How to plan your startup’s growth
For a startup, the decision on how to go about financing the business is intimately related to the decision on growth strategy and both of these have direct consequences on founder wealth. Many founders believe that they should be growing as fast as possible, however, the purpose of a business is not to be as large as possible. The purpose of starting the startup is to return wealth to the founders. Growth has wide ranging implications for the success of a venture. If growth is too slow it leaves the venture vulnerable to competition and potential technological obsolescence, while on the other hand, growth that is too fast threatens the entrepreneur’s ownership share of the business. There are a multitude of factors that impact the equation and therefore careful consideration is required to make optimal decisions that maximize founder wealth. The challenge is determining the strategy that fosters long term survival while retaining value for the entrepreneur. Lucky for us, with a robust financial model there are a number of tools that can aid a founder in navigating the waters.
In order to understand how to properly grow your business, the first thing to do is to get a better understanding of how a business grows. A business begins with cash that is financed through either debt or equity. The business then invests that cash in a combination fixed assets, raw material, and labor. The labor portion includes all marketing expenses and this will determine your customer acquisition cost (CAC). Those three investments come together to create the finished product, which, when sold, creates cash flow back to the company. The portion of that cash flow from each customer that is above the contribution margin is known as the customer lifetime value (CLTV). The profit from sales is used to pay back interest and principal owed on loans, gets distributed to equity holders through dividends or stock buybacks, or gets retained in the business to go through the cycle again to fund further growth.
If your CLTV is greater than your CAC then there should be positive growth that contributes value to your startup. Without further investment the startup will be able to internally finance growth at a pace known as the sustainable growth rate. This rate can be calculated by multiplying the return on equity by one minus the dividend payout rate. If the startup needs to grow faster than that rate then it will have to raise outside financing to do so. The “fundamental law of growth”, a commonly used rule of thumb among tech startups, states that a CLTV:CAC ratio of 3:1 or higher should be achieved. This can vary between industries and business models, but it’s something to think about when considering how much outside financing you need.
The next thing is to get an idea of the size of the relevant market and the market dynamics in terms of competition and regulation. It is important firstly to distinguish the relevant market from the total addressable market. While the total market size is a good starting point, you need to narrow down the market based on the qualities and features of your product or service to get a more accurate picture of what is achievable in terms of who is going to use your product or service. Next it is important to get a sense of the market dynamics. Is it a highly competitive market that is fragmented? Is it a winner-take-all type of situation where there are a few players at the top and the rest are small players? Porter’s five forces is an analytical framework that can be used to breakdown the competitiveness of your industry. Based on the market analysis, estimate the market share you should be achieving at maturity. This will give you an upper limit to expected growth and help you strategize your path.
Planning for growth means understanding the inner workings of your variable and fixed costs and understanding your metrics of CAC and CLTV. A variable cost is a cost that scales with revenues. The greater the revenue, the greater the cost. A fixed cost is something that doesn’t grow with revenue. All fixed costs, however, become variable in the long run. For example, an office may service a company and be unrelated to the amount of sales, however if sales grow by ten times, it is likely you will need a bigger office. Practical impediments to growth include challenges such as needing to rapidly build a management team, acquire assets necessary for production, maintain the quality of the product or service, and obtain financing to support the rate of demand growth.
Once you have a handle on the internal mechanisms by which your startup creates cash and you understand the external environment in which the business is operating in, it is possible to build your financial model and plan your growth milestones. Taking a big picture point of view, you can glean from your estimate of market size and dynamics a target of where you should be at maturity and a sense of how long it takes to get there. You can then plot out your milestones of number of customers that you need to acquire each year. If you have estimates on CAC, CLTV, fixed costs, and variable costs then you can get an idea of how much external money you need to raise in order to achieve your milestones.
The last part of the equation is optimization. For this step to be fruitful requires your model to output a valuation that is based on cash flows. It should be possible to adjust the milestones you are setting, which will impact the amount of money that you need to raise and change the overall valuation of the startup. The metric that is important to take from this is how the amount of money you raise, the timing of the money you raise, and the overall valuation of the business impacts founder wealth.
Growth planning can seem like a daunting task, however with the proper planning and tools it can go a long way towards establishing the most profitable path for founders.
