I Want My Money Back

I met around 500 companies face-to-face last year.

Phew. Deep breath. Shut down. Restart.

That’s an interesting mix of 500 hours of healthy conversations and 500 shots of unhealthy coffees at the same time. At this volume of emails, investment decks, business plans, calendar syncing, notes, database updates, founders should realise that it’s tough to stand out from the crowd. If you’re one of the lucky ones who get to the “let me read their business plan” stage, this is your chance to be seriously considered for an investment. Make it count.

It’s important to understand what will an investor look at if they spend only a few minutes on your business plan, so I am listing some of that information down here. I’ll focus on Seed-stage and will be taking an example of a real business that I met recently without divulging any info about the company (of course). The company in question is a B2B business. It serves as a marketplace and does not keep any inventory but has its own fleet for deliveries. It’s deal size per month from one customer is an average of $5000. The company was raising a Pre-Series A round of around $1M, was at $100k MRR and was aiming to raise a Series A round in 6 months.

Let’s start.

Contribution Margin

My favourite metric to track of all. It’s always interesting to see how much profit a company makes with each unit of its goods/services sold. Contribution Margin is calculated by taking the revenue per order or per user and subtracting all your costs associated with selling that particular unit. I usually don’t put in the marketing costs here, just so that I can see what every $ of marketing spend in the early days returns back to the company.

Here is the breakdown of the unit economics (last 3 months average) of our example company:

Revenue: $5000
COGS: 77%

Gross Margin: 23% or $1150 (so far so good)

Direct Wages: 19%
Delivery Costs: 9%

Contribution Margin: -5% (ouch)

Just based on the contribution margin, this is not a healthy business. However the company is trying its best to be more cost efficient and improve its margins. I felt their future margin assumptions in the business plan were not realistic, so I played around with the numbers, gave them the best margins they had historically achieved in any month and got the following 6-months economics (my prediction).

Revenue: $5000
COGS: 75%

Gross Margin: 25% or $1250 (feeling better)

Direct Wages: 15%
Delivery Costs: 8%

Contribution Margin: 2% or $100

$100 from a $5000 deal is not much, but at least it’s positive.

CAC

Another metric to closely watch out for. If it is too expensive to find a customer, it’s probably not worth finding them at all. I always try to calculate the fully-loaded CAC. For this I need two things: marketing spend and sales & marketing staff salaries. Unfortunately the founder did not break down the salary costs so I had to make my own assumptions, and this is how I did it:

The business is pure B2B with a typical sales process starting from usually a cold or a warm email. I assumed one junior/mid-level sales staff’s salary to be $4000 per month. With the current outbound sales approach, the staff is likely to reach out to 100 companies, generate 20 leads, and probably close 5 of them in a month. Add in rough Facebook/Google marketing cost of around $2000 per month to generate 100 leads and we get a CAC of:

(4000 + 2000)/5 = $1200

In my opinion this CAC is quite high, but to judge it objectively the following two ratios become important.

CLTV

Usually people try to estimate the CLTV/CAC ration at this point. My problem with this ratio is that it is very hard to predict the Churn rate at an early stage of the business. You can still go ahead and do that, and assuming a 2% m-o-m churn you’ll get a customer life-time of 50 months (1/2%) and CTLV of $100x50 = $5000 and CLTV/CAC of around 4, which is healthy by usual standards. Do note the use of contribution margin to calculate your LTV, not your revenues.

Payback Period

Based on CLTV/CAC we feel the economics of the business are good. Here’s the catch. You may be happy that in the end you’ll recover much more from your customer than what you spent to acquire them. But if this takes years to happen you might as well shut shop now rather than later. A lot of founders as well as investors don’t pay attention to Payback Period. To understand the ratio better, read Mark Suster’s post here. Infact, read it now! I’ll be waiting.

We calculate the payback period as CAC/Contribution margin per month. In this case the number is $1200/$100 = 12 months. That is to say, the company breaks-even on a customer after 1 year (assuming the customer sticks on)! We haven’t even considered the fixed costs of the business yet. Now this is where the trouble starts. I usually like to see this number much below 12 months and preferably below 6 months. Why? Essentially, if you’re not able to recover your direct costs spent on serving a customer fast enough and at least faster than the speed at which you need to raise the next round, you’ll always be looking to bridge the gap through external financing. VC investment, especially at Series A, should be used to grow your business, not plug lost margins and fund high burn.

There are a few other metrics I considered for this company, but for our current discussion the ones above will suffice. Needless to say, I found the economics of the business hard and hence decided to pass on the company, till the time something changes in the business or the economics.

Trivia Question: What do you think was the business of this company?

Note: Inspiration for the title from Lenka’s “The Show”