Every business has a limit
Understanding the limit : why it matters, where is it from, and how to push it further
Two and a half years ago, I wrote an article on the importance of CAC payback versus LTV/CAC (in French, you can find it here). This post goes a bit further on the inner ratios and metrics that influence a business.
Fundraising criteria
Fundraising is hard. To get interest from investors your company not only needs to perform on its own, but you also indirectly compete with the entire dealflow of the investor at that moment in time, which is most likely full of other great businesses.
Even though venture investing resembles an art more than a science sometimes, and interpersonal relationships play a role in getting funding, there is still a “checklist” aspect to it. Boxes of qualitative and quantitative expectations that you are expected to tick to have a chance at seeing the money.
Point Nine’s SaaS Napkin is a good example of fundraising expectations. This is without a doubt the most frustrating thing because you have little control over market expectations. What would have been enough ARR (or any other measure) to raise money during the 2021 euphoria would not pass a sniff test in 2023.
Companies themselves need their economics, their funding requests, and the overall growth and equity story to make sense. Both Rodrigo Sepúlveda Shulz (ex Expon Capital) and Augustin Sayer (Partner @ OVNI Capital) wrote good posts on the topic with quick math to explain the reasoning. That’s also why getting a super good deal valuation-wise may turn out to be a poisoned chalice that will compromise your chances to raise at a later stage. Xavier Lazarus (Partner @ Elaia) explains this very well in this podcast (timestamp : 39m50, in French)
In case you aren’t quite there yet and you don’t meet the criteria to raise money today, there is hope the business grows and you will eventually reach the milestone expected from you in the future. Right ?
The existence of ceilings
There is a paradox between the limitless ambition of founders/VCs and the fact that every business has a ceiling.
A size you will not be able to grow past
A size that you will revert to naturally (if you somehow managed to get past it with a trick1)
The bathtub analogy
Imagine a bathtub. The drain at the bottom represents your clients churning. The faucet is your newly signed clients. So long as you have more water pouring in than draining, you’ll be fine right ? The tub will fill up.
That’s correct, but with one caveat. While the incoming water is a constant flow, the draining water is not. It’s correlated to the water level. The higher the water level, the more pressure there is, and the faster water goes out the drain.
Applied to a SaaS business
It works exactly like that for your SaaS business as well. Churn is expressed a function of your customer base, whereas your acquisition is not (2). Every given period, you lose a given % of your clients.
Consequently, as the customer base grows, the churn will naturally grow with it (because it’s proportional). Assuming the number of new clients signed is constant, then at some point in the future, the number churned clients will be equal to the number of new clients coming in. When this happens, the number of “net new clients” (new clients - churned clients) becomes 0.
As a result, the total number of clients stops growing. Because it’s a function of number of total clients, churn stops growing aswell. The business has reached its limit under the current assumptions.
Calculating the ceiling
If we take very simple assumptions, we can figure out what the ceiling is of a given business with a few inputs.
Assumptions
Monthly subscription price, lets say 1K€
Monthly user churn, we will use 5%
Number of new clients per month, a constant. We’ll set it at 10.
Calculations
1/churn gives us lifetime. (why ? see here)
1/5% = 20 month lifetime.
Lifetime multiplied by subscription price gives us Lifetime Value (LTV).
20 x 1K€ = 20K€
LTV multiplied by new clients signed per month gives us our ceiling.
20K€ x 10 = 200K€ MRR, or 2,4M€ ARR.
Given the assumptions we picked, the business will naturally grow to this size of 2,4M€ ARR. If for some reason it’s already bigger, then it will revert back to it naturally. This number acts as an attractor/asymptote.
This example is fairly simple, and its weakness is the assumption that client acquisition is constant. I chose it because it simplifies the math while still allowing to get the point across.
In reality, sales team get more efficient, juniors become seniors, and for a sales team of constant size you can expect the sales volume to grow. To apply it to a real case, I would suggest using the realistic maximum you can get out of your team (instead of the current rate at which you acquire new clients).
I built a super simple model that you can download and play around with. You can find it here.
We’ve established that businesses have ceilings, and we know from the introduction that investors have criteria. The question now becomes, is your ceiling high enough to have a chance to raise money ?
Low hanging fruit
If your ceiling is under what’s expected from a company at your stage to raise the next round, it means you can’t just let time do its thing. You need to change something now, otherwise you will be stuck.
Below is a sensitivity analysis on the impact of a change in a parameter on the total ceiling. Note that I have both churn (Y axis) and new clients per month (X axis) with +/- 20% increments.
Our previous case at 10 new clients per month and 5% monthly churn puts us at the 2,4M€ ARR ceiling. As you can see, mathematically speaking, reducing your churn by 20% (from 5% to 4.16%) or increasing your acquisition rate by 20% (from 10 to 12) are equivalent.
However, bettering these two aspects might not be equally as easy from an operational standpoint. If your product is missing some features causing a high churn, this is probably the first order of business. If your sales team is understaffed, then maybe this is the lever you need to pull on.
I don’t want this to be a fancier version of the classic business cliché “it’s 4x cheaper to keep a customer than to acquire a new one”. Each business is unique and needs to figure out where the low hanging fruit is when it comes to increasing their ceiling.
Ceiling & Burn multiple
The last point I wanted to touch on was the relationship between your ceiling and the burn multiple metric. Burn multiple has been introduced by David Sacks. I strongly advise you read more about it here, but long story short this ratio measures your capital efficiency like this :
Burn multiple = Net Burn / Net new ARR
As a reminder :
Net burn is your monthly cash “loss” (not to be confused with gross burn which measures the total outflow regardless of the cash inflow)
Net new ARR is your newly added ARR net of churn. I.e. if you sign 10K€ but you have 2K€ worth of churned users, then net new ARR is 8K€
Investors use this metric to measure how good you are with putting your cash towards growth. It’s even more relevant nowadays because as David Sacks puts it, it’s not just about growth anymore, it’s about the efficiency of growth.
For reference, here is the rule of thumb benchmark for Burn Multiple :
The relationship between the burn multiple and the ceiling is interesting. Assuming a constant gross burn :
If your gross burn is higher than your MRR ceiling, your burn multiple will naturally deteriorate over time.
If your gross burn is lower than your MRR ceiling, your burn multiple will naturally improve over time.
Here is an example of the evolution of the burn multiple over time for the business we modeled above with a ceiling at 200K€ MRR or 2,4M€ ARR.
So even though your ceiling is higher than the milestone you’re expect to reach for your next round, it also ideally needs to be higher than your gross burn.
If your burn multiple deteriorates too much (above 3x) you will be perceived as a cash intensive business, which could harm your fundraising chances if you’re not in a winner-takes-all market.
Conclusion
SaaS (and subscription businesses) in general have become very common, because they are predictable and reliable, and have a lot of inertia to them. If you’re trending in the right direction, it’s awesome. On the flipside though, you can also end up backed into a corner without much room (or time) to change things.
That’s exactly why I think being mindful of the ceiling of a business is important. It is very forward looking. Most of the KPIs you can track for a company give you an idea of the trend you’re on. Measuring your ceiling tells you where this trend will take you.
Competitor going bust, merger with another business, purchase of a client list etc.
New clients can be a function of the total client base in some cases when the business benefits from network effects (good read on this topic available here by Max Olson, product @Mashgin). VC firms love this, to the point that some of them (Samaipata) even make it the core idea behing their investment thesis.