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. 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 which 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.

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.

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 SaaS companies 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 Midmarket 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

High payback time is like a warning light on your car’s dashboard: You know something is wrong but don’t know what exactly. The problem, however, always lies in your sales and marketing functions. Here’s how to find it:

1. Analyze your LTV:CAC ratio and CAC payback by channel

The LTV:CAC metric can be very telling when applied to specific channels by showing which marketing and sales channels perform well and which fall behind.

For the mentioned business case, this strategy revealed the gross inefficiency of their outbound channel: It had low conversions, extremely high CAC payback and small customers delivering low payback/ARPA. All in all, this channel delivered less than 10% of the new MRR but comprised over 30% of the customer acquisition cost. It was the definition of dead weight. On the other hand, the partnership channel turned out to be highly profitable — less than 25% of the customer acquisition costs were bringing in a whopping 50% of the revenue.

2. Analyze your LTV:CAC ratio and CAC payback by segment. By doing so, you will confirm assumptions about your product or ICP (ideal customer profile). This approach repeatedly reveals unprofitable products that waste effort and costs or help identify customer segments that yield low payback.

When running analysis for the client in question, we uncovered that the company needed to shift its focus toward more high-paying customers. Unless the company could somehow automate the acquisition of the lower-paying customer segment, it needed to entirely reconstruct the ICP it targeted to drive higher payback.

Reduce your CAC

Cost-cutting is the fastest way to reduce your CAC. It often includes:

  • Staff cuts in underperforming channels. Sounds harsh, but according to investors, 20%-50% of staff can often be cut without impacting the company’s top line and team morale. Just go about it wisely: Leave all the critical positions filled, compensate the remaining people adequately and manage risks.
  • Redistribution of your marketing and sales investments in favor of cheaper options. It can include reducing reliance on paid ads and doubling down on SEO, repurposing budgets from events and other activities with high CAC to brand awareness, content and partnership channel support.

Increase MRR (and hence LTV)

Cost reduction is key, but don’t forget to work on the other part of your CAC payback — the revenue. The following practices effectively drove instant revenue in companies we worked with:

  • Increase prices. That’s the most simple and effective route most companies take.
  • Start charging for previously free functionality. In our case, the company began charging for implementations. These charges were still below the market level, but this change helped the company introduce an early first payment to offset some of the initial CAC.
  • Move upmarket. This step isn’t universal and can involve different amounts of legwork depending on your business case. In our case, however, it was just a matter of employing more targeted outbound efforts toward landing more high-paying customers.
  • Go back to good ol’ growth hacking, all hands on deck. It might sound dull and obvious, but for some, getting creative with their growth strategies might be the only way to get your payback time in order during the recession.

All the above activities helped the company we worked with reduce their CAC payback from 35 months to a much more digestible 21 months — all within six months. However, CAC payback and other marketing efficiency metrics only tell one part of the story. To tip the capital efficiency scales in the eyes of investors, you might need to take a peek outside of your marketing.

That’s when the king of all efficiency metrics — the Rule of 40 — comes in.

The Rule of 40

The Rule of 40 metric helps investors evaluate software companies’ financial health by ensuring their revenue growth rate and EBITDA margin add up to at least 40%. You can calculate it by adding the company’s revenue growth rate and earnings before interest, taxes, depreciation and amortization margin.

Too many founders we worked with had never heard of this rule until talking to investors and learning that it isn’t up to the mark. This puts them in an especially unfavorable position during the fundraising, with such companies receiving reduced valuations or getting passed on the round altogether.

Since the downturn began, investors have paid special attention to the Rule of 40, rewarding those on par or above it with consistently higher valuations. We don’t need to go far to see this trend in action. For example, Salesforce, with a Rule of 40 score of 48%, has a valuation almost 10 times higher than HubSpot’s, with only 28% in the Rule of 40.

On the other hand, Zoom, with its Rule of 40 at -5%, had to lay off 15% of its workforce to restore some of its capital efficiency. Asana has it even worse with a whopping -24%, and it’s on top of its grim CAC payback.

What if a company has a low Rule of 40 but great CAC payback? Usually, it’s a sign that the company is inefficient somewhere outside of its marketing and sales function, with its growth not covering for these inefficiencies. Typical cash bleeds in this case would include lofty management bonuses, chunky travel spending, expensive R&D teams and other operational expenditures. Some companies waste hundreds of thousands of dollars without a clear business ROI, which starts taking its toll on their capital efficiency when the tide is low.

In this case, the answer is obvious — to trim costs. I know what you might think: “But isn’t it better to double down on increasing my business velocity?” While you can push in this direction, there’s a chance it can worsen matters if you are already capital inefficient and need to raise soon.

In our experience as a venture consulting firm, over 70% of companies that went this route failed because growth isn’t cheap. It takes time to see your initiatives take off and bring returns, and it requires additional cost infusion most companies can’t spare. In this situation, recklessness can be that nail in the coffin that will burn your runway faster and decrease your chances of getting funded.

On the other hand, cutting costs is a risk-free way to boost your EBITDA immediately. Here are some obvious and maybe not-so-obvious strategies to cut costs:

  • Reevaluate your tool tech stack: 80% of the companies we worked with have underused tools, tools with overlapping functionalities or apps they forgot about but still pay for.
  • Pause all noncritical new hires.
  • Look at your recruitment fees and budgets to scout for cost-saving opportunities.
  • Consider adopting a remote work model or using coworking spaces.
  • Pause travel.
  • Review R&D teams’ performance, especially if you’re a late-stage/scaleup startup with a complex, multilayered structure. There’s almost always a way to cut some of the layers without impacting the output.

Simultaneously, look for ways to amp up productivity per department. For example, can your CS team handle more clients per person? Can your sales reps increase their minimum quota? In four out of five companies we inspected, these numbers were below industry benchmarks, so be sure to track critical leading metrics department by department.

Why does this all matter?

Because in this environment, investors are increasingly more selective about who they trust their money with. If you are bleeding money far and wide, and it shows on your efficiency metrics, you will either be deemed “default dead” and passed on, or you’ll get a significantly lower valuation than expected.

The good news is if you have an exciting product and a sharp investor narrative, VCs are usually willing to wait and see if you can get your metrics in better shape. So if your capital efficiency is in a bad place, focus on improving it at all costs, as it will not only make you rank high on VC scoreboards but also help you build sustainable long-term growth.

In my experience, some companies can get to a good place in two quarters, but on average, it takes about a year — it all depends on the gravity of your situation.

Once your capital efficiency metrics are healthy, your funding odds will skyrocket. Just be sure to highlight the new numbers in your pitch deck!