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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