Valley Nordic
Valley Nordic
S4E10: Startup Financials - LTV and CAC in B2B SaaS
We are back after a long summer break. In this episode we get inside Arne's box of B2B SaaS and discuss CAC, LTV, Payback period, and other financial metrics.
Chand back. This is Chander in Palo Alto,
Arne Tonning:and this is Arne in Oslo.
Chander Chawla:We are very glad to be back after, I think, almost six weeks of holiday to accommodate RNAs vacation schedule,
Arne Tonning:absolutely it's maybe even longer. You know, I'm a European, so I take my vacations very seriously
Chander Chawla:and the European lifestyle. And the funny thing is, we had planned to record this episode where RNA was visiting Palo Alto almost a month ago, and he did visit, and he did bring me an echo eat, and we just started talking, and we forgot to press the record button. So said, Okay, we'll do it another day, but that didn't work out. So here we are back to recording on Zoom remote. But I'm glad I was able to just talk to him and see him in person and drink Aqua wheat and beer with him.
Arne Tonning:So very professional in other words, and at least fun.
Chander Chawla:Yeah, I think our listeners know how professional we are. It's casual conversation with all we may have new listeners. So welcome new listeners and all listeners. Valley Nordic, our podcast is about conversation, casual conversations, between Arne, who's a venture capitalist in Oslo, and me, who is an entrepreneur in Silicon Valley. So you will see how we think about the world differently. I am. I don't see the world in boxes. Arne sees the world in boxes. So today, after our summer break, we're going to get into RNA box, and that's B to B. SaaS. The topic will broad. Topic we'll discuss today is startup financials, but then we'll narrow it down and focus on B to be SaaS financials. How does that sound good? Okay, so maybe let's start with, you know, financials, like it's as you know, I talk to a lot of startups. You who you know, that's your job to talk to a lot of startups. Most of them are founded by engineers, especially in the Nordic countries, and they don't have as much financial literacy they learn on the job or start doing it. But the basic you know idea that the finance, at least the public finance world expects you to have three financial reports, income statement, that's about profitability, cash flow statement, that's about how much cash is going in and out of the business. And third is balance sheet. That's basically accounting, but how much assets you have, and assets equal liability plus equity. So they I see the public companies manage mainly for the income statement, most of them, I think the activist investors have brought attention to the balance sheet. What are you doing with the cash? Why don't you give back to shareholders, etc? And I'd see Amazon is probably one of the few companies that had been managing for cash flow so that, like we are, you know, you are venture capitalist, so you know all this inherently. And I'm in business, and I run businesses, so I understand this. How, how prevalent is that understanding our like in the talks you have the startup founders, like, what percentage of people understand this like you manage business differently if you're managing for income statement and versus you're managing for cash flow?
Arne Tonning:I think it varies a lot. But I think, like most startup founders, are not, as you say, financial people, and they don't focus on these things a whole lot. A lot of you know about developing technology, about building product and about getting customers, which I think you know is, is fundamentals of the really fundamentals, I think, like if you if you are. Focus on sort of the nitty gritty and sort of tailor your financial statements more than driving your fundamental business, you're probably wrong. That said, like understanding the financials and like, what are the main levers and what to look at, they can be very useful in sort of guiding you in building your business. So, so I think they're more sort of helpful around the fundamentals of the business, and, and some are more experienced about that, and and sort of manage the right things about them.
Chander Chawla:Yeah. So you're all three of them are backward looking. You look how you did in the past. I mean, in the US, it's, you know, every 90 days, if you're a public company, as you produce these three statements, but their reports, they don't tell you what the business drivers are. So you bring up a very good point. As a founder, you have to focus on what is driving the business. So that's forward looking. How can I make something happen like, maybe I reduce CAC, you know, maybe I increase the MPs, whatever that is what drives the business. What are the forward looking things? And all these three statements are backward looking.
Arne Tonning:That's That's true. But I think like in terms of managing your company, you want to have a dashboard of of metrics, and some of them are lead indicators, maybe like leads generated or something that doesn't generate anything directly in your financial statements, but you also want to have some parameters that are either directly related or can actually be found in the period of periodical statements. So So let's take an example. I you know, when I look at these statements. There are specific things I zoom into for each of them, and they are typically also the things that you find on the dashboard for the management to drive the company. So let's take an example, your burn rate, which is a super important is also, you would also find that in the cash flow statement, right and how much money you have left in the bank, which is essentially, you know, your runway is essentially how much money You burn and how much cash you have left. And these are like absolutely key parameters to understand what room you have to maneuver. And so the burn rate you would find in the cash flow statement and your cash balance, you would find the balance statement, right? So these are, like absolutely critical factors that are both in your dashboard but also in your financial statements.
Chander Chawla:Yeah, yeah.
Arne Tonning:These are examples, right? Yeah.
Chander Chawla:So we let me, like people who don't know what burn rate is. It's, you know it, I think it's a good term the venture industry came up with. Literally, it means how much cash you're burning. What that means is you look at the cash coming in from all operations, or however, from and then cash going out, and what is the after you have, like, if you take all the cash in a month, and generally, it's a monthly metric, so how much cash, how much money you have spent or burned, deducting the cash Coming in,
Arne Tonning:that's burned, right? Yeah. And you can even say, oftentimes you talk about both net burn and gross burn and not burning.
Chander Chawla:That's interesting. Like I always see just, you know, burn, which is okay, the cash coming in, and then you know how much cash you spend.
Arne Tonning:Yeah. But, you know, some, I mean, if you're a mature company, you know, the the money that comes in is, you know, statistically, fairly predictable. If an early stage company, you know, it might be that you have a contract this month, and the next contract comes, or the payment for next contract, maybe is in five months, or something like that. And the income flows might not be predictable in a statistical way, whereas your cost base is. Yeah, to large extent, right? So the gross burn is essentially the same as your cash cost base, and the net burn is when you account for the money coming in from customers or other soft funding or anything else that's not, like, directly customer payments.
Chander Chawla:So in your world, gross burn would be, let's say, in operations we are spending, like, sales, marketing, salaries, everything, yeah, spending million dollars a month. Yeah, that would gross burn. And if, let's say off that million dollar we are spending the early stage. We're getting half a million in revenue or cash. Sorry, not revenue cash coming in, yeah. So that would be million minus half a million. So half a million would be net burn.
Arne Tonning:Exactly, exactly. So, so the growth burn is your worst case burn, right? We have no income, yeah, or cash from from income or any other source,
Chander Chawla:yeah? So it's kind of like a simpler version of, you know, let's say Balance Sheet and Cash Flow Statement combined, yeah, yeah, it's
Arne Tonning:essentially, essentially the key, key parameters taken out of of those financial statements.
Chander Chawla:Yeah, one of the things I learned, you know, later in life is profit is an opinion, like you would think, if you put a number to something, that's fact. No, it's not. Profit is an opinion. That's why I have become more aligned to managing a business based on cash, not on profit. But I think that deserves a separate episode. But today, I want to get more into your box of B to B SaaS. So given all this burn and gross and net burn and income statement, balance sheet and cash flow statement in the B to B SaaS world, like, what do you look for when you're looking to invest that is series A or Series B. Well, let's take them on that one. If you want to make a series a investment in a company, what do you look for in terms of numbers like growth rate and the burn rate, sales and marketing expense as percentage of revenue. I don't know whatever that is, so tell us. What do you look for when you invest in A, B to B? SAS company for Series A?
Arne Tonning:Yes. So I think, like there are, like a couple of top level qualifiers, whether this is a series a company in the first place, one is sort of the revenue, run rate. I mean everything I say, there are exceptions to right. There are exceptional companies that maybe have, like, a huge potential, but they're not at a normal series, a revenue maturity, for example. So they're sort of all, all exceptions. But I think, I think, like the first framing, whether it's like a normal series, a company is one thing is like, what's the revenue run rate, or, or as a SaaS company, revenue is oftentimes accounted for us annual recurring revenue, or monthly recurring revenue, which is like the core revenue of a SaaS company. I mean, if you take revenue overall, it might be that you have consulting income or installation fees or sort of like from a SaaS perspective, impure revenue streams. So you tend to drill
Chander Chawla:on it, impure,
Arne Tonning:no, I mean, this is something I made up now or but ultimately, a software as a service company lives on the subscriptions, right? The recurring revenues from subscriptions. As you tend to zoom in on that, which is like the core metric of a SaaS company. And some SaaS companies might have other revenue streams as well. So we kind of zoom into, like the revenue part. That's actually the core business, which is the subscriptions. And that part of the revenue is called Arr, MRR, depending on how the subscription structure is put up, but it is, like the main revenue, right? You look at, is it, is it, you know, mature enough for an a company. And I'd say, like, this is sort of the Rule of. Thumb that existed for 10 years, right? That a million dollars of annual recurring revenue, that's, that's the series a company so like that, sort of the general level of subscription or recurring revenue is kind of like a rule of thumb you look at immediately the second,
Chander Chawla:when you say, is it mature enough to be series A you mean, do they have million dollars in ARR which stands for annual reoccurring revenue
Arne Tonning:exactly and and, like you know, there are times where companies raise at half a million, or there are times when they race at two, 2 million. So I'm not saying a million dollars. A million dollars is a rule of thumb, not a, you know, some sort of, you know, specific threshold,
Chander Chawla:if you like, yeah.
Arne Tonning:And the other is the growth rate, right? The expectation of of growth rate for venture back people, company is like, you have to be 3x year over year growth as you pass a million dollars. This is also rule of thumb, right? So I think these are sort of like rule of thumb framings. Is this a series a company?
Chander Chawla:Yes, but when you said 3x year of your growth expected, when you invest, how long do you invest? It like expected for or next three years, five years like when? What is the time frame for 3x year over year growth?
Arne Tonning:Well, you know, the back of the envelope formula for building a venture backable company is fight your way to a million dollars of ARR but you have to have some sort of velocity as you pass a million dollars. And your expectation is that you triple in the first year after that, and the triple in the second year after that, and then you go to a doubling for a few years, two to three years. That's like, that's like the slam dunk formula, if you like. There are great companies that don't hit that. Essentially, if you hit that, you're a unicorn in five years, and nobody dies. If you're unicorn in six or seven years, to be honest, that's also as a success, but, but, but, like, if
Chander Chawla:you go by the rule of thumb, that's what you aim for, right? Get to a million dollars with velocity, and then triple triple, and then three times double. Okay, so wait, let me, like, get put numbers to that. So let's say I have a company, RNA and chanderb sas.com and we achieve million dollar revenue in 2022 so you invest so you would want us to be 3 million company in 2023 and then 9 million company in 2024, and then 18 million company in 2025, 32 million in 2026, and
Arne Tonning:36 if you're 36
Chander Chawla:Yeah, I Yes. I think it's showing up. I Arne brought me Aqua weed when he came, and I came to the office today to record this podcast. I said, Oh, I'm talking to Arne. Let me have some echo eat. So it's showing in like my you know, math 18 times two is 36 not 32 but that you get the idea, yeah, like that what you would want, like, 3x 3x 2x 2x 2x right? It's all made up. Like, you don't really know. How do you know it's going to actually happen?
Arne Tonning:Well, I mean, the only thing you know is that that's not exactly going to happen. That's for sure. Then, again, there are companies that go 4x or 5x and then the next year, it's so even in a very successful scenario, it does not follow that particular path, because there tend to be plateaus, and you know, you have to fight, you know, to go from this stage to that stage, you have to implement a different management structure, or you have to find a different channel, or or something. You know that this, it's not going to be like a machine that ticks, because a lot of things have to happen from a company to go from, you know, for argument's sake, $1 million they are, to 72 Yeah. So, so it's, it's sort of a little bit more sort of accelerate stop, accelerate stop kind of thing, even through this pattern, yeah. Yeah.
Chander Chawla:So you know, because it's a rule of thumb, that means all founders know that, or not all, but let's say most of them know that. Yeah, of course, you're going to show you a projection that shows you that. Well, what do you double click on? Get deeper into if Okay, is to increase your confidence that these people or this company can actually achieve that. And I think you don't know, as you said, but how do you increase your confidence? What do you look at beyond just the projections?
Arne Tonning:Yeah, I mean, so this, I mean, it's a multitude of things, and some of them are sort of metrics oriented. Some of them are more sort of looking at, you know, potential of it, and how the organization is structured, and sort of, you know, more or less quantifiable things. But I should also mention this another sort of qualifying factor here. It's generally something that's a hygienic that you want to want to check it right, and that is that to be a very valuable company, you have to have a very high gross margin. Most SaaS companies do have a very high gross margin, you know, 70 to 90% or something like that. But, but that's it's. There are examples where, where just deploying this is very costly because it might be very computational intensive, or something like that, that that, or it's very costly to implement new customers, or because it's manual, or something that might be able to, you know, you might be able to grow after that by automating or something, but you Want to check whether you know. The general assumption is that software as a service is already high gross margin. But if it's not, you won't understand why. But in most of the cases for software as a service, it is very high gross margin. So that was, that was a sidetrack, but it's important anyway.
Chander Chawla:No, no, that's good sidetrack. So let's get deeper into that. So gross margin for people new to finance is basically what somebody's paying you. That's revenue minus the cost of producing the good or service that people are buying. So in the hardware world, that would be cogs, cost of goods sold. And I think it's also sometimes used in SaaS, but sometimes it's called cost of revenue. So in the SaaS world, you know, it's basically up to me. Let's say I'm running the company like, what do I associate with cogs? What developer time is going towards cost of revenue, and what goes towards R and D, and what goes towards is, basically I am deciding that I can make it high gross margin. Do you get into that level of detail? Or how do you figure out if the gross margin, what you're seeing, is the actual gross margin?
Arne Tonning:Well, that goes towards, you know, understanding your cost structure, right? And I think anything that's truly variable per customer should go into your gross margin. So if it's sort of more so, that means variable cost in nature, and variable meaning it scales with with customers that goes into gross margin, but like so r, d doesn't scale. You know, if you develop code and you deploy it, it doesn't increase cost per number of of customers you have. But if you have, like, you know, storage and traffic on AWS, that scales per customer, typically, because it's dependent on the usage of a customer, or if it's, let's say, commission to a partner for distribution that's also paid per customer. So these sort of variable or or like every customer typically spends two hours to support calls every month, on average, with you know, your support organization, these things are linear variable costs with the number of customers, and that goes into your gross margin. And support
Chander Chawla:calls are not in gross margin.
Arne Tonning:Yeah. Well, depends on how you package it, I would, I would actually say it is,
Chander Chawla:but that's after the customer has bought it. Yes, so that, I wouldn't put that that's not cost of revenue. That's the support cost, right? Like it's so you know that's more OPEX or the I don't know where you in the income statement. I wouldn't put that in cogs, the support cost of after customer has bought the product. That's where that would go. It's in OpEx. That's operational
Arne Tonning:expense, no, if it's in my mind, but, but the same thing, if you know the the AWS storage and traffic associated with the customer only happens after the customer have bought it. So I think any variable cost should go into your gross margin calculation.
Chander Chawla:Okay, I see what you're saying, because you see that they're paying you, let's say monthly. And for them to pay you monthly, you need to have AWS. You need to have whatever infrastructure cost and support cost as part of that. Yeah, so
Arne Tonning:I in the cost, the cost part of the gross margin. I would bundle anything that's variable and linear with the customer. And you can label those costs various things, if you want to. It could be support costs, and it could be hosting cost, and it could be commissions, and it could be whatever, but anything that's linearly variable I would deduct to get the gross margin. Okay,
Chander Chawla:I see, so you like, you see people doing that. They're putting support cards in cogs. Like, do startups actually do that? Well,
Arne Tonning:whether you call it cogs, or you call it something else, but I would, I would, I would definitely call it into, you know, the gross margin calculation that said, I think there are a lot of trickery in this space, in assuming, for
Chander Chawla:example, yes, well,
Arne Tonning:well, you think that, you Know, an argument would be, well, you know, we have three people in support. That's an overhead. We just have to have them right. And as they take support calls, we'll learn more. And it's not a variable, linear cost, because, you know, when they take support costs, will, you know, update FAQs and the support pages and whatnot, and it will not, you know, new customers will not generate the same number of support calls. For example, that would be an argument to make this an overhead rather than a you know. And you know, sometimes that argument sticks and sometimes it doesn't. Yeah,
Chander Chawla:it's so when RNA says overhead, I say GNA. So we are saying the same thing for people who are not financially, you know, tuned,
Arne Tonning:yeah, yeah, whether it's GNA or whether it's something else, but, it's GNA is definitely an overhead, whether support is
Chander Chawla:we when you say overhead, I say GNA, but I think our intent is the same,
Arne Tonning:yeah, but overhead in my mind, you know, in my mind, GNA is general and administration. So that's management and administration, right? Whereas there are there are
Chander Chawla:in
Arne Tonning:it depends on how you look at R and D, for example, because R and D is also an overhead, even if it's a very value, creating overhead but, but it's not cost that linearly, scales with deployment, with the number of customers. So there's a scale benefit to
Chander Chawla:rd. You can argue that, like management scales with number of customers, so, but
Arne Tonning:not linearly. Yeah, right, and, nor does R and D, right? Does you have more customers? Maybe they want more features. You have to do more in R D, but those features can be deployed to rest of the customer base as well, right? So, so, of course. Like a HP has a larger GNA than a startup of three people, but it does. It's a nonlinear scaling. Of course.
Chander Chawla:It depends how we define linear. You can say, okay, for every 100 people, every 100 customers, I need a new manager so you can, okay, that's linear. You know, you can predict every 100 is one, but is it? You know,
Arne Tonning:in theory, a large a large companies should have economies of scale in that the administration is spread over more customers, and so is r, d, and so are other overheads. In my mind, yeah,
Chander Chawla:by the way, it doesn't sound good, but I think I've been an overhead most of my life. Management is always overhead,
Arne Tonning:yeah, but you've been in marketing, for example, and marketing, in my mind, is definitely not an overhead, but it's also not a cost of serving customer, but it's a cost of acquiring a customer,
Chander Chawla:right for it's brand marketing, it's not cost of acquiring customer. If you can relate to acquiring customer, then it's cost of acquiring customer, but management of all the functions, it's, again, gray area. Do you call it overhead? Or it's part of tech, yeah, I'm mixing things. I think the this CAC, LTE, is like a more B to B, SAS thing in the old world, it's more, you know, as it used to be, s, DNA, sales, general and administrative expenses. But then it became GNA. We started separating, separating sales and marketing. And if I remember correctly, all like these changes were started with Salesforce. When they became big, they were kind of the first SaaS company that became big. Their logo used to be no software. Basically, you don't have to buy software and how it evolved from that. But for the listener, you see how you know RNA has been doing it for 20 years, and on the VC side, or capital side. I'm doing it for 20 years, on business side, and you see how much debate there is, or it's all it's very contextual, even we are talking about numbers, it's not as factual. There's lot of opinions involved in what goes where. Okay, that it may be another sidebar. Where would you put product people? Are they part of cards, or are they part of GNA?
Arne Tonning:No, they're part of r&d.
Chander Chawla:Why is that? Because you have to build the product
Arne Tonning:to sell it exactly,
Chander Chawla:so you're constantly
Arne Tonning:but it does not enter into the cost side of the gross margin. In my mind, I 100.
Chander Chawla:And where would you put the software development people? Are they in cogs? Are there all are r&d. They're all r&d. Okay. What was in cogs in your world, the variable cost, yes, the infrastructure cost and support cost. But are there any like salaried people going to cogs
Arne Tonning:in in the event that support cost is linearly variable with the customer, the support people go in there, in my mind.
Chander Chawla:Okay, so let's say support people and infrastructure cost. That's it. That's cogs. Well,
Arne Tonning:yeah, but it depends on how you define infrastructure as well. So say, I mean for a pure place, software as a service. Software
Chander Chawla:service, so everything's happening in the cloud, yeah, but
Arne Tonning:there are a lot of things that are, you know, being packaged as a software as a service, like thing that might have other components to it. So and So you try to, like, analyze it, kind of like a software. It is, but it might be that there's also a like, say, an IoT service you have, maybe, you know, some sort of connectivity to it, in addition to that, like a cell phone subscription or something that is also variable with the number of devices. Or it could be that you have to have a device to have the subscription of the software, and there's a hardware that you have to ship, and you have to amortize over the lifetime, or a subset of the lifetime of the subscription. So there could be other elements that are directly related to how many customers or subscriptions you have, even if I agree, if you have a SIM card or a hardware device, it's not no longer a pure play software as a service company. There are companies that are similar in many ways, and you look at them in a similar lens, and then you might bump a lot of things into it.
Chander Chawla:So let's say for us, like a company that's selling IoT and they're let's say you're paying, I am the company. You're paying me 100 bucks a month, and I'm paying 10 bucks a month in network cost to see you would put that 10 bucks in cogs? Yeah, wow, that's like, in my like, you know, I've been in all types of businesses. I've never done that, and even in public companies. So that means it's not required by gap accounting, you. So it's more opinion based, because I that happens after the thing is sold. My view is COGS is what it requires to sell the
Arne Tonning:thing. Yeah, in a SaaS world, I look at what does it cost to service the I mean, I don't necessarily use exactly the cogs term on it. I i look at the variable costs of servicing the customer periodically, and those that periodic cost of servicing the customer whatever it is and it's variable by time, I bundle that into the variable cost, and which is, subtract from the revenues to get the gross margin. Yeah, I
Chander Chawla:think, I think, from a VC perspective, you're doing the right thing. You don't care about, you know, whatever the prevailing thing is, or the gap accounting rule you care about, okay, is this a business I want to invest in and to understand that you see, okay, how much does it cost these people to get service a customer on monthly or annual basis, and you want all that variable cost to be in cards across the revenue? Yeah, exactly.
Arne Tonning:So ultimately, what you're looking at, what we call it, is the unit economics of a customer, right? And, and, and sort of the the time unit based profitability once we have a customer is a very important part of that, right? And then you want to make sure that you haven't, like forgotten, a lot of costs that it costs to actually serve as a customer, right? Yeah. And so the way that we frame it is kind of like the unit economics of it, and the gross margin over the subscription period is a very important component in
Chander Chawla:that, yeah, yeah. That reminds me of the difference between what I was used to as Ltd in the consumer world and then I learned it SaaS world is very different, but I'll come to that. But before that, I want to get your thoughts on that. On thoughts on like, how does the equation change with the size of the company in terms of, rather like, what are the ratios you look for? Let's say a $1 million company versus what did we say? I wrote that down, 3 million, 9 million, 18,000,030 6,000,070 2 million. Like, how do the ratios change of sales and marketing, R D to as percentage of revenue? So. Yeah, I
Arne Tonning:think the census marketing goes up over time, because it's a little bit hard to put exact numbers on it, because, like, when you start to start up, right? Unless you've built a product, you don't have anything to sell. And, you know, tends to be like to find out whether somebody actually wants to find product market. It tends to be like founders meeting early customers, right? So in reality, a very large cost. Part of this cost stack is R and D for developing the product and sales and marketing. And certainly it might be that founders spend a lot of time talking to customers and product people spend time, which tend to be founders spend a lot of time talking to customers. But in reality, the resource allocation of a company is primarily r, d or product development, right? And as you mature, you have to, like, reach more customers to to grow, and you start building sales and marketing to to achieve that. But you can, like, overcook that, because typically, you know, you have some sort of iterations to to really find product market fit. And then, you know, then you have to find an effective way of doing sales and marketing. And that's also a learning loop, right? You just don't pour money into sales and market until that's sufficient, right? So, so it tends to start with very little sales and marketing. And as you become a mature company, you know your product development is actually the least or the thing that scales the most, right? Because certainly, well, if it's a software as a service company, you supply the same code base to all customers through deployment, and it doesn't you have, you don't typically have to add a lot of extra R and D to serve more customers, and then sales marketing becomes a larger proportion, right? So I think at Series A, that it's still a company that has more R D than sales marketing, but a mature company has much more sales and marketing activity than R D,
Chander Chawla:yes, of course. But what are the general numbers like? What are the rule of thumbs like at Series A, when you fund a company at million dollar revenue, or Arr, generally, the sales and marketing is X percent of revenue, and R and D is y percent of revenue. So what are those numbers and how do they change? Let's say when it's$18,000,000.03 years from the fund. Okay, there
Arne Tonning:is no general rule, I would say, because it depends how difficult what you're doing is. So say you're deploying an app where, like most of the nation, is just doing something where the user experience is better. That doesn't require a lot of r, d and a lot of your efforts going to the go to market part. You don't need a lot of engineers to build a better front end, if you like, whereas, say, this is some sort of data heavy, machine learning, complex back end thing. A lot of value is in that bit, but it's really hard. And then, you know, even at Series A, maybe, you know, 70% of your organization is R D, and the rest of it is, you know, GMA and sales, marketing or or something like that.
Chander Chawla:Okay, but directionally, as you grow R D should go down as percentage of revenue, yeah, should go up as per se has a revenue.
Arne Tonning:So you can look at for listed companies, you can look at this, and I would say that most of the I think, I think, like Nordic, companies are probably bigger on r&d relative to sales and marketing than you will see in the in in the US. But I would say that at series A what I see in the Nordics, certainly, more than half of the staff are R and D and product people. If you look at like the US, you would see that. I think of all the IPOs we've looked at, I think. I assume, was the one with a large, smallest proportion of of the cost. That was r, d, and it was like 10%
Chander Chawla:Yeah, it's all how you know you define it. It's like, very subjective, very quickly, if it's salary, but it's I remember, you know, for my own or I vaguely remember from my personal investing experience, like Salesforce. Few years ago, 66% of revenue was going into sales and marketing, 66% two thirds of revenue. Like, I don't remember the year, but at some point, a few years ago, there was the number, and that's because I was shocked from my like, I had never seen that before, so that's why I remember it, yeah, and you see that like it's a normal thing for bigger companies that are growing fast. That's how it's been in sales and marketing, 66% of revenue.
Arne Tonning:I 66 sounds high, but if you look at, if you look at, you know, the companies that have have listed in the US over the last, last years, you know, a lot of them have great unit economics, and yet they're losing a lot of money, and the reason for that is that they're pouring money into sales and marketing to grow fast so so like this over relative overspend in sales marketing relative to other cost buckets in a company is is quite normal, so to speak.
Chander Chawla:Yeah, that reminds me of something else I've seen change, and maybe a, b to b, SAS, thing. And for people who are, you know, younger, it's like relatively new thing, B to B, SAS. It used to be all licensing, and everything was on prem. So it's like, I've seen that in my lifetime, and it's so normal. If we entered the workforce in like 2010 or 22,000 a you don't even know what it was like, like for you. This is the norm, like when I have discussions with, you know, newer developers or who are just graduating, they don't consider memory and compute cost. But if you were, you know, doing software development 20 years ago, 25 years ago, that was a constraint you had. Now it's not a good thing. But where I was going with that. Something else I've seen changes in the income statement. It was SG, a the line item, now sales and marketing, the separate line item. Then. GNA, have you noticed that? RNA, like I. I noticed that few years ago, like it, and mainly again, this was in the SaaS world. Yeah, no, I
Arne Tonning:haven't really thought about that. So I just looked up a statistic. So KeyBank, which is an investment bank, have done a survey of self process service companies, and I don't know there's some 200 companies or something that's answered, and they're like from a few million dollars of revenue up to, Let's say, 50 $200 million of revenue, and the medium sales, marketing spend as percentage of revenue is 36 but the range is from 9% to 109%
Chander Chawla:and What stage of the company? Like, how big is the company? Or does it not say, yeah, so, I
Arne Tonning:mean, they've surveyed, you know, from, let's say, $1 million ARR to the Humber, but, but they have excluded for this particular graph, companies that are less than five millions of AR,
Chander Chawla:okay? This is 5,000,200 200 Okay, okay, wow. Yeah, you're right. No rule of thumb here how crowded the market is and how much you need to create a new market category, or you have the value proposition is so clear, yeah, it depends on a lot of factors. So let's come to the final topic, which was, I thought that's how we started. We will talk about in this episode, is attack and LTV ratios. So the prevailing wisdom in Silicon Valley is, oh, if you're if you're B to B SaaS company, and if your LTV Recker ratio is less than three, then you're not good enough, like Andreessen, or the big firms won't invest in you. So it's like and lot of the smaller venture firm use that as like a filter mechanism. Oh, don't talk to us if your LTV CAC is less than three. So how? Okay, before I ask you your view. Now I want to come back to what I mentioned earlier, how my view of the LTV from the consumer world was LTV, it's lifetime value of the customer. It's about the profitability of the customer to the organization or its sum of cash flows over time. So that meant you the formula is, you take, you know how much it costs for you to acquire the customer, and how much are they you per monthly divide that by turn, and then you look at how much does it cost to support that customer? That's where I think you and I differed. Like, for me, that's cost of supporting the customer divided by churn. So that gives you okay, this is the lifetime profitability of the customer. But in the B to B SAS world, I noticed LTV is basically revenue divided by char. So there's no account support cost taken into account. Or that's why you look at, you know, LTV divided by CAC to get the actual idea of profitability. So that's very different than what I was used to in the consumer world. So okay with that clarification, assuming you know that's how people define it, revenue divided by churn or ARR divided by churn. What is the like? Why is three the magic number? And when you invest, do you look at that and what? What do you how do you take that into account when making an investment decision into a startup. Yeah,
Arne Tonning:so, so let's just take a step back, right? So, like the framing is, first of all, like we were in this series a setting, right? Is it, is it mature enough that was kind of revenue run, right? It was like, Is it growing fast enough, and is it, is the gross margin good enough, right? That's sort of like basic qualifiers, are we in the ballpark? Yeah, and, and, and, I'd say, like the the the LTV to cap ratio three is also a rule of thumb. Kind of thing to look at, just to put it in the ballpark. And I think, once again, we think about it as a rule of thumb and and the way that I think about it is it should be at least that, right? And when you say that the LTV is like the the revenue over period divided by the churn over that period, that is as kind of true, but it's, it's an approximation, right? What you said from the consumer world actually holds here as well. It's just that, you know, you're used to thinking about, well, you know, the gross margin is 90% so this is an approximation that's good enough if, if the GM, the gross margin test. Doesn't hold up, then that LTV simplification also doesn't hold up. So I think that's important to keep in mind. And then the way to think about it, it should be at least three, even if that's an arbitrary number, if it should be at least three, that means that, well, if it's well above three, doesn't matter that, you know, gross margin is 90% because it's close enough anyway, right? So, so I think it's more about approximation and I but I think that fundamentally you should there are a lot of people who are oversimplifying here and don't understand the consequences, right? Because there are different definitions of LTV and there are different definitions of CAC and and also, I think, like the number of three is so arbitrary that it looking at that in isolation, also get you, you know, off essentially and, and the reason for that is that I tend to look at another parameter as well, which is kind of the payback period. Which is essentially, how long does it If so, if you assume that churn is very low, and that's why your LTV is very big, right? Because it, you know, your average customer lasts for 1010, years, because your churn is so low, is that actually true? And do we think that we can see into the future. So you can, because your LTV is huge, because you have this time period, and that pays back cap. But in reality, you pay back your cat over three or four years. Three years, let's say, for argument, if you have an expected lifetime of 10 years, because your turn is low and and the LTV is is high because you have that 10 year period, but your payback time is three years, then you will have a CAC LTV for simplicity, cycle, 3.3 that would be good enough, but, but do we have confidence enough that the world won't change so that the churn will be steady over 10 years. That sounds too good to be true. Whereas, if you're if your CAC LTV is two and a half, but your payback is three months, that is actually more comfortable, because you're pretty sure that the world is not changing within the first half year, so you already paid back your CAC, and you're pretty sure that that you're in the money, right? But, but to pay the churn, let's say you have a huge pay so that, like your expected lifetime can be too long to be believable. But also the churn can be so high that even if the CAC LTV is good in the short term, if you churn all the customers too quickly, are you sure you can keep adding customers for forever? So there's this like you have to balance that and fundamentally understand what's going on here. And do you believe that the numbers actually make sense and don't just make sense when you do the calculation? Yeah.
Chander Chawla:By the way, if you have find a business that has LTV ducac of more than three and the payback period is three months, please call me. I will invest. So it's very nuanced. I think what I have from the consumer world, I think it's much more accurate and insightful definition of LTV. It's the lifetime profitability of the customer in the SaaS world. You just look at the revenue as LTV, assuming it's 90% margin, assuming low churn, so and, etc. So I still find that more insightful. But, you know, it's a bigger equation. People have to think more. So rule of thumb is like rule of you know, three fingers. Nobody wants to lift three fingers. So it's kind of prevailing thing. Now just do this simple thing, Ltd by CAC, not three we are not investing
Arne Tonning:well, but I don't necessarily well. I halfway agree with you, but I don't agree with you fully, because the simplified formula, which a lot of people use, to be honest, but you know, people need to understand. That's a simplified formula, right? Is good for, sort of rule of thumb, and quick check. It's not actually good for, like, understanding, truly what's going on in this. This a good business. So it sort of helps in terms of, let's say you have to look at 100 deals per day. And you know, it helps. It's helpful for putting 20 of those 100 into a box to look closer at, but it's not actually helpful in terms of understanding the business fundamentally. Yeah,
Chander Chawla:you're right. Yep, absolutely. Like, from a VC perspective, it may be helpful if you're getting, you know, 100 calls a day, and how do I figure out who to talk to? So it may be helpful, but I'm saying like I, you know, as an operator, I look at fundamentals. So for me, the LTV from the consumer world helps me understand the fundamentals much better. And I a sidebar is how the world works in reality is, I had this discussion with another VC in who remains unnamed, in the Bay Area, so I asked him, like, why is the three? Like, why is it three? Like, what's wrong with two? Like, I would, if it's cash flow positive business, it may not give you, you know, an extra return on your investment, but it's still a good business. Like, why do you look at three? So after a long discussion, the summary was basically, oh, because, and recent, Horowitz doesn't invest in less than three, so we're not going to be less so it's basically people, you know, copying others without applying their own thinking. So I'm glad you're not doing that,
Arne Tonning:but, but the three, the three, kind of gives margin for error, right? And, and. And the reality is that, fundamentally, too many of this businesses have too long a payback period and, and the reality is, then you can't really trust it, so you want to have, like, some margin of error, or whatever we should
Chander Chawla:call it as Buffett would call this margin of safety, yeah, yeah, yeah. From a VC perspective, you know, filtering the deals from 100 to 20, I think it makes sense, like you want that margin of safety, yeah, but that doesn't necessarily mean you are a bad business. If you're LTV to CAC, as defined by B SaaS world, is less than three.
Arne Tonning:Okay, so particularly not if, if you know there are like E commerce businesses where we're like the first transaction is profitable, so you don't actually have any risk on the first transaction. You don't know if the customers will transact again, yeah, but if they do, then it's very profitable. But, but, like, the payback time is instant, so you don't have to have a tax lifetime of free to bet on that, as long as the CAC is not too elastic,
Chander Chawla:and you are, for the listeners, I want to clarify you're defining payback period is time it takes to get the CAC back exactly
Arne Tonning:in that setting, you also have to, like, not only take it in revenue terms, if there's actually cost of servicing the business as well. So it's, it's like, your gross profit on, on whatever payment stream you get, not, not just the gross revenue,
Chander Chawla:yeah, so for, yes, that's good. Thanks. So let's say, you know, I'm a business, and I it took me, you know, let's say 200 bucks to acquire a customer, and they're paying me 20 bucks a month, and it's costing me five bucks a month to support that customer. So let's say it's 200 to acquire in a year. I have two $40 in revenue from them, so five bucks a month, at $60 per year. So that's 260 so 240 and 260 would be 13 months. So the payback period in this case would be 13 months, because it would take me 13 months to recover $260 Yep. Now let's get into what do you include in tech? So there is, you know. Money you spend on advertising, there's salaries of, you know, people in sales and marketing, excluding brand. What else is there? Or is that? How you calculate? CAC, what's what's in? CAC,
Arne Tonning:well, there, there are multiple cats wondering about out there, but so there's a paid CAC, a direct CAC, and a fully loaded CAC. And so the difference between these are like Peg Cat is essentially the paid advertising you do to acquire a customer. A direct cat is that plus individual sales people that are involved in closing that customer and the fully loaded cat is essentially, you know, your total budget for a period of all sales and marketing activities divided by the number of customers you get over that period. And I think in for venture capital purposes, I go for the fully loaded because that's ultimately what impacts your unit economics. I think you can probably argue that January in that well, if you stuck brand in here, and the brand doesn't have an instant payback, it has, like, accumulated payback over time, and so that should. It's incorrect to put that in there. But most of those startups we look at don't really spend money on brand, to be honest. So we look at the full fully loaded, because we view that as as as the right metric in terms of unit economics. Is this actually profitable? Is it profitable to get and serve these customers over time. That doesn't mean that like a paid cat is an invaluable metric. It just maybe works better for marketing person who who can look at cats for uh, well, what's the cat on Facebook acquiring customers on Facebook versus Google, and comparing those two metrics and say, Well, I shift my marketing spend from one channel to another or something like that.
Chander Chawla:So when you look at the fully loaded tag, Arna, like, is there rule of thumb or guidance our listeners can use from you on, like, what is the decline rate? Like I've seen, I've launched products where, generally, like, somehow, I don't know why that is, but somehow, in more than three occasions, the new products have launched. The CAC was around 3000 and then, when you start, and then you know, you fine tune and learn and iterate, and you can bring it down to 1000 pretty fast, from 3000 to 1000 I have brought it down in three months or less. But after that, it's tricky. Like how what have you seen? Are there general like rules, or initially it's going to be high. Anything you do when it's new, you gotta spend money to make people aware, get them interested, free trials, whatever, like, what are the rules? Or what do you see in the market, or how you make investment decision. Okay, there can't give this much, but they can bring it down to XYZ.
Arne Tonning:Yeah, this is one where I wish I had better answers on, you know, rules of thumbs, because i i I mean, I mean, the pattern that you described is obviously correct, but
Chander Chawla:it's not just me. You see that like my view is, you know, let's say three to five startups. I've personally done this ad, and maybe, you know, 3040, startups I've spoken with, but you have much broader view. So you see that as a normal pattern,
Arne Tonning:yeah. So, so I think there are fundamental reasons why the pattern is normal, right? Because, you know, as you start up, part of the reason why, as you say, it's unknown. So. Forth, but, but the other reason is that you know every marketing and sales marketing problem is unique in a way, and so is finding like your ultimate customer profile, and you know your segments and so forth. So there's just these learning loops right about where does it fit and and how does it how do we execute, right? So there's a learning group that is naturally as you learn, you get better, and it improves a lot, right? But, but the speed of that improvement and the magnitude of that improvement has a lot to do with how well you've you hit in the first place, how skilled are the marketers and the salespeople? How good is really the product, relative product market fit and so forth. So the pattern is consistent, but but the pace of learning and so the payback you can get from executing is very different. And secondarily, the pattern that it then has a tendency to sort of slip away from you over time, or worse than, if you like, is also due to underlying reasons, right? Because there's some lower hanging fruits, once you've found them, you know, you have channels, maybe for marketing purposes, that are very effective, but they saturate, or they shift and and you have to find new channels or or so forth. And it just gets harder as as you become bigger. And once again, that depends on how big your segments are, and you know what kind of channels you're on, and these sort of things. So I, I think this is a question for for, for maybe deep operational marketing people and sales people and growth people, rather than a venture capitalist like me, because, you know, we can have the luxury of looking at the metrics on a comparables level, right, and go, Well, you know This, I'm not sure about, so I just don't do the deal, whereas this is, like, brilliant, so I'll do that deal if, if you like, yeah, and, but, but even if it looks brilliant, it's bound to change over time. Nothing stays brilliant.
Chander Chawla:Yeah. So it's what I in operational roles I've seen. So I think I've done 3000 to 1000 few times and couple of times 3000 to below 300 but I see, like lot of times, after a quarter, the organizations lose patience. As you said, they're learning loops. Sometimes it's easier. You can do it faster, but sometimes you just have to spend money to figure it out. And to get to that below, let's say 300 or some number that makes sense for LTV. But how in your when you look at the numbers and startups, like, what is the right time period for experimentation and after that, if you can bring it down to where you need to be, then you give up. Like, is it a year? Six months? Yeah, I definitely can say in three months, you can bring it down from 3000 to 1000 but generally not 3000 to 300
Arne Tonning:Yeah, I don't know. So, so, like, I think a lot of the companies that we see and and look, we do early stage and we do SAS. I think, I think the the what you describe is, you know, getting low enough is a bigger problem in some other segments than SaaS in, like consumer and so forth. This is, you know, huge challenging in in gaming, right? Because the LTVs are so low, and you, you know, you have, you just massive volumes, but you have to get the cat so low is, is, is like a big, big challenge, and I think this is a bigger pain point there. What we see more in in SAS, in particular, early stage SaaS, is that actually the CAC, LTV, is actually pretty good, but.
Chander Chawla:Sorry, pretty good is three, like, when you say CAG, no,
Arne Tonning:I mean, I mean, we see 1010,
Chander Chawla:yeah, but CAG is 10, yeah,
Arne Tonning:absolutely, and, or eight or seven or something like that, but,
Chander Chawla:but
Arne Tonning:the problem is that, like you can hustle your way to half a million dollars or something like that, but it doesn't mean that you have something that scales right in go to market terms, and immediately you start putting money into it, and it's like you found like a small Gold Orb, but you haven't found a big one, right? And, and once you try to scale the sales marketing organization, it turns out it's not effective at all. Right? There's not this. I mean, there's product market fit with the segment, but you actually don't have, like, a great go to market machine that you can just put money on. Yep, yeah.
Chander Chawla:Well, what is there? Like, let's say you are. You have to try to bring the CAC down to a number that makes sense for Ltd, how much time do you give? Is it six months? Three months? Let's say you have in a lot of money. Money is not an issue like how intellectually, how long does it take how many learning loops or time should it take for you to figure out, can I bring CAC down To a certain number?
Arne Tonning:Yeah, so, so, you know, I'll it slightly differently. Okay, so the way that I frame it is because of the role that I have, right? I'm a venture capitalist, and I don't, I don't run the iterations of experiments on a daily basis in these companies, but I sort of, I'm, I, if you like, bet on companies or back companies, right? But when we do, they tend to have like a plan, and they have a performance, and it's a backable performance at a time that we put the money in, right, at whatever stage they are, which, you know, if it's pre seed, there is no performance, but it's a bet on an idea, right? All the way to like there are like for whatever stage, the current performance is reasonably good, but there's no guarantee that that will continue or scale. But ultimately, you put the money in and the company ends up with, let's for argument's sake, say, 18 months of runway. It could be 12 or it could be 24 but, but generally you have a, you know, a plan and a burn rate, and you have a time frame, yeah, of that, and, and so within that time period, you have to experiment, or the team has to experiment to get An outcome to make it fundable after those 18 months. And if it's a running business that that means essentially tripping the revenues and proving that customers want it even more or whatnot, right? And so ultimately, it's a question of how many experiments it's how quickly can you get feedback to improve? How many experiments can you run in 18 months? And those could be sales, marketing experiments. It could be product experiments. And soon, the later in this age, it's less product and more good to market. Because, like, you know, if you already have $3 million of revenue, something is right with the product, right? But ultimately it's not so that I say, Well, you have only three months to prove this. This is for the management to say. Well, my input would be, you're out. Your job is to maximize the business before the next time you need to raise money, right? Yeah, and it's for management to figure out whether they will. And ultimately, you do that by if it's runs great, just keep optimizing. But if it, if something breaks down, you need to experiment your way out of it. And then it's a question of maximum number of experiments in whatever direction you take those experiences within those 18 months. But I don't have like
Chander Chawla:a
Arne Tonning:emergency break at three months for anything this is for management to and founders to sort out. Right?
Chander Chawla:Okay, I see. So let me. Me summarize what I heard as a VC you invest in, let's say, series, a that gives them 18 months to figure all that out, do structured experiments and see where you know how you can get the CAC to a number that makes sense for the LTV. So there's no like, a hard line or expected. It may be that, you know, they experiment for a year, nothing happened. Then suddenly they find the click, and then it goes down. So for ignorant perspective, you are betting that in 18 months they'll figure it out.
Arne Tonning:Yeah, I mean, I don't get my money back anyway, unless they succeed Some way or other. And succeeding is generally figuring things out which makes it fundable again. There are instances where it goes break even, or it gets sold, or it fails, right? But objective, generally, if it's going to grow very fast is to bring it to the next level, to make it fundable next time around.
Chander Chawla:Yeah, yeah. Makes sense. Wow, thanks, Arne. I'm glad we are back with a bang. This was so much fun.
Arne Tonning:Yeah,
Chander Chawla:you know, this is still season four. Yeah, this was just a summer break where new season will begin next year.
Arne Tonning:Yep, yeah. Okay.
Chander Chawla:So thank you, Arna, for the echo. Read again. I am falling asleep now which I will go home and do.
Arne Tonning:Well was wells to you were micro impacted by the Aquavit today, I think we can safely say that you're not too dependent on Aqua since the bottle has lasted more than a month already.
Chander Chawla:Oh yeah, there's still a lot left, so you can still have some somehow. You know, I'm a fan, but the Nordics and the Swedes and the Finns are not, because at the innovation house here, I offer it to everybody, but nobody wants to drink, which I don't mind, but I was surprised, because it's a, you know, Nordic pain. But I hope I can have one with me soon.
Arne Tonning:Yeah, maybe it's a particular selection that makes it to California that's not representative of the whole population,
Chander Chawla:yeah, or maybe I should go to Oslo and join you there somewhere. Yeah. Thank you for joining us. We'll see you in two weeks. Bye, bye, bye.