant if your startup operates in a highly competitive environment. When a VC allocates capital for you to deploy in order to acquire customers. If it takes a customer on average 1 month to generate profits equal to your CAC and it takes your competitor 2 months, you can deploy that capital twice as fast to acquire your next customer and you will grow twice as fast. This is something to keep in mind. Notice how in the example I started this article with, you will never get there. Even if your CAC is €0 (which is a fair assumption in a transparent commodity market where the only differentiator is price), you only make losses so your LTV will be negative.
What to benchmark it with?
In general a LTV/CAC ratio of 3 or higher is considered good by VC’s. However, it will be benchmarked with your industry and the most relevant competitors. The same holds for the CAC payback period. VC’s are often pitched similar ideas by different founding teams simultaneously. These metrics are often crucial in deciding which startup they will ultimately back.