Don’t Raise VC Money Before You Understand Unit Economics

Over the past couple of years, VCs have become more conservative, expecting significant commercial traction and a stellar team to get funding.

The coronavirus has not loosened these criteria. Commercial traction is not a magic phrase that gets you money. The quality of this traction and how that projects into the future matters even more.

Investors will ask questions such as:

  • How much money are you spending to get each client?
  • What is each client worth to you?
  • What percentages of your clients will churn?
  • When do you expect profitability?

These types of questions help investors create an economic health check, otherwise known as Unit Economics. The outcome will determine if you have potential for sustainable growth and if your company has the potential to be valued at 8 or 10 times your revenues upon exit, meaning Enterprise Value (EV) / Revenue will be 8 or above.

Source: Allied Advisers

Shift in the investor’s mindset

Unit Economics were not always in the investor’s mindset. Not long ago, investors rewarded high-growth companies, without looking at the costs. These companies survived and thrived for years, at the expense of their investors, and normally hit a wall when attempting an IPO and more conservative investors analyzed the numbers. We’ve witnessed a drastic pivot in the VC industry toward a more conservative result-based mindset. COVID-19 has made this even more apparent.

Basic requirement at any stage

Investors are looking for entrepreneurs who understand Unit Economics. Even if the economic indicators will straighten out in a few years, they want to know that you, the entrepreneur, know where you’re headed, and that you’re measuring the right economic indicators to steer the ship in the right direction.

The three main rules of Unit Economics

  • Rule of 3: The lifetime value (LTV) to customer acquisition cost (CAC) ratio is at least three. Lifetime value is calculated as the gross profit per user, multiplied by the lifetime. Lifetime is calculated as one divided by churn. Having a high LTV/CAC ratio may not be an advantage, as it could mean you are not spending enough on marketing and sales while your competitors are. Hence your growth will be slow and you will lose market share. If your LTV/CAC ratio is lower than three, investors will question the scalability of growth and spend needed to grow larger.
  • Rule of 40: EBITDA margin in percentages, plus annual growth in percentages should sum up to 40 percent or higher. Balancing profitability with growth is essential. As most SaaS-based tech startups are not profitable, they would require a growth rate of 40 percent or above to survive in the long term and provide the revenue multiple of eight or above. Profitability (EBITDA margins) of 10 percent means you can grow at 30 percent or higher.
  • Rule of 4: The growth to churn ratio should be four or higher. Churn is the percentage of people who leave in a period of time. So a growth of 40 percent allows for a churn of 10 percent, which is not easy to reach. It should be noted that churn figures are very hard to come by as companies tend to keep them a secret. Enterprise B2B SaaS companies can have a churn of 5 percent to 10 percent. Companies focusing on medium/small size business or B2C startups normally see a double-digit annual churn rate.

Summary

While you build your forecast and business plan, you should note the basic Unit Economic indicators. Beyond the numbers, the C-level executives have to create a culture of great customer service, of value-adding products that continuously evolve, with a good pricing strategy that makes sense to the end user, and that rewards long-term engagements. Adhering to the Unit Economic mentality could help you commercially as well as with your fundraising efforts.

Written by Itay Sagie, a lecturer, contributor and strategic adviser to startups and investors. He is also co-founder of VCforU.com, which helps over 18,000 startups with their Investor One Pager while hundreds of investors use the platform for deal flow. Sagie is also the Israeli adviser at Allied Advisers, a boutique investment bank from Silicon Valley. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.

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