Hacking fundraising as a marketplace business: benchmarks for a successful round
In startups like in life, never trust what’s immediately visible on the surface
There is a common misconception among founders according to which once a business reaches a certain magnitude (e.g. in terms of revenue) it automatically qualifies for a VC round. This is not only incorrect but also a dangerous milestone to target.
Investment readiness is relative and not absolute
The real question founders who aim to raises a VC round should focus on is how scalable their acquisition (or growth) model is. It might be silly to even mention this here, but saying that acquiring customers is highly scalable “because we use Adwords” makes VC’s cringe (surprisingly, it’s more common than you might think at pre-series A level).
Scalability is analytically quantifiable. I generally define three broader set of metrics:
- dimensions
- measures
- ratios
The first includes things like GMV, revenue, number of customers, etc., while the second mainly includes derived metrics like CAC, CLV, AOV, but also metrics like churn, growth, etc. Both of them tell the story but don’t offer sufficient depth, which is where ratios play a role. Ratios give contexts to the formers and provide the perspective needed to analyze a business. What I have noticed is that founders tend to focus too much on the first two while neglecting the perspective, ignoring that that’s where the VC ball game is played. This misconception not only causes misunderstanding of the fundraising process but leads founders to set the wrong targets and aim at the wrong milestones.
It’s not where the business is at that makes the difference, but how fine-tuned and scalable is its engine.
VC’s are not (necessarily) investing in today’s profitability: they are investing in the speed of execution. The assumption on which VC’s pour capital into a company is based on an expected multiplier on the metrics that will lead the company to the next round of financing. As said, this comes down to the acquisition model, hence the stress on Customer Acquisition Costs. It’s the direct CAC’s that should determine the size of the round and create a powerful story for valuation discussions.
The beauty of clearly defining the acquisition multipliers is that the bigger the round today, the faster you’ll grow and the higher the chances that the next round (and valuation) will hit a parabolic curve.
So what are the multipliers that make VC “tick”?
How does Retention work in Marketplaces?
I broadly distinguish between two types of acquisition analysis: one with and one without customer lifespan. Lifespan is tricky, that’s why it’s a type of instrument that I would advise to use in small doses. If the business is relying too much on retention assumptions to have a multiplier effect, then you’ll have a hard(er) time convincing investors.
A renowned ratio is the CLV/CAC analysis (Customer Lifetime Value to CAC) whose benchmark is usually 3 (at least).
The CLV is composed of the total net value per customer (i.e. Revenue — Variable Costs) multiplied by the lifespan. This is where things get interesting, as founders will use what’s in their power to boost the lifespan in some esoteric way to match a ratio > 3, leading to endless discussions on churn and its calculations.
What I have observed is that unless the company works in monthly or annual subscriptions or can count on multi-year contracts, or other types of high switching costs (like for Enterprise Saas), VCs will most likely either ignore the lifespan or use some assumptions, the most common of which capping it at 12 months.
So for marketplaces, things get tricky, as in most of the cases (and certainly in the early stages), the only revenue model is transactional and not recurring.
One-Off Purchases: Profitability per Transaction
A widely adopted approach is based on the analysis per transaction. Set aside considerations on the take rate, VC associates will look at
Gross Margin / CPO (Cost Per Order)
The CPO is the sum of the direct marketing costs that you have to pay to generate a certain order. This is especially applicable to businesses where the product/service transacted is not of intrinsic recurring need, and market or reactivation campaigns are required to re-trigger the purchase. This should be compared to the Gross Margin (per order) and it usually one-sided — that is, it focuses either on the demand side or the supply side.
If we look at it from a demand-side only, this makes it a top-of-the-funnel metric which should, therefore, be high enough to cover the costs of acquiring the supply side.
A ratio up to 2 equals a 50% contribution margin which will probably leave little to no profit left to cover the overhead (or need a LOT of transaction volume), while a ratio between 2 to 4 sounds more like something that would get you the VC attention, meaning you have a contribution margin between 50% and 75%. A ratio > 4 … well, it speaks for itself.
My take on this is that, while most of the blogs other there focus on the demand-only CPO, probably assuming that the supply side has natural retention, in my experience also supplier might require substantial re-activation costs between transactions. If that’s the case, I would recommend blending the two.
The bottom line of this approach is determining how much is left from each order to reinvest in growth. If the business doesn’t meet these benchmarks, it’s likely that it is not adding enough value to its customers to justify long-term value creation. As I explain in the next session, the CPO also has another advantage: being directly connected to the moment an order is made, founders should be able to clearly distinguish between organic vs. paid orders, thus avoiding to “dilute” the CPO by the non-paid acquisitions. In businesses that rely on constant re-activation (and therefore shorter acquisition funnel), the CPO should be easy to calculate without the “noise” of organic acquisitions.
On the other hand, some type of marketplaces do have stronger retention and the CAC is distributed across future transactions. This is where VC rely on assumptions.
Recurring Purchases: Marketplaces with high CAC
Some marketplaces work in verticals where the type of product/service transacted has a recurring nature. If an average customer performs 3 purchases per year without incurring reactivation costs, focusing too much on the profitability per order could prove a limit and completely wrong. This is where the CLV / CAC analysis is widely adopted but with fixed lifespans, the preferred of which being 12 months.
However, as opposed to common knowledge, VCs tend to break-down also the CAC’s between blended vs paid-only.
Blended vs Paid-only CAC’s
Simply put, the CAC (or blended CAC) is the result of:
(sum of) all the marketing and sales acquisition costs / (sum of ) number of customers acquired
However such ratio is based on the assumptions that all customers were acquired equally, while this is often not the case. More importantly, VCs are interested in the acquisition channels that are actionable, so a blended CAC (or gross) only tells part of the story in terms of direct costs. The number of customers acquired is, inevitably, a mix of paid and organic customers, so VCs will often ask founders to calculate (and monitor) on the paid-only CAC, which can be calculated as:
(sum of) all the marketing and sales acquisition costs / (sum of ) number of customers acquired via paid channels
Likewise, the CLV should be calculated on the paid-only acquired customers, which yields a paid-only CLV/CAC analysis. What makes VC “tick” is:
12-month paid-only CLV / CAC ≥ 2
The Growth Multiplier
What this means is that in for each customer the business acquires leaves enough margin to reinvest in acquiring another one. Basically, a growth engine generating such results would determine that the business can double the number of customers every year without any additional investment. From a VC perspective, investing today in this business, assuming all things equal and an investment horizon of 5 years, means multiplying that capital by a ²⁵ (32x). We can extrapolate a quick formula to estimate the revenue at exit:
Without investment
Exit Revenue = Current Revenue * (paid-only CLV/CAC) ^ (years)
With investment
Exit Revenue = [ (investment * CLV/CAC) + Current Revenue ] * (paid-only CLV/CAC) ^ (years-1)*
*the first year is used up to convert the investment in revenue
Assuming a business with €100k in current revenue, a CLV/CAC of 2, and a period of 5 years, this determines:
No investment: €3.2m
Investment of €1m: €33.6m
It becomes pretty clear how founders can leverage this to make a strong case for the size of their financing round (and the implied valuation). In reality, every investor knows that growth is always more expensive than initially planned: acquiring customers when the business is a first mover and it’s relatively small might be much easier than later on, when it might have to chase the long tail of customers and/or competition might arise. Therefore, one can expect the paid-only CAC to increase over time, thus reducing the multiplier effect, although this effect might (hopefully) be counterbalanced by a strong growth in organic customers which will be reflected in the blended CAC.