The venture capital landscape has undergone a tectonic shift in the past year. A year ago, 90% of VC meetings with startups would have been about growth, regardless of how that growth would be achieved.
It didn't matter if you were burning money left and right: as long as you had interesting growth numbers, a solid story, and charisma, your round was pretty much guaranteed.
But as cash becomes more expensive, investors are paying increasing attention to savvy, resource-focused founders who can handle the tough times ahead. In 2023, most VC meetings are focused on whether a company can deliver sustainable and efficient growth during the downturn. And when it comes to this new reality, most founders haven't fully adapted to the change.
It is repeatedly appreciated that startups at all stages fail to raise the same multiples and at the same speed as they used to because, by today's standards, they are terribly capital inefficient and may not even realize it.
Here's why that happens and what metrics to track to understand where you stand on the capital efficiency ladder. Some possible solutions that have proven to be useful for companies based on experience are also raised.
To get started, let's talk about how should not measure capital efficiency.
The largest error in measuring the efficiency of capital
Understanding where you stand as a company comes down to the metrics you use and how well they can be interpreted. In this sense, the efficiency of the capital remains the blind spot for most founders, who rely on a single metric to draw conclusions. This figure can be found by dividing the customer lifetime value by the customer acquisition cost (LTV/CAC ratio or what is the same LifeTime Value/Customer Acquisition Cost).
The biggest problem with treating LTV/CAC as the holy grail of capital efficiency comes down to its oversimplified and often downright misleading nature. In fact, the rate at which SaaS companies misunderstand this metric has even sparked conversations about the need to retire the metric entirely.
For this method to be foolproof, reliable retention data must be used, which can be difficult for start-ups with little historical data to obtain. As an example, we've worked with several startups that miscalculated their CAC or based LTV calculations on unrealistic churn assumptions in the absence of historical data. This, in turn, showed false LTV/CAC ratio numbers.
It may be debatable whether or not SaaS should ditch the LTV/CAC metric entirely, but the point still stands: You can't measure capital efficiency. solo that way. Today, investors are focusing on other efficiency metrics that paint a more reliable and complete picture of a startup's capital efficiency. Below are other relevant metrics for capital.
Return on Investment in CAC (Payback)
CAC Payback is one of the most insightful and focus metrics to turn to if you need to understand how efficiently you are using capital. It shows how long it will take to pay off customer acquisition costs.
CAC Payback = Average CAC per customer / Average ARR per customer
ARR, Annual recurring revenue
How long should your recovery time be? Ideally, as short as possible, with specific gaming spaces depending on the industry and the business model. According Bessemer Venture Partners Here are the B2B SaaS benchmarks against which investors will measure their recovery:
| Small SME | Large SME | Company | |
|---|---|---|---|
| All right | 12 | 18 | 24 |
| Better | 6 – 12 | 8 – 18 | 12 – 24 |
| Ideal | <6 | <9 | <12 |
The importance of staying within these benchmarks is vital when competing with companies in the same market. For example, while it takes almost five years for Asana to recover its CAC, Monday manages to this 2.3 times faster, with a return of the CAC of 25 months.
Unfortunately, we see startups that fall outside of these benchmarks all the time. One of the startups we worked with turned out to have a CAC return of More than 35 months. Just analyze it: almost three years to break even on the acquisition of a single customer!
How do you fix a situation? There are a few key things that can reduce your payback time:
Discover the fallen zones
High recovery time is like an alarm light on the dashboard of a car: you know something is wrong but you don't know exactly what. The problem, however, always lies with the sales and marketing functions. So it can be found:
- Analyze the LTV/CAC ratio and the CAC return per channel
The LTV/CAC metric can be very insightful when applied to specific channels by showing which marketing and sales channels are doing well and which ones are underperforming.
For the business case mentioned above, this strategy revealed the gross inefficiency of its outbound channel: it had low conversions, extremely high ROI CAC, and small customers that delivered low ARPA/ARPA. Account, Average income per account). In total, this channel delivered less than 10% of the new MRR (Monthly Recurring Revenue), but represented more than 30% of the cost of customer acquisition. He was the definition of dead weight for the company. On the other hand, the partnership channel turned out to be very profitable: less than 25% of customer acquisition costs generated a whopping 50% of revenue.
- Analyze the LTV/CAC ratio and the CAC return per segment.
Doing so confirms assumptions about the product or ICP (ideal customer profile). This approach repeatedly reveals unprofitable products that waste effort and cost or help identify customer segments that generate low profitability.
In conducting an analysis for the client in question, we found that the company needed to shift its focus towards higher paying clients. Unless the company could somehow automate the acquisition of the lowest-paying customer segment, it needed to completely rebuild the ICP it was targeting to drive higher profitability.
Reduce CAC
Cost reduction is the fastest way to lower your CAC. Often includes:
- Staff cuts in underperforming channels. Sounds harsh, but according to investors, 20-50% of staff can often be removed without impacting the company's top line and team morale. It just has to be done sensibly: leave all critical positions filled, properly compensate the remaining people, and manage risk.
- Redeployment of your marketing and sales investments in favor of cheaper options. It can include reducing reliance on paid ads and duplicating SEO, refocusing event budgets, and other high-CAC activities for brand awareness, content, and partnership channel support.
Increase MRR (and therefore LTV)
Cost reduction is key, but don't forget to work on the other part of your CAC recovery: revenue. The following practices effectively generate instant income in the companies analyzed:
- Raise prices. That's the simplest and most effective route most businesses take.
- Start charging for functionality that was previously free. In one case reviewed, the company began charging for implementations. These invoices were still below market level, but this change helped the company introduce a first advance payment to offset part of the initial CAC.
- Move segment or market. This step is not universal and may involve different preliminary workloads depending on the business case. In many cases, however, it's just a matter of employing more targeted exit efforts to attract more high-paying customers.
- Get back to good growth hacking growth, all hands on deck. It may sound boring and obvious, but for some, getting creative with your growth strategies may be the only way to get your recovery time in order during the recession.
All of the above activities help businesses reduce their CAC rebate by an average of 35 months to 21 months, much easier to digest, and all in six months. However, CAC payback and other marketing efficiency metrics only tell part of the story. To tip the balance of capital efficiency in the eyes of investors, you may need to look at other aspects outside of marketing.
That's when the queen of all efficiency metrics, the Rule of 40, comes into play.
the rule of 40
The Rule of 40 metric helps investors assess the financial health of software companies by ensuring that their revenue growth rate and EBITDA margin add up to at least 40%. It can be calculated by adding the company's revenue growth rate and earnings before interest, taxes, depreciation, and amortization margin.
Too many founders we work with have never even heard of this rule until we talk to investors and find out those founders don't measure up. This puts them in an especially unfavorable position during fundraising, as such companies receive reduced valuations or are eliminated from the round entirely.
Since the recession began, investors have paid close attention to the Rule of 40, rewarding those who are at or above par with highest ratings. You don't have to look far to see this trend in action. For example, Salesforce, with a Rule of 40 score of 48%, has a rating almost 10 times higher to that of HubSpot, with only 28% in the Rule of 40.
On the other hand, Zoom, with its 40 to -5% Rule, had to lay off 15% of its workforce to regain some of its capital efficiency. Asana has it even worse at a whopping -24%, and it's above its dismal CAC.
What if a company has a low rule of 40 but a large CAC payback? It's usually a sign that the company is inefficient somewhere outside of its marketing and sales function, and its growth isn't covering these inefficiencies. Typical cash losses in this case would include large management bonuses, significant travel expenses, expensive research and development equipment, and other operating expenses. Some companies waste hundreds of thousands of dollars without a clear business ROI, which begins to affect your capital efficiency when the tide is out low.
In this case, the answer is obvious: cut costs. It's obvious what you might think: "But isn't it better to double the speed of business increase?" While you can move in this direction, there's a chance you could make things worse if you're already capital inefficient and need to raise soon.
As a venture consultancy, more than 70% of the companies that followed this path failed because growth is not cheap. It takes time for your initiatives to get off the ground and turn a profit, and it requires an infusion of additional costs that most companies can't spare. In this situation, recklessness can be that nail in the coffin that will burn the road faster and decrease the chances of obtaining funds.
On the other hand, cost reduction is a risk-free way to increase your EBITDA immediately. Here are some obvious and perhaps not so obvious strategies to reduce costs:
- Reassess the technology base: 80% of companies have underused tools, tools with overlapping functionalities or applications that they forgot but still pay.
- Pause all non-critical new hires.
- look at the recruitment fees and quotes to look for cost saving opportunities.
- Adopt a remote work model or use coworking spaces.
- Stop work or promotion trips.
- Check the performance of the R+D+i teams, especially if you are a late-stage or expanding startup with a complex, multi-layered structure. There is almost always a way to cut some of the layers without affecting the output.
At the same time, look for ways to increase the productivity by department. For example, can your Customer Support team handle more customers per person? Can your sales reps increase the minimum fee? In four out of five companies we surveyed, these numbers were below industry benchmarks, so keep track of critical leading metrics department by department.
Why does all this matter?
Because in this environment, investors are becoming more selective about who they trust with their money. If money is being lost all over the place, and it shows up in the efficiency metrics, the project will be considered “dead by default” and move on to the next one, or a significantly lower valuation than expected.
The good news is that if the product is exciting and has a sharp investor narrative, VCs are generally willing to wait and see if the metrics can be improved. So if your capital efficiency is in a bad place, focus on improving it at all costs, as it will not only make you rank better in VC scores, but it will also help drive long-term sustainable growth.
From experience, some companies can get to a good place in two quarters, but on average, it takes about a year; it all depends on the severity of the situation.
Once capital efficiency metrics are healthy, funding odds will skyrocket. Just highlight the new numbers on the next pitch deck!
