Payback’s a gift
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Image Credits: http://www.gettyimages.com/search/photographer?family=creative&photographer=Monica+Rodriguez / Getty Images
Each year, we meet thousands of internet businesses that run the gamut from industry or vertical to product and business model — and just about everything in between.
On the surface, these businesses might not have much in common; internally, we’ve converged around one single metric that’s applicable to almost all consumer and/or marketplace businesses that use paid customer acquisition.
We regularly share this metric with both our portfolio companies and the entrepreneurs we meet. We’re sharing this metric here in the hope that founders can use our Payback Ratio as one useful benchmark when evaluating the health and progress of their businesses.
Payback Ratio: Cumulative contribution margin within 18 months ≥ 2*CAC
Where:
- Contribution margin = revenue – COGS – variable operating costs. For internet and software businesses, variable costs typically include costs associated with hosting, payment processing fees, onboarding or implementation costs, customer support, returns, shipping and discounts.
- CAC = fully loaded costs associated with paid marketing (paid advertising, retargeting, paid referrals, branding, PR, sales and marketing salaries, etc.).
This rule states that businesses should strive to consistently generate at least two (2) times the amount spent on customer acquisition on a contribution margin basis within 18 months. We see many companies calculate CAC payback on gross margin, but we believe contribution margin is a more reliable measure because variable costs have a meaningful impact on unit economics and should not be discounted (pun intended!).
Here are three examples of how this can manifest across various companies:
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- Company 1: E-commerce company that breaks even on first purchase but few customers come back. Doesn’t achieve the goal.
- Company 2: High-frequency transaction business, like Uber, where the company may not even break even within the first few transactions, but usage increases over time and leads to 2X+ in 18 months.
- Company 3: Medium-frequency business where usage decays over time but company just skims 2X in 18 months.
As Warren Buffet says, “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” Our Payback Ratio is one way of measuring this and determining if a company has the potential to scale profitably for a long period of time.
While there are many benchmarks that founders should consider, we think this is an attractive and important goalpost to keep in sight. Predicting the future is hard, and even if a business hasn’t yet achieved this, it by no means is a deal breaker for us from an investment perspective, but we do like to see continued progress toward this milestone. (In fact, many of our portfolio companies haven’t even existed for 18 months yet!)
How did we come up with this benchmark? We evaluate the health of our funds in terms of multiples and IRRs. Venture capital funds target 3X multiples and 30 percent (or better) returns. Generating 2X the spend on acquisition in 18 months yields roughly a 60 percent internal rate of return, and that’s fantastic.
Of course, the business still needs to cover its fixed costs, and many businesses find their CAC payback gradually declines as they scale up to reach less and less attractive customers, so the actual return on each dollar invested in customer acquisition is much lower, but likely still quite attractive. As investors, we would be delighted to invest in a company that consistently generates this type of return, and we think most entrepreneurs would also be thrilled by such performance!
If your business’s CAC payback is in line with our Payback Ratio, your company’s success might only be rate-limited by your speed of execution and scale!
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