Photo courtesy of Burst

What do you look for in a Series A? (Part III)

In the first installment of this series, I outlined 3 less discussed tenets for raising a Series A and dove into the first — prioritizing sustainable revenue. In the next post, I focused on the second — scaling team.

In this third and final post, I will focus on positive economics.

Economics matter. Shortcuts to subsidize growth in an unhealthy way will come back to hurt in the future.

There are few things I would advise an entrepreneur do to optimize for fundraising; rather, I would suggest making decisions that are optimal for the business. If executed well those decisions will improve fundraising success as a byproduct.

Positive economics is an important example of this. Growth is important but growth at all costs is dangerous.

Below are some examples I’ve seen of unhealthy growth metrics. Please bear in mind that there are exceptions to each, but in general these signs give investors pause.

  • Negative gross margins — A business selling $1 widgets for 90 cents of course will experience huge growth because it is a great deal for customers. If it costs more to produce your product than you are charging for it, it’s inherently high value for your users and will lead rapid growth but is an unprofitable strategy.
  • Negative contribution margins — The true cost of fulfilling a product or service includes cost of goods sold (COGS) but also logistics, customer service, shipping, and any other variable cost required to do so. It is important to take full account of your unit economics to understand how you should price your offering, whether you are truly selling profitably, and what levers you have available to lower your costs.
  • Long payback on customer acquisition — Customers only become profitable after the business is able to recoup its cost of acquiring them (CAC). CAC is recouped over time with positive contribution margins that contribute to this equation. For example, if my business’s CAC is $100 per customer, I make $100 in revenue per customer per month, and contribution margin is 50%, then I will make $50 in contribution margin per order, and will break even on the customer after 2 months. The lower the payback period the better, because it means it is more likely that the customer will stick around to that point. For example, if it takes a business 5 orders to break even on a customer, it is important to understand if customers on average make at least 5 orders and therefore spend enough to become profitable.

Why are these situations dangerous? How do I avoid them?

Without an extremely good short term reason for having the metrics above or a plan for correcting them, a company puts itself at risk of running out of cash because it is manufacturing demand and subsidizing each sale by not including the true full cost of delivering its product to customers.

The most important step in avoiding these situations is to be honest about your metrics and to track them closely. Often, I see founders tracking what many blogs have called “vanity metrics” — metrics that make teams feel great about their progress without digging into the underlying drivers.

For example, by only looking at gross margins a company can believe it is profitable on each transaction when in reality it may not be because fulfillment and customer service costs are extremely high.

Identifying the true drivers of your business and the resulting KPIs early is essential to sustainable, long term growth that will lead to true value creation for the entrepreneur, team, and investors.

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