Your startup has customers? Turns out, that’s not enough.
Seed funded? Check.
Product-market fit? Check.
Core team? Check.
No early startup hiccups (from payroll to cofounders)? Check.
Seed-funded, pre-Series A startups are off to the races — for the above four reasons, and more.
But, as we at Founder Collective watch our seed companies grow and progress towards their Series A / B / C fundraise, several challenging new realities quickly start to sink in for the founding team:
- You grow, or you die. Sensationalistic? Maybe. But it’s true: just ask any post-A founder). If they don’t continue to grow rapidly, they A) won’t hit the milestones necessary to raise future funding B) risk losing out to their bigger competitors — be it hemorrhaging market share, or getting acquired. Also, you only have two years to prove out your idea — if you hope to raise any outside funding.
- Paid growth has limits. They start to see how tempting — and dangerous — it is to rely solely on paid, i.e. venture funded growth. If their growth is achieved exclusively through massive marketing or sales spend, not being able to raise the next round of funding becomes a company killer. (My colleague Eric, writes about this in his post “Venture Capital is a Hell of a Drug.” It sure is.)
- Competition for funding is fierce. Before seed funding, most founders are (rightly so) “staying in their own lane”. Now, they suddenly become hyper-aware of the competition — especially as they look out to their next fundraise. As disproportionate value accrues to the front-runner in a space, the #3, #4 or #5 competitors will find it nearly impossible to get funded by growth stage investors.
What all this boils down to is…
Quantifiable growth, or “growth economics” matter
As a founder, you get swept up in solving a customer’s problem with a fantastic product offering, and so it might seem sacrilegious to reduce your business to numbers. But here’s the truth: after you’ve hit product-market fit, the business of scaling is about quantifiable numbers — what I would call your “growth economics.”
As you scale, your growth economics can make or break your company.
Managing your growth economics becomes your secret weapon because growth economics are the inputs to your growth chart over time. They reveal whether you have identified any ways to scale more efficiently, from levers for exponential growth, viral/product-driven ways to get away from paid acquisition, to plain vanilla, smarter ways to manage paid spend. (Unfortunately, series A and B stage founders learn this lesson too late — when many of these metrics are visible, measurable and hackable from much earlier on.)
Measuring growth economics: three simple equations
Three simple equations can reveal the “quality” of your growth and the strength of your business. Whenever possible, I prefer to use operating metrics because ideally a founding team is monitoring these metrics on a quarterly, monthly, or even weekly basis and this is harder to do if the metrics require you to close your books before you can calculate them.
In math terms, velocity — how fast a company is growing — is the slope of your growth curve. Velocity is one of the most significant drivers of value in venture capital, and founders ignore its demands to their significant disadvantage.
There are three major vectors of value creation in the venture: the myth of new technologies creating entirely new markets is only the most prominent one, but not necessarily more important than others. In fact, much of the value of high-growth/ venture-backed startups are created because they are scaling so rapidly.
As my colleague David Frankel puts it, it matters a lot if you get to $1M ARR in one year or ten. This is, even more, the case with venture-backed startups, because you’re essentially building with someone else’s money.
2. Unit economics
In math terms, unit economics relate to the height of each slice of your growth curve, between your revenue and your costs.
Unit economics are a much more atomic glance into profitability, i.e. at a customer or product level. As with revenue efficiency (the third metric I’ll discuss), the downstream impact of a low-margin business is that you have less in your war chest for customer acquisition — which is a downer, especially when you hit post A raise, i.e. right when you’re most sensitive to competition and do-or-die growth milestones. Also, you are much less likely to be able to fund your own growth, which means that you’ll have to go back out to the venture market for funding each time (and crucially, where the market has leverage not you).
We believe exceptional teams can build unicorn-scale companies despite poor unit economics. But this requires that every single other aspect of their business has to be steered as finely as a multimillion-dollar racing yacht.
There can be extenuating factors — say, if you have positive network effects, or it takes Olympian execution — but we’ve been lucky enough to work with some of these founders, and maybe you’re one of them! For everyone else, poor unit economics are more friction you’ll need to combat, as you head up Olympus.
3. Revenue efficiency
Revenue efficiency is, in math terms, the area between the profit and revenue curves, and so at its most basic level, how profitable a company is. Often as founders, and definitely as investors, we are optimizing for maximum profitability, i.e. how fat is that slice?
It seems like a fundamental truism that the revenue you can generate — relative to paid acquisition spend or fixed costs — is a measure of your business’s health. However, the demands of growth have created an unhealthy market distortion where funding unprofitable growth sometimes seems like good business.*** We have assembled a data set showing that the startups that raise the most money do not return the most capital — either to founders or to investors. In fact, frugality forces founders to make tougher, more strategic investments, which ultimately results in stronger businesses.
While there are many different ways to calculate revenue efficiency, the most important variables seem to be:
- Revenue: This can be total revenue when evaluating a company at a very big picture level (which almost no one ever does); or incremental revenue, which is more practical for a team to update every month.
- Acquisition spend: Whether this is in fixed costs (number of bodies on your sales and marketing team) or variable costs (i.e. performance marketing or SEO optimization spend), founders need controls to determine whether acquiring customers, aka growth, is profitable or not, and if not, how bad is the bleeding? You can be sure that investors and board members are asking, even if — very rarely founders are not.
- Payback on acquisition spend: This often overlooked variable is so essential to managing cash flow. Does it take 3 months or 12 months to pay back your CAC? The latter suggests a business that will need to raise large growth rounds in order to scale. The more VC dependent a company is, the more the market will be able to set the terms for further financing, sometimes to the detriment of founders and earlier stage investors.
Essentially, these equations answer the following fundamental questions…
- How will you grow?
- How fast will you grow?
- How profitable is each unit of sale?
- How capital efficient is your growth? and…
- How efficient are you at generating revenue?
The purpose of this post is to remind you that as you scale, the goal posts actually do move and that you should start thinking ahead about how to optimize your business to succeed. This even suggests questions you can ask when you are at the idea selection phase, to forecast which businesses might be untenable to scale beyond a certain point, and which ones could be winners.
As a founder, I wished I had simpler tools and frameworks to help me understand how well my business was going, and how good a business it was going to be. As an investor, I know that I’ll rarely, but probably never know more about a business than the founders. Every week I see savvy founders stumbling on ways to optimize their acquisition costs, design for great unit economics, or instinctively understand capital efficiency (or not.)
Steering effectively is some combination of trusting yourself and your team, having great advisors and learning as you go. No framework, equation or rule of thumb will substitute for that. Good luck building! If you’d like to get notified about my next blog post, please add your name to my brand new email list.
In the next two parts of this series, I will explore some case studies and go deeper on the 7 key operating metrics that make up growth economics. Stay tuned!