Until recently many Startups have prioritized growth at all costs, using copious amounts of venture capital to acquire users and dominate markets without regard to profitability or sustainability. However, recent market conditions have shifted towards “efficient growth”, balancing growth with profitability to create a sustainable path to scale.
As investors, we are laser-focused on identifying effective growth early in the company’s journey. What are the early indicators of a startup’s long-term success and effective growth? As we try to find the answer to this question, we use various analyses, some of which we cover in this article.
The Flaws of Using LTV/CAC — why we use cohorts to evaluate sales effectiveness
Before we move on to our analyses, we want to cover why a commonly used metric can be misleading. Often, investors evaluate a business’s traffic engine by the LTV/CAC (customer lifetime value/acquisition cost) metric, but this metric is often irrelevant for early-stage companies for a number of reasons:
- There are many ways to calculate LTV.
- The churn rate is not stable enough to accurately predict customer lifetime. As an early-stage company, the rate at which customer churn fluctuates as the company seeks to fulfill product-market fit. As a product improves over time by adding features that meet customer needs, we would expect the churn rate to decrease. Despite a product improvement, there are external factors beyond a company’s control, such as macroeconomic headwinds, that may encourage a higher churn rate.
- There is a time mismatch within the ratio: LTV/CAC links today’s sales and marketing spend to a customer’s projected, discounted future cash flow, which is inherently an estimate. For example, using metrics collected during COVID-19 to predict the future will likely result in inaccurate predictions.
As investors, we leverage cohort analyzes to clarify the mechanisms of sales growth, retention, and efficiency.
Given the various ways to calculate LTV, the lack of steady-state churn rate data, and the estimated value of the LTV/CAC calculation, there can be no real sense of what drives a company’s customer acquisition and retention. Given the shortcomings of the LTV/CAC calculation, we recommend using cohort analysis to plan how long it will take to pay back the initial sales and marketing spend to acquire each cohort.
What are cohorts and why are they important?
Cohort analysis is a method of evaluating businesses by grouping customers into groups (cohorts) starting at different acquisition points and observing how they behave over set time intervals. Tracked behaviors include number of orders placed, amount spent, and number of features used in periods.
One can apply this analysis to various business models, such as SaaS, fintech, and even marketplaces (back then, we used it to analyze a riding company). Cohort analysis is valuable because the observation of a particular variable over time it allows one to understand the business narrative of revenue, acquisition costs and churn in a single cohort and across cohorts.
Here’s how we conduct the analysis:
