Tens of thousands of startups are founded every year. Without real potential to truly scale and become a large, stand-alone business, the vast majority of these companies whither on the vine.
Great products forge strong foundations while effective distribution strategies cut through the noise. When an early stage venture capitalist evaluates an investment opportunity, he often has an imaginary benchmark in mind: can this startup become a $100 million business?
According to award winning Canadian superangel Boris Wertz, there are only two ways to scale a startup to hit the $100 million threshold: your business either has a high life time value per user, or your business has a high viral co-efficient. Let’s take a look at these two paths to success.
As Boris puts it, “the exact definition of a ‘high’ user LTV depends on the specific vertical, so it’s typically better to analyze the ratio between Customer Acquisition Costs (CAC) and the Life Time Value of the customer.” In his experience, having an LTV that’s three to four times greater than CAC makes a business (and potential investment) interesting.
The biggest driver for high LTV is repeat purchase behavior (in an e-commerce business) respectively a low churn rate (in a SaaS company). Companies that score highest in this criteria are typically: E-commerce businesses that fulfill regular needs and offer a differentiated experience or SaaS businesses that help businesses or individuals manage core activities.
“As a VC, the biggest challenge in evaluating LTV models is that metrics can dramatically change at scale,” he writes on his blog for Version One Ventures. “For example, Customer Acquisition Costs often increase once the more efficient marketing channels are maxed out and the company needs to find new users through less efficient means. In addition, churn tends to rise as a company grows. Early users of a product are often strong advocates and company ambassadors, while those users acquired through paid marketing channels down the road show far less loyalty.”
The other way to scale a business is through a strong viral and/or network effects that lets businesses grow to tens of even hundreds of millions of users, the Vancouver-based superangel affirms. “With this model, user acquisition is generally close to free,” he explains, “and monetization per user is often low (advertising-based or freemium businesses).”
Many businesses built in the early days of the Facebook platform (like Zynga) benefited from a huge viral co-efficient and scaled very rapidly. (As we all know, this is no longer the case as Facebook has essentially removed most of the free viral channels and businesses must now pay for most of their user acquisition via Facebook.) Even more interesting are businesses that create network effects like marketplaces or social networks. Not only do they acquire lots of users for free due to viral effects but also create important barriers to entry and lock-in effects as the network grows over time.
Unfortunately, as Boris notes, many consumer internet startups find themselves stuck in the middle of these two strategies. “They have a low monetization per user and limited viral effects,” he says. “That unfortunate combination makes it rather difficult to reach the $100 million mark.”
As the consumer Internet space becomes more and more crowded, every startup founder needs to be thinking about these two ways to scale a business, Boris argues. “Too often I have seen entrepreneurs believe that customers will automatically flock to their cool new service, completely underestimating how tough it is to cut through the noise and build an audience.”
His concluding advice? “To build a standalone company and capture the attention of investors, you need a viable way to scale your business.” Boris says that the earlier you figure this out, the better, since it may require you to build your product differently.
“While the $100 million mark may seem far away in those early days,” he concludes, “it’s important to begin thinking about paths to reach this threshold from the start.”
Originally published in August 2013.