In the startup world, there is typically a line drawn between bootstrapped and venture-backed companies. VC-funded companies are expected to grow incredibly fast, to shoot for the moon. Bootstrapped companies tend to grow more slowly and rely on customer-financing. It is almost a religious thing — the rocket riders with puffy jackets versus the craft beer-drinking indie hackers.
As CEO of Tiny, we have been on both of these paths at different times. We’ve been profitable, repurchased shares, and even paid modest dividends. Today, we are burning money after raising $4M from BRV in 2018. Once you get to $1M ARR, the strong distinction made between bootstrapping and VC-backed is not that helpful. Either way, you are now responsible for spending a lot of money, wisely.
It can be a difficult experience to wrap your head around spending a lot more money in your business life than you do in your personal life. As a young technical founder, I found it intensely uncomfortable. I had been brought up thinking that the key with money was not to lose it. By nature, I would make big spreadsheets even to compare which digital camera to buy (back when people bought digital cameras). Dealing with the dotcom bubble burst, 9/11, the global financial crisis, the high cost of living in the San Francisco area, and now the Covid-19 pandemic has reinforced this feeling that economic disaster can be just around the corner and the need to be careful with money.
In particular, marketing and sales are some of the hardest expenses to get comfortable with. It feels so ephemeral to spend money on ad clicks, tradeshows of indeterminate quality, SEO, and even commissions. However, a lot of time and money goes into great marketing and sales. If a product is good, shouldn’t it sell itself? This is the unsaid question that many technical founders have, and they couldn’t be more wrong.
Of course, even great products don’t sell themselves. Most SaaS businesses with product-market fit, ourselves included, could be pushing harder even in a tough economy. I have found it helpful to think about this mathematically, and I thought I would share the mental model.
In SaaS, customer acquisition costs (“CAC”) are what you spend on attracting and closing new subscription revenue. These investments are often way more than you imagine. According to KeyBanc, SaaS companies spend $1.14 or more to get $1 in new annual recurring revenue (ARR). If you are trying to add $1M in ARR next year, you would typically expect to spend $1.5M or even $2M in CAC to get there. If you are at $10M ARR and hoping to get to $20M, you may need to spend $20M or more in CAC to get there. Gulp.
Despite the scary numbers, CAC is key to growing your company, and there are some good numbers-based ways of rationalizing the investment. The goal is that when you put a dollar in, you get back more than a dollar of valuation out. Hopefully, significantly more.
With public investors valuing recurring revenue at greater than 10X, this isn’t as hard as it first sounds. If you get $0.50 in new ARR for $1 of marketing and sales costs, you are - in theory - creating $5 in enterprise value (10 x $0.50 = $5.00). This most certainly beats your own “hurdle rates” as an investor, and will meet the needs of many outside investors too.
There are many caveats here, of course, not least of which is that smaller companies don’t tend to attract these sorts of revenue multiples. SaaSCapital says 5.9X is what an average private SaaS business is worth in 2020 and their whitepaper is worth a read. Regardless, I have found this a useful way to think about when to invest and when to pull back.
“Capital efficiency” in SaaS is basically the rate at which cash is converted into ARR. How high you are willing to rev the engine comes down to your appetite for risk, availability of capital, product-market fit, and the nature of the opportunity you are chasing.
Building a scalable, repeatable, and efficient customer acquisition engine is amongst the top priorities of any startup. In an ideal world, you may want to spend $100K to grow by $500K. But, if you are thinking like an investor, spending $100K to get $50K in recurring revenue growth is probably still worth it so long as ARR multiples remain so high. This is particularly true if you have great customer retention and expansion.
As a cash-strapped entrepreneur, it can be hard to wrap your head around the idea that there is plenty of capital in the world and not enough returns. But it is completely true; bank accounts are getting practically 0% interest these days. Putting money to work to build a world-class SaaS business can be a great investment.
Crunch some numbers and get to it!