Investors use high-level metrics to form a picture of a company’s business model, judge its relative attractiveness, and think about ways to improve it—You can, too!
by Karin O’Connor
We’re always intrigued with the ways in which our work with early-stage companies informs and improves our mid-market advisory practice. Young companies work hard to craft models that will enable them to build large and sustainable businesses. With little-to-no track record, thinking the key components through can be fairly straightforward. But it’s easy for companies with years (or decades) of history to lose sight. Here are some simple concepts for getting back to basics.
1) (LTV/CAC) > 3 or “Lifetime Value of a Customer > 3 X Customer Acquisition Cost”. Start-ups are encouraged to think about their businesses as machines that spend money to get customers and then monetize them. Though it’s common sense that a company needs to make more money from a customer relationship than it costs to acquire the customer in the first place, a lot of established business owners don’t think about it in those terms. We say they should.
Why the 3 X minimum? This is a standard rule of thumb in the Software as a Service (SaaS) space—a 3 X contribution has proven over time to be the minimum needed to cover product development, overhead, and other fixed costs and still generate a reasonable return. Top-performing software companies can hit 5 X or more; at that level, it makes lots of sense to invest heavily in acquiring more customers. Though these specific numbers don’t work for every business, they provide a solid starting point.
2) Acquiring profitable customers efficiently (and retaining them) is a big deal! If Lifetime Value and Customer Acquisition Cost are so important, let’s focus on optimizing them. Lifetime Value = Annual Revenue per Customer X Contribution Margin X Customer Lifetime (in years). Customers who generate lots of revenue with high contribution margins and who stick around for a long time are business nirvana. But, if one of these variables is relatively weak, we should work on making up for it with the other two. How can we expand our relationships, charge higher prices, lower our delivery costs and/or make our solution something that is harder to replace?
An efficient go-to-market is likewise critical—e.g. if we can replace an expensive direct sales effort with a lower-touch inside sales team, we may be able to cut CAC dramatically and grow the pool of desirable prospects. Start-ups spend a lot of time working on strategies to impact these variables—and see big jumps in value when they are successful.
3) Customers aren’t created equal. Taking our analysis down a level, it’s pretty much a given that some customers or customer segments are “more valuable” than others, and we don’t have to handle them all the same way. A customer with a relatively low contribution margin might still be profitable if he/she cost very little to acquire and sticks around a long time. On the other hand, we might be able to justify spending a significant amount to acquire a high-contribution relationship. And some customers simply cost more than they contribute—pretty obvious what to do with these. The trick is not to fool ourselves about which is which!
4) Beware the working capital sinkhole! Know any companies with growing revenues and good margins that can never seem to generate any cash? Often, high working capital investment is to blame. Take a look at this ratio: Net Working Capital as a Percentage of Sales/Gross Margin. The higher the ratio, the bigger the problem. We’ve seen plenty of companies with ratios approaching 1:1—meaning that every gross margin dollar is being plowed back into working capital. Absent special circumstances (e.g. gearing up for rapid growth), this is a very bad place to be. Working to either boost margins, cut working capital levels, or, ideally, both of these things, can start paying dividends (literally!) very quickly.
Given all of the details that go into running a business day-to-day, it’s all too easy to lose sight of the forest for the trees. Taking a step back and thinking about the business as if it is a blank sheet of paper can give you the fresh perspective that you need to start making changes and building value. Give us a call if you’d like to know more!