Photo: kk+ via Flickr
With tens of thousands of new start-ups being created every year, the potential of a company to truly scale and become a large, stand-alone business is more crucial than ever before.A great product is always the foundation but a clear distribution strategy becomes essential to cut through the noise.
So most early-stage VCs have started to evaluate investment opportunities with an imaginary benchmark in mind: can this company become a $100 million opportunity?
Generally speaking, there are two ways (and only two ways) to scale a business to hit that $100 million threshold:
- Your business has a high Life Time Value (LTV) per user, giving you the freedom to spend a significant amount of money in customer acquisition. High LTV can usually be found in transactional or subscription businesses.
- Your business has a high viral co-efficient (or perhaps even a network effect) that lets you amass users cheaply without worrying too much about the monetization per user or spending money on paid acquisition.
Route One: High LTV per user
The exact definition of a “high” user LTV depends on the specific vertical, so it’s typically better to analyse the ratio between Customer Acquisition Costs (CAC) and the Life Time Value of the customer. In my 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 behaviour (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 fulfil 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. 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.
Route Two: The Viral Effect
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. With this model, user acquisition is generally close to free, 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) benefitted 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.
Startup Purgatory: No Man’s Land
Unfortunately, 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. That unfortunate combination makes it rather difficult to reach the $100M 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. 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.
To build a standalone company and capture the attention of investors, you need a viable way to scale your business. 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, it’s important to begin thinking about paths to reach this threshold from the start.
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