Capital efficiency is the new VC filter for startups

The VC landscape has undergone a tectonic shift in the past year. A year ago, 90% of VC meetings with startups would have been about growth, with little regard for how that growth would be achieved.

It didn’t matter whether you were burning money left and right: As long as you had chubby growth numbers, a strong story and charisma, your round was pretty much guaranteed.

But as cash becomes more expensive, investors are giving more and more attention to resource-focused, shrewd founders who can handle the hard times ahead. In 2023, most VC meetings focus on whether a business can deliver sustainable, efficient growth during the downturn. And, as far as our anecdotal evidence is concerned, most founders haven’t quite adjusted to the change.

We repeatedly see startups at all stages failing to raise at the same multiples and velocity they used to because, by current standards, they are terribly capital inefficient and may not even be aware of that.

In this article, we will explain why that happens, and whi h metrics to track to understand where you stand on the capital efficiency scale. We also explore potential solutions that have proven helpful to companies we worked with.

But first, let’s talk about how you shouldn’t measure your capital efficiency.

The biggest mistake in measuring your capital efficiency

Understanding where you stand as a business boils down to the metrics you use and how well you can interpret them. In this respect, capital efficiency remains the blind spot for most founders, who rely on a single metric to draw conclusions. This figure can be found by dividing Customer Lifetime Value by Customer Acquisition Cost (LTV:CAC ratio).

The biggest problem with treating LTV:CAC as the holy grail of capital efficiency boils down to its oversimplified and often straight-up misleading nature. In fact, the rate at which this metric gets misconstrued by SaaS companies has even started conversations about the need to retire the metric altogether.

For this method to be foolproof, you must use reliable retention data, which can be hard to come by for startups with little historical data. As an example, we worked with several startups who calculated their CAC wrong or based LTV calculations on unrealistic churn assumptions in absence of historical data. This, in turn, showed “fake good,” bogus LTV:CAC ratio numbers.

Whether or not SaaSs should ditch the LTV:CAC metric entirely is debatable, but the point still stands: you can’t measure your capital efficiency only that way. Today, investors zoom in on other efficiency metrics that paint a more reliable and comprehensive picture of the startup’s capital efficiency, and so should you. Let’s see what they are.

Look into your CAC Payback

CAC Payback is one of the focal and most telling metrics you can turn to if you need to understand how efficiently you use your capital. It shows how long it will take for your customer acquisition costs to pay off.

CAC Payback = Average CAC per customer / Average ARR per customer

How long should your payback time be? Ideally – as short as possible, with specific ballparks depending on your industry and business model. According to Bessemer Venture Partners, here are the benchmarks for B2B SaaS that investors will measure your payback against:

B2B SaaS CAC Payback benchmarks

SMB
Mid-Market
Enterprise

Good
12
18
24

Better
 6 – 12
 8 – 18
12 – 24

Best
  < 6
 < 9
 < 12

The importance of staying within these benchmarks is vital when you compete with companies in the same space. For example, while Asana takes almost five years to recoup its CAC, Monday achieves this 2.3 times faster, with a CAC payback of 25 months.

Unfortunately, we see startups falling outside of these benchmarks all the time. One of the startups we worked with turned out to have a CAC payback of over 35 months. Just think about it: almost three years to break even on a single customer acquisition!

How do you fix a situation like this? There are a few key steps that will bring your payback time down:

Uncover sagging areas

Capital efficiency is the new VC filter for startups by Walter Thompson originally published on TechCrunch