What’s the Magic Number?

Angela Warner
Portfolio Director, YFM Equity Partners

Entrepreneurs are intuitive and instinctive. Investors like to analyse numbers. That’s just the way they both are. For earlier stage businesses in a rapid growth phase this can be particularly tricky.

So, how do you determine which performance indicators (KPIs) are really key for your business and useful to inform business decisions rather than being no more than data?  Similarly, if you are looking to raise funds, can such KPIs be used to help articulate the story so far and underpin the future strategy when presenting your business to potential external investors? Here at YFM we are constantly evolving these metrics with companies in our growth capital portfolio.

The Evolution of A Business

Consider the evolution of a business from the perspective of new customer traction and recurring income streams.  At the outset it will be difficult to determine any key decisions from data metrics because the low volumes involved and potential early “deals” to attract initial clients will necessarily distort the results.  That doesn’t mean it is not worth tracking the data but more that it should not be relied upon to drive business decisions.  However, as the business develops and more customers come on stream, it will possible to start to assess the “norms” from the data to help direct decisions.  For example, which routes to market are most effective and which marketing gives you best bang for your buck?  Such information should also help to assess what each customer, or type of customer, is actually worth to your business.

What Is The Value Of A Customer & What Does It Cost To Bring Them Onboard?

What is the average customer typically worth (lifetime value “LTV”) & what does it cost to win them (cost of customer acquisition “CAC”)?  It may sound obvious but it only makes sense if the former outweighs the latter!  In the early stages, particularly for SaaS business models, the business may be loss-making with the investment in overhead outstripping revenues from early adopters but the assessment of LTV to CAC will provide comfort that it should become profitable in due course.

Similarly, calculating LTV will highlight customer churn levels.  Are these the same for all customers & products?  Are they an indicator of areas which need addressing as part of the product roadmap?  In assessing the answers it will be necessary to bear in mind the nature of the business itself.  For example, in a SaaS model where customers are expected to be “sticky” you would expect to see very little customer churn.  However, in another software business (perhaps with a different end user purpose) it may be more acceptable / understandable to have higher churn rates.  One size does not fit all and it is important to interpret the numbers in the context of the commercial world in which you operate.

Another interesting measure is “the Magic Number”.  This considers the lead : lag between sales & marketing spend and incremental customer revenues. Put simply, will marketing spend this quarter increase revenues next quarter?

Change in revenue quarter on quarter   =   Magic number
Previous quarter’s marketing spend

You are looking for a magic number > 1.  That is to say, £1 spent this quarter should deliver more than £1 of incremental revenue next quarter.  Again, whether it is quarter on quarter or a longer period will depend on the specifics of your business but the key is having information to give the business the confidence to spend precious funds now in the knowledge of reaping future rewards.

What Else Can Such Measures Provide?

As the business moves to scalable, recurring revenues i.e. normalised trading, deeper analysis beyond the headline numbers should help to assess:  Which spend is most effective – sales overhead or marketing spend? Which cohorts of customers are most valuable?  How many new sales people should be recruited & what should they deliver?  Which aspect of marketing spend is best?  How long does it take to recover CAC (in months)?  Is the answer the same in all geographies?

This insight & information can then provide real value in shaping the marketing, overseas expansion, recruitment and funding strategies moving forwards.

In Summary

Although investors like to work with numbers what they like even more is to work with management teams that not only monitor key performance indicators but truly understand how to both construct and interpret them for their business.  It is not about data.  What is powerful is having numbers which, when assessed in the context of the company and its market, can be used to provide an understanding of market positioning and also help to drive decisions about the future growth and direction of the business.

It’s not magic after all!

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The YFM approach to managing investments

James Savage
Portfolio Director at YFM Equity Partners

My colleague Andy Thomas recently wrote an insightful piece on the myriad funding routes available to entrepreneurs and the key factors to making a successful private equity investment. In the years after that investment has been made, there are many reasons for success but two stand out – a partnership approach and structural evolution.

Partnership approach

A good private equity investor will look to partner with the management teams they have backed.  They will put in place the building blocks for growth but recognise that management teams and investors bring different, complementary skills and experience. Management teams bring   entrepreneurial zeal, deep knowledge of their market, operational excellence and strategic vision.  Good investors bring a wealth of experience of supporting small fast-growing businesses, the issues they will face and the ways they can create value, as well as an extensive network of experts who can support the executive team as they grow.

The above combination can be a powerful one for growth but needs to be underpinned by alignment, both economic and strategic. Equity participation brings economic alignment and it is crucial to take time getting this right – to recognise who is creating value in the business today and who will do so in the future. Getting this right (or wrong) can make a significant difference to motivations and to the ultimate outcome. Strategic alignment comes through taking the time to understand management’s wider growth ambitions for the business and their personal aspirations and then making sure these match the aims, ambition and timescales of the investors.

Structural evolution

At YFM we have funds which cover both growth and buy-out capital, so the businesses we invest in will naturally be of different shapes, sizes and stages of their journey. Quite often we back a management team with great ideas and skills but who haven’t had the time, resources or the need to build out a wider operational, financial and governance framework that the business will require as it grows. An important part of the value we can add is through helping the management team to put this framework in place so that the business is not held back by having outgrown its way of working.

For a business to evolve it needs to take that step forward – to look at itself and where it wants to be in say five years’ time. We have built a network of non-executives who have “been there, done that”, bringing extensive sector knowledge and, crucially, experience of scaling up and selling businesses and of working with new investors.  They can help advise teams how to build the right teams and decision-making processes to keep one step ahead of the growth of the business.

One of the most important areas for this structural evolution is the finance function which in smaller businesses can often be seen as administrative but which we see as crucial to the value creation strategies of the business. There are no hard and fast rules on the optimal set-up but when it works well, finance permeates every level of the business, capturing performance and articulating it via a clear set of KPIs and providing timely and accurate information, but more importantly informing board level debate and ensuring implementation of its strategic decisions.

What does success look like in practice?

Our investment in Waterfall Services is a good example. We first invested in 2007 and then supported two acquisitions prior to our exit in 2014.

There was plenty of scope for misalignment amongst the shareholder base with three institutional investors, a group of private shareholders and management. And along the way we had to overcome the sad passing of an important team member and the appointment of a new Finance Director, who became a key member of the senior team.

This mix of stakeholders, coupled with the inherent conflicts of interest of the ultimate exit path (a secondary buy-out) meant the potential for misalignment was ripe. However, the strong relationship built up over the preceding years meant we collectively had the ability to navigate this complexity resulting in a successful exit for the institutions (a 5x return) and some director shareholders, while other directors achieved their aspirations of remaining with the business alongside a new investor.

Conclusion

Completion of an investment is the first step on an exciting journey. Thereafter the factors to create value are multiple – but we’ve found that if you stay focused on alignment between investors and management, and ensure the management team put in place the right skills and processes to manage the business as it grows, then you’re heading in the right direction.

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Funding Options for SMEs

Andy Thomas
Investment Director, YFM Equity Partners

There’s a huge array of funding options available to businesses seeking to grow. The low interest rate environment, increasing regulatory pressures on traditional capital sources, and improving technologies means there are more types of funding solutions on the market than ever before.

Providing choice to entrepreneurs is good of course, though with choice comes complexity, and there is a danger that businesses can get lost in the myriad of options available, or even worse, take on the wrong type of capital or investor for their particular situation.

Over our many years of experience we have been involved in bank lending lines, mezzanine loans, venture capital and later-stage private equity structures. Given the myriad of funding options available today here are the top things for management teams to think about when seeking new capital:

Risk and Reward go hand in hand: Money costs money, and there’s a temptation to go for the cheapest form of capital available, which can often mean the bank. But the cheap price of money is a signal that they are only able to accept a low level of risk. If your business is stable and predictable and you can therefore guarantee your funder a certain level of profits and cashflow, then bank debt may be the best option.   But where your business is less mature, or your future cash flows are less certain, it is unlikely to work for them so you may need to look at funders that can accept more risk, albeit for a higher cost of capital.

Allow plenty of time to raise capital: If you leave yourself with very little time to raise the funds you need then this could risk delaying the underlying project, or reduce your negotiating power with the funder. You always need to plan for the unexpected so start your investment process early, allow for it to take six months not three, and that will give you the best chance of success.

Ensure the funders objectives are aligned to your own: Generally speaking, any provider of debt, mezzanine, or equity finance to your business has a vested interest in its success. However, there is the potential for misalignment. For example, debt instruments that require you to repay capital can cause a business problems if the management team and shareholders would prefer to reinvest that cash in the business to drive future growth. Try to put yourself in the shoes of the investor and work out where there may be a potential for conflict with your own objectives.

Meet the ultimate decision makers: Often the person you meet from any financial intermediary will not be the person that makes the final decision. Where possible, try to insist on meeting at least one of the key decision makers. It helps management teams to understand more about the organisation they’re working with, and their rationale for investing in them.

Don’t let the process distract you from your business: Raising capital takes time, whether that’s through preparing business plans, meeting with potential investors, or navigating your way through important legal documents. If that process distracts you from running the business then it can be counterproductive, and could even mean the financing falls though at the 11th hour. There’s no perfect solution to avoiding this, but taking on some additional professional support from a corporate finance advisor to help you through the process is often a good start.

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