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These simple metrics will tell you if your startup is ready to scale

Consider gross churn rate, the magic number and gross margin

Tae Hea Nahm

Contributor

Tae Hea Nahm is co-founder and managing director of Storm Ventures and is the co-author of the “Survival to Thrival” book and podcast series. For more, visit Unlock, his online resource.

Finding go-to-market fit (GTM) is a pivotal moment for a startup. It means you’ve found a repeatable formula for finding and winning lead that can be written into a repeatable GTM playbook. But before you scale up your sales and marketing, you should check the metrics to make sure you’re ready.

You have to consider three metrics — gross churn rate, the magic number and gross margin. With these, you can measure the health and profitability of your business. By combining them into a simple equation, you can get your LTV:CAC ratio (long-term customer value to customer acquisition cost), which is a measure of your business’ long-term financial outlook. If the LTV:CAC is over 3, you’re ready to scale.

Let’s unpack the three basic metrics:

Gross churn rate (GCR) is a measure of product-market fit (PMF). GCR is the percentage of recurring revenue lost from customers that didn’t renew. It answers the question: Do your customers stay with you? If your customers don’t stick with you, you haven’t found PMF.

GCR = Lost monthly recurring revenue / Total MRR.

Example: At the beginning of March, the company brought in \$60,000 in MRR. By the end of the month, \$15,000 worth of contracts didn’t renew.

GCR = \$15,000 / \$60,000 = 0.25, or 25% GCR.

The magic number (MN) measures your go-to-market fit. You can calculate it by taking new ARR divided by your marketing and sales spending. This metric answers the question: How much new revenue is generated for every dollar spent on sales and marketing? If every dollar of sales and marketing spend brings in more than one dollar of revenue, you’re in good shape. But keep in mind that the magic number is a lagging indicator, and it may take you a few quarters to see a positive result.

MN = New ARR / S&M.

Example: In March, the company spent \$25,000 on sales and marketing and generated \$65,000 in New ARR.

MN = \$65,000 / \$25,000 = 2.6.

Growth is your new revenue (based on MN) minus churned revenue (based on GCR).

Gross margin (GM) measures your unit economics. It’s equal to net revenue as a percentage of total revenue. It answers the question: How much gross profit do you get over the cost to produce each unit sold?

GM = (Revenue – COGS) / Revenue.

Example: In March, the company sold \$170,000 worth of services at a cost of \$85,000.

GM = (\$170,000 – \$85,000) / \$170,000 = 0.5, or 50%.

Scaling usually improves the GM, reduces the MN and has minimal impact on the GCR.

If your gross churn, magic number and gross margin are the three elven rings, your LTV:CAC is the One Ring to rule them all. Your LTV:CAC answers the question: Do you have a financially sustainable business?

You can derive your LTV:CAC with a simple equation using just the three metrics above:

LTV:CAC = (MN x GM) / GCR.

As a general rule, if your LTV:CAC is at least 3, you’re in good financial shape to hit the gas and grow your business.

Example: In the exercises above, we calculated the following metrics for the company’s performance in March.

GCR = 0.25.

MN = 2.6.

GM = 0.5.

So, that means our LTV:CAC is the following:

LTV:CAC = (2.6 x 0.5) / 0.25 = 5.2.

That’s higher than 3, which means this business is ready to hit the gas and scale.

At this point, it’s natural to ask what values of GCR, MN and GM you should target in order to achieve an LTV:CAC ratio of more than 3. The answer is that it depends on the business.

The table below shows different “magic number” and “gross churn rate” combinations that would generate a TLV:CAC ratio of 3 for a 40% to 80% gross margin business. As expected, a high gross churn requires a very efficient go-to-market (high magic number) to make the business viable.

 Subscription Marketplace GCR 10% 25% 80% 90% GM 40% 60% 80% 40% 60% 80% 40% 60% 80% 40% 60% 80% MN 0.8 0.5 0.4 1.9 1.3 0.9 6.0 4.0 3.0 6.8 4.5 3.4 LTV:CAC 3 3 3 3 3 3 3 3 3 3 3 3

Since a good subscription-based business has a low GCR (say 0.1), renewals can subsidize a smaller magic number. In a SaaS business, the magic number doesn’t need to be quite so high.

In a marketplace business with no renewals, the gross churn is close or equal to one, and the magic number must be much higher. In this case, you need a magic number 10 times higher than the SaaS business to maintain an LTV:CAC of 3.

Whatever your particular business, it’s worth spending some time with these metrics to find realistic targets that will push LTV:CAC over 3. Otherwise, you might be in danger of running off a cliff.

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