Hello hello hello.
A few interesting things happened over the last couple of days, most notable being Boris’ resignation as the UK PM.
Hugh Grant (yes, Notting Hill actor Hugh Grant) sends out a tweet asking protesters camped out to play the Benny Hill theme from the speakers they had set up at the protest.
Predictably, the protestors play it on full volume.
That leads to one of the most hilarious background score for a seemingly important moment in a nation’s history. Tory MPs are pontificating on TV and explaining what happened/will happen while Benny Hill plays in the background. Much ROFL ensued, at least for me. But you don’t have to take my word for it. Watch for yourself here:
I was secretly hoping they would play “Another one bites the dust” after each ministerial resignation but now I guess it is moot.
Who knew Hugh Grant is the Galactic Emperor of Snark?
On to serious matters now…
1. Context
Today’s essay is in continuation of my previous post where we looked at some KPIs for subscription businesses. For better or worse, LTV/CAC has become the most important metric to determine growth potential and profitability prospects of startups. Lost in translation somewhere was an even more important indicator - the CAC Payback.
Now that some measure of sanity is returning to the VC world i.e. focus on cash flow and profitability (gasp), cash efficiency is once again an important lens through which to view the world.
In this essay, we will look at the following:
Why long CAC payback is murderous to any business.
Key benchmarks for healthy businesses (something that took me an inordinately long time to compile).
2. Framework:
We will look at this entire thing with this framework. I have taken a 5 large companies with well documented journeys as examples but I think one can see how most startups can be bracketed in this chart.
Now, while a lot of the focus of late has been on LTV/CAC (including mine), CAC payback is an important indicator of the underlying business dynamics. While often conflated, they actually measure different things:
LTV/CAC is an indicator of the margin efficiency of customer acquisition costs (RoI).
CAC payback is an indicator of the cash efficiency of customer acquisition spends.
Now, of course companies move around on these axes but the typical life cycle goes something like this:
Most VC funded companies start in the Bottom Right quadrant. The winners will move to Top Right and stay there. Some that mature from there would typically move (or get pushed) into the Top Left quadrant. Some will be forced to move directly from Bottom Right to Top Left in response to large environmental shifts or commoditization. The danger zone is the Bottom Left. Bad execution/highly adverse shifts will dump companies there. If you are elongating your paybacks, the business would typically not survive with low LTV/CAC.
Now, Let’s look at each of these quadrants one by one and see what makes them tick.
3a. High Growth and Cash Efficient:
Everyone want to be here. This club is exclusive and only rewards stellar execution. These companies have bolted down their engagement, operate in large markets and have high gross margins. As a result of their fast paybacks, they can recycle cash and invest in new growth flywheels, product and marketing. When these companies hit the market, they get high multiples.
However, there is the inevitable risk of sliding into the bottom left. Multiple factors exist to exert the force of gravity on these high flyers:
Inevitable decline in LTV: as the core market saturates and more adjacent customers are acquired, retention and engagement will degrade. Then there is tech obsolescence and the caprice of customer preferences.
Increase in CAC: As the core market saturates, the CAC will increase. Then we have to also contend with the dynamics of competition and increased capital - as more and more dollars compete for the same eyeballs, Google and Facebook make out like bandits. CAC shoots up.
A good example is Peloton. It spent a good two years in the top right before gravity dragged it down. Which brings us to…
3b. High Growth but Cash Inefficient:
Companies in the Bottom Right quadrant have a high CAC/LTV - high growth potential. However, slow payback means they need significant amounts of capital (working or otherwise) to scale up. As I said this before, most VC funded startups start here. Slow CAC payback has a significant, cumulative effect on cash flows and growth potential. To successfully move to the next phase (i.e. the upper parts of the chart), companies must demonstrate strong retention and flattening cohorts. This sets them up with a healthy base on top of which they can build product and growth strategies. If one doesn’t have these fundamentals, funding will be hard to come by in this environment.
As an example, let’s take a couple of companies:
Company A has a 3x LTV/CAC and a CAC payback of 2 months. (Top Right)
Company B has the same 3x LTV/CAC but with a CAC payback of 12 months. (Bottom Right)
Now, If I were running Company B and I deployed $1mn to acquire a cohort of users, I have to wait till next year before that cash comes back to me. Generating profits takes even longer. On the other hand, Company A will have given me back the same money in 2 months. That means that I can cycle the same $1mn 6 times before Company B gets it back even once.
Let’s say I were to invest $1mn each month in these companies. Here is what the cumulative cash flows would look like (not to scale):
So, Company A doesn’t need to raise much money and has many more optionalities to drive growth. The Company B strategy (in my opinion) has just gone out of the window given the environment we have today. The gravy train of endless funding rounds has stopped (hopefully, barring an act of Tiger / Softbank).
Welcome to the new normal.
3c. Low Growth but Cash Efficient:
Many companies as they mature, will end up here. This is true of online newspapers, subscriptions - most D2C businesses. Some will get pushed here from the top right. Some will see their core fundamentals erode to land here (e.g. Newspapers). Products with loads of alternatives and weak retention can be found here. Defensibility and moats can be built here using network effects or significant product differentiation / new products.
3d. Low Growth and Cash Inefficient
Welcome to the Danger Zone.
Companies end up here because of poor execution and weakening fundamentals - pressures on margins, high CAC, limited or no product differentiation and weak retention. The negative cycle of falling LTV/CAC and elongating payback periods is brutal, to say the least:
A great example here is the online mattress business. Take any name in any geography - they all exhibit this dynamic.
Companies here are significantly reliant on external capital to even breathe, let alone grow. These companies are forced to cut their marketing spends and cut costs to the bone to manage their burn. Getting to profitability, if even possible, comes at the significant cost of growth, moving these companies to the top-left quadrant. It is a death spiral few recover from.
To continue the example above, lets add a company C to the mix. So, our setup now is:
Company A has a 3x LTV/CAC and a CAC payback of 2 months. (Top Right)
Company B has the same 3x LTV/CAC but with a CAC payback of 12 months. (Bottom Right)
Company C has a 1.5x LTV/CAC and a payback of 24 months. (Bottom Left).
If you thought Company B’s cash flows looked bad, Here is Company C added to the mix. Absolute train-wreck.
4. Benchmarks for Great Execution
This one chart has been why this post took me almost two months to write. It took a lot of data crunching to evolve this framework. I would love to hear from you on what you think about this:
The average company in the Top Right quadrant is able to demonstrate >60% retention with flattening cohorts, >3x LTV / CAC, with a 6-12 months payback.
If one finds that our company has annual retention <40%, LTV/CAC <2x, or CAC payback>12 months, we need to examine the fundamentals in painful detail.
Interesting Asides:
Integra communication held its AGM on June 27. Transcript here. Some interesting moments. From Page 6 of this gem:
Housekeeping
As always, I look forward to hearing from you. If you liked this post, pls feel free to share this or subscribe to this newsletter using the links below. I try to write a 1000-2000 word essay once every two/three weeks.