Vinod: I thought it would be good to catch up on how things are going.
Entrepreneur: We are just hitting $45M ARR now. One of the biggest things last year is we moved very quickly into enterprise customers: we started with small firms, and now enterprise is more than 50% of revenue. Our acquisition channels are diversified. The easiest lever right now is outbound, with a CAC payback period of around 8 months. The aggregate CAC payback last year was about 13 months. Our gross margin is just over 80%. As for burn, our gross burn is about $3M, and our balance divided by burn is 10 years. How do you feel about our burn rate? What do you like to typically see to scale?
Vinod: It will come down to CAC payback period. Gross margins are nice, but you shouldn’t be optimizing margin percent in isolation. You should be optimizing margin dollars — true contribution margin after all variable support and acquisition costs, because that's the cash that actually funds growth. The percentage focus is not the right focus. If you can grow faster on lower margin percent, I would grow faster.
Keep an eye on CAC: those are the accelerator and the brake. You could trade off pricing, for example, first-year incentives, in return to get a lower CAC, which would reduce CAC payback period. I would play around with those numbers. The more customers you get, the better you are.
One critical caveat here: CAC payback must be measured correctly — fully loaded CAC (all sales and marketing costs) paid back by fully burdened contribution profit dollars (aka variable cash profit per customer after taking out all onboarding, customer service costs, payment fees, etc). Not gross margin dollars or percent. This distinction is important. I'd say 80%, maybe 90% of companies measure CAC payback materially wrong, including many in our own portfolio, which is worse than not measuring it.
CAC payback is indeed criteria #1, and yes, way more important than gross margin. But long-term retention matters too. The best way to measure that is net dollar margin retention (LTV) over time, and having that be well over 100% is very important. That is an indicator of actual long-term customer satisfaction. CAC payback is risk reduction and comes first on marketing spend. If CAC payback is less than 6 months, you have time to experiment with LTV maximization.
Margin percentage is poorly taught in business schools. Boards still live in the past, so boards give the wrong advice. Common sense says the more gross margin dollars you have to spend, the better off you are. What is the cost of a gross margin dollar in acquisition costs? If you can get $2 to spend instead of $1, go for it. The only question is, what does that incremental dollar cost you? If it costs you 50 cents, then you get six-month CAC payback, and you are deploying your cash effectively for growth. Higher margin often equates to higher CAC to acquire customers but doesn’t always optimize CAC payback.
Entrepreneur: That’s very helpful. I haven't seen that insight framed that way before. I appreciate it.
Vinod: Gross margin percentage came from the old world of manufacturing. If you manufacture something you can’t sell, your gross margin gets wiped out, and your risk profile goes up. That’s not mostly the case today with software products. Fast growth matters more than margin as long as your dollars of margin per $ invested in acquisition is a good ratio and the payback period is short.
The real financial metric is how many dollars do you have to invest into a business and what do you get back in what time frame. What matters in a business is the cash cycle because it tells you how cash consumptive growth is.
Entrepreneur: One of the main things we are trying to figure out is: is our growth plan aggressive enough, too aggressive, or not aggressive enough? The constraint on growth is how fast we hire that team. Is there a risk of over-hiring, hiring too many people at once? How quickly should you hire that outbound team?
Vinod: You hire an outbound salesperson, they’re consuming cash. A new outbound person is cash negative, and then at some point they start selling and they start generating cash. You care about when you get to positive cumulative cash. As long as that number is six months, hire all day long. At eight, it’s okay. This is related to the idea that you spend money to get these accounts and then you get gross margin dollars back. Of course the cheaper you price things, the easier it is to sell, so cheaper to get accounts but fewer on dollar per account. Another metric is risk: the longer the time period gets to payback, your assumptions are less reliable, and that introduces risk. Let’s say you hire a person and they cost you $150K, and with overhead $250K or $300K. You should also think about AI salespeople. That's a separate discussion. If the salespeople have to touch 20 people to get an account, how many people can they touch a week? How many accounts can you get? How much business can they generate in what month of their employment? And when does it get cumulatively positive?
In a competitive environment, keep two years of runway, not ten. I think it’s really bad judgment to have 10 years of cash in the venture business. A good way to do it: assume your cash lasts three years, what’s your revenue or margin at the end of year three? If you reduce runway to two years, what’s your revenue or margin at the end of year two? How much bigger a business are you? If you’re spending $25 million a year and you have 10 years of cash, that’s $250 million in the bank account. That seems silly. Go up to $5M a month or even $7.5M a month. Roughly $10 million a month gives you two years. The question to ask is if the world changes, say in August, Trump invaded Greenland or something else happened or GDP growth slowed down and people were hunkering down at home, how fast can you reduce your burn rate to 2 million a month from 10 million? That’s the important metric. Let me give you an analogy.
If you're doing Formula One racing, I think every startup should be running cash like a Formula One race car. Let's say you are gunning full speed ahead at 10 million a month and you run into some uncertainty — in Formula One terms, you're coming up on a curve: you want to brake as late as possible, and as hard as possible. So your rate of deceleration has to be the fastest. This becomes a critical variable how fast it can go from spending 10 million to 1 million a month. And because then you are slowing down for the shortest period of time and you maintain that all the way through the turn so you don't skid out. Aggressive spending makes sense when you have a measured edge — better retention, switching costs, win rate, or sales efficiency; otherwise high burn is just paying to keep up. But fast deceleration allows for you to take more risk on monthly burn.
Now, as soon as you are out and visibility is clear, you hit the gas pedal and accelerate as fast as possible back to ten. Because the danger comes not from the high burn rate. The danger comes from not being able to change it rapidly if things change. So if it's all head count, it's hard to change rapidly; if it's all advertising, it's easier to change rapidly if you haven't entered into contracts. And the worst is if you have real estate and have a five year rental contract for your real estate, you're not going to change anything rapidly. What the burn is composed of and how fast you can hit the brakes or hit the accelerator becomes a key business decision-making criteria that they also don't teach you in business.
Most finance people have the wrong sense of how to look at this. When you can see clearly, you go gun as fast as possible and use your cash. The sooner you use it, the more effective it will be as long as it is meeting the CAC payback numbers quickly. And when things are fuzzy and visibility isn't clear, you want to drop it very quickly. So make it as variable as possible. While CAC payback is fast, experiment enough to maximize your LTV.
Entrepreneur: That’s a very useful analogy that makes a lot of sense.
Vinod: Tell me about competition. That determines how much risk you want to take. Sometimes not taking risks is the biggest risk you end up taking. In your enterprise market, if five years from now, you dominated the enterprise market, you’d be a bigger company. How often do you run into Competitor #1 or Competitor #2, and what’s your win percentage head to head?
Entrepreneur: Last time I looked at the data, we ran into competition like that maybe 5-10% of the time.
Vinod: That would say to me you don't have great sales coverage or they don't maybe. You want to keep track of the win percentage against each competition. When you’re not seeing accounts they’re seeing, and they’re not seeing accounts you’re seeing, that says neither party has enough sales coverage. The second most important thing is: when you go up head to head, how do you win? And an important metric will be who has the highest volume of contracts.
Also expand your sales coverage as long as you have monitored CAC payback, keep improving LTV and have cash to manage risk.