There is a domino effect that starts at public markets and tips its way back, stage by stage, to the first round of venture capital for a startup. The initial tip is the exit or liquidity event for the privately funded enterprise, the valuation that gets set for comparable inventory items on the venture shelf.
In principle, this stands to reason, particularly for the late-stage venture-backed investments that may be on the cusp. It’s good to know what may await, in order to prepare, or celebrate, or try something different, and figure out how best to mark the portfolio to market. This, especially in the case of the second domino in line.
But as the tipping progresses, and the advance gets farther from the point of origin – the public exit reference point – the comparisons weaken on two fundamental counts: (1) there is a long and unpaved road to travel, with unexpected turns and obstacles along the way, before that exit reference point has any real significance, and (2) the time that this can take is such that public market tone, liquidity, and expectations are prone to change by then, as public market tone, liquidity, and expectations always do.
Nevertheless, markers are important, particularly on an unpaved road with unexpected turns and obstacles along the way. And in the early stages of an enterprise that’s likely to need further funding as it grows, it’s good to keep track of what these upcoming funding sources will expect, to plan ahead and work to optimize the probabilities.
Where the exercise can become very messy though, is in the apples-oranges comparisons and certain reference markers that may be rigidly and formulaically set, without the needed scrutiny of scope and nuance, the differences in circumstance between the case at hand and its supposed model, and the strategic implications of financial decision making that may ensue, perhaps correctly or perhaps not. The critical result – to not run out of cash before the next shipment has arrived – is always in the balance.
The current day example of such formulaic dominos that seem to be tipping, triggered by the class of last year’s IPOs and their performance, is unit economics.
The concepts of lifetime value (LTV) and customer acquisition cost (CAC) aren’t new, but it feels perhaps like now they’ve become elevated, universally, in stature and attention.
This is a good and healthy thing for markets and financial planning, as unit economics are about as fundamental as it gets, for both. By the same token, however, it can be dangerous where the concept is misapplied, misunderstood, and improperly compared, because unlike, say, a P/E ratio, which is truly formulaic – there’s a price, and there’s an earnings figure, and there’s a ratio of the two – LTV and CAC are entirely dependent on underlying assumptions.
The nature of the business or the product, its stage, the costs and revenues included or excluded, the timeframe in question, the growth or churn assumptions (and definitions), the scope of the analysis, these basic elements of unit economics are fundamentally subjective, and the results much more interpretive than, say, a high or low P/E multiple based on growth.
For the clearest and most comprehensive overviews of what makes up this fickle exercise, here are the classic summaries that you may want to bookmark and review as a reminder from time to time:
- The Dangerous Seduction of the Lifetime Value (LTV) Formula by Bill Gurley
- Why is Customer Acquisition Cost (CAC) like a Belly Button? by Tren Griffin
And from the ledger’s other side, the venture funding market, which is always top of mind and governed by unit economics of its own:
- The Venture Capital Math Problem by Fred Wilson
These have withstood the test of time, and maybe even grown in relevance in the new decade and environment.