The “growth at any cost” mentality that has been so prevalent among young companies, specifically in the technology sector, is no longer the most important factor for management. Investors and the public are now placing a far bigger emphasis on revenue and efficient growth.
According to many finance experts, and the market response that backs this up, the hyper growth mentality was already far ahead of itself, but was pushed over the top during COVID-19. A wide array of factors caused this inevitable mentality shift.
The end of “easy money”
Projects and business opportunities that made sense during the pandemic, are no longer such easy decisions for management. What used to be “easy” money for both businesses and customers thanks to economic stimulus and miniscule interest rates being abundantly available, is no longer so easy, as interest rates were raised significantly and customers are being more conservative in their spending habits.
In addition, energy and transportation costs were extremely low during the peak of the pandemic, but they have only been going up since then. They seem to reach new record highs every week.
If a year ago companies were willing to pay any salary for talent due to the relatively unknown Great Resignation phenomenon and the excess of cash on hand, today companies need to think twice. Salaries are more and more inflated, the market has been on a downturn, and the talent shortage doesn’t seem to be going away, all causing executives to start to explore other options such as learning how to do more with less.
All of these factors, along with 40 year high inflation and low economic optimism is causing stakeholders and the public to put far more of an emphasis on revenue and efficient growth instead of hyper growth at any cost.
Measuring profitability vs. the cost of acquiring customers
Fewer than 5% of startups grow fast enough and scale sufficiently enough to have a chance to later adjust for business inefficiencies and make it out OK. Measuring profitability in relation to the cost of acquiring customers will give businesses a good sense of how efficient and sustainable their growth is.
A common mistake is when executives go after hyper growth at the expense of poor unit economics. Burning through VC money to operate at a loss by subsidizing user costs in order to drive acquisition numbers is tempting, but the public will see through this quite quickly.
If a company has to cut prices below their cost in order to win customers, then their company is not creating enough value for their customers. Not only that, but these types of customers are not high valued and usually don’t stay long, which drives up costs over time.
In order to control capital efficiency in a sustained and healthy way, three important things need to be established:
- Achieve a proven product-market fit
- Determine a scalable business model
- Build a repeatable sales process
If these 3 elements aren’t fully in place for a business plan with short and long term goals, the company is essentially burning through precious capital just to manufacture growth on paper. The business turns into a cash-burn machine with the hope that a venture capital firm will be there to back it up.
Instead of focusing on PR headlines such as “We doubled our customer base YOY” or “Our employee growth rate was 70%”, startups should focus on unit economics. This helps companies measure the value they’re getting from each customer in comparison to the amount that is being spent. Two great measures in startup unit economics are:
- Lifetime Value/Customer Acquisition Cost ratio- a long-term indicator that shows how many times the Customer Lifetime Value (LTV) exceeds the Customer Acquisition Cost (CAC). This is one of the most important measurements, however the obvious downside is that it can be hard for a young startup to accurately predict a customer’s lifetime value. LTV refers to the total worth of a customer to a business over the entire period of their relationship and is an important metric for revenue.
- CAC Payback Period- a short-term indicator that defines how fast the business breaks even from the Customer Acquisition Cost. A general rule of thumb is to aim for an 18 month CAC payback period, and a 3:1 LTV to CAC ration- meaning that the value of a customer should be at least three times as much as acquiring them.
How to move forward
VC giant Sequoia Capital has advice for how companies can navigate the change of focus from hyper growth to revenue: “What works in any market, is consistent growth and disciplined financial management that translates into improving margins. Companies who move the quickest have the most runway and are most likely to avoid the death spiral. Do the cut exercise. Reduce costs on projects, research and development, marketing, other expenses… Don’t view cuts as a negative, but as a way to conserve cash and run faster.”
In order to properly understand how cutting costs will affect the organization in the short and long term, companies need to go beyond estimates and relying on historical performance data. Instead, tools such as financial forecasting software that allows companies to conduct scenario planning will allow for a deeper analysis and understanding of how cutting costs or any other action deemed necessary will affect all aspects of the company’s performance.
Global business adviser Ram Charan addressed this at the CFO Leadership Council event: “Once again, cash is king. Some of your products are no longer profitable on a cash basis. “It’s time to take the cash-absorbing products and services out.”
Both investors and the market are proving that the days of hyper growth without the long term profit numbers to back it up are over. With the increased focus on efficient profits, startups will need to think twice before investing huge sums of money for unequal returns. This doesn’t mean that startups need to be profitable from day one, but rather that good management and measuring revenue success is the new focus.