At Smedvig Capital, one of the most common topics we end up discussing with entrepreneurs is metrics.
Investors obsess over metrics because they provide an objective measure of the current and future health of a business. But for the same reason, they should also be an essential part of the entrepreneur’s tool kit.
However, with so many metrics out there now, choosing and making sense of the most important ones can be a daunting task.
When we discuss metrics with founders, they usually ask three questions:
- Which metrics are the most important?
- What do ‘great’ metrics look like?
- How can I use those metrics to add value to my business?
Last week we gave a presentation to a room of SaaS CEOs at Silicon Valley Bank where we tried to answer these three questions from an investor perspective. Over a short series of posts, I will lay out our answers one at a time, starting with “which metrics are the most important?”.
Ultimately, only two questions matter.
The ‘value’ of your business will be driven by two specific questions:
By ‘maturity’ we mean, once a business has reached a ‘fair’ share of its potential addressable market and has stopped investing heavily in growth.
These two factors will eventually define the financial return to the founders, the management team, and the investors.
So how can we go about answering these questions for an early stage business?
These questions are tough to answer.
Sadly, this is easier said than done. Most early stage businesses are investing heavily in growth, growing really fast, and losing lots of money. This makes it difficult to answer these two key questions simply by looking at the P&L.
With SaaS companies, the problem is exacerbated because value is realised through recurring revenues spread over a long period of time. Businesses typically have to spend a significant amount of sales and marketing budget upfront to acquire a customer (Customer Acquisition Cost, or ‘CAC’) and then receive regular, relatively small payments over a long period of time.
This means that high top line growth can mask a fundamentally flawed underlying business, and conversely, many great businesses may need to burn through a lot of cash before realising their potential.
So how can we assess the potential of a business if the P&L can be so misleading? The answer is unit economics, and in particular, two ‘killer’ ratios that tell us everything.
Luckily, two ratios tell us everything.
By looking at the economics of a single (average) customer, we can get a sense of how the economics of a businesses will unfold as it scales.
There are many different metrics of unit economics, which can tell us about different aspects of business performance. But there are two specific ratios, which tell us how all these different aspects aggregate up to answer our two fundamental questions.
These two ratios are ‘Lifetime Value to Customer Acquisition Cost’ (LTV:CAC) and ‘Customer Acquisition Cost Payback Period’ (CAC Payback).
LTV:CAC is the ratio of the total gross profit we expect to receive from an average customer during its total lifetime, versus the average cost of acquiring a customer (sales and marketing spend).
LTV:CAC is a powerful metric because it tells us how profitable the business will be at ‘maturity’. High LTV:CAC means high profitability.
CAC Payback is the number of months of recurring gross profit from an average customer, that it takes to payback the average cost of acquiring a customer (sales and marketing spend).
CAC Payback is an indicator of how much sales and marketing spend will be required for a business to reach a certain size. It is therefore a great proxy for how much investment the business will need in order to reach its next milestone. High CAC Payback means high cash burn.
I will discuss in more detail how these metrics are calculated in a later post.
So the answer is…
LTV:CAC tells us how profitable a business will be at maturity and CAC Payback tells us how much cash it will take to get there. Therefore, these are the two most important metrics and entrepreneurs should monitor them religiously.
These two metrics are not only vital for proving the potential of your business during fundraising but should also be used as a constant barometer of business health.
In my next post, I will demonstrate the impact of these metrics through a worked example and will try to answer the question “what is a ‘great’ LTV:CAC ratio and CAC Payback?”.