Startup founders have a million things on their minds: building a product, hiring a team, raising money, getting that early traction, figuring out how to scale, or frantically throwing water on whatever metaphorical fires are inevitably burning.
Compared to those things that are clearly existential in importance — failure on any one can be the end of your company — keeping accurate books can seem a bit mundane, and something that a founder can outsource and call it good. But the reality is that the appropriate setup and accuracy of your books, and a close eye on what they’re telling you — can play just as important a role in making or breaking your business.
Even for startups.
Gauge Your Startup Metrics
If you’ve raised money, you’ve probably done a lot of talking about and a lot of analysis on metrics like lifetime value (LTV) and customer acquisition cost (CAC). For many startups, especially in tech, these metrics form your “unit economics” and essentially dictate if you’re ready to step on the gas and scale with additional capital.
If you’re earlier in your journey, you’ll want to get familiar with this concept. The basic idea is this: the value of a customer to your business, over its lifetime with you, must be greater (usually significantly greater) than it cost you to acquire that customer.
As a simple example, if an average customer is worth $1,000 to your business over time, you won’t want to spend $2,000 acquiring that customer (through marketing and sales costs, etc.). This would be an example of the old dot-com era joke “we lose money on every customer but we make up for it in volume.” (Here’s looking at you, MoviePass!) In order to have a scalable business, you need, at the very least, a positive LTV to CAC ratio.
How to Improve Your Unit Economics
We won’t go into the specifics of what “good” unit economics look like here, though many investors place the minimum acceptable value for the LTV to CAC ratio at 3:1, and some argue that it needs to be much higher. You can improve this ratio by decreasing acquisition costs (through more efficient sales channels) or increasing lifetime value (through more effective pricing, a stickier product, etc.)
Many startup founders, though, drastically overestimate their LTV to CAC ratio.
The first way to they do this is by using revenue instead of gross profit when calculating lifetime value.
As an example, a SaaS startup may have a 3% monthly churn rate (the percentage of customers you lose in a given month — inverse of retention) and a product that’s priced at $90/month. Many founders would calculate LTV simply by dividing revenue by churn rate — in this case, $90/.03 = $3,000.00.
Let’s say (and we’ll explore this more in a moment), that this founder believes they can acquire customers for $1,000. That would give a 3:1 ratio — looking pretty good, right?
Well, no. What the founder neglected to count was a bookkeeping fundamental: the concept of gross profit.
What is Gross Profit?
Gross profit is the value that remains when you take your revenue and subtract away all the direct costs that are necessarily incurred by delivering your product or service. In our hypothetical SaaS company, this probably includes at least server and storage costs, customer success, any third party software used to deliver its own software.
Often, these costs will eat up 20-30% of your revenue (said another way, leaving you with a 70-80% gross margin). Meaning, our example customer wasn’t actually worth $3,000 — instead, they were actually worth something like between $2,100 and $2,400.
Only a closely tracked and accurate of set of books will give you your gross profit accurately — every time a cost is incurred that is directly related to delivery of your product or service, that needs to be categorized somewhere in your cost of goods or cost of services categories. You’ll then be able to see, at a glance, exactly what your gross profit is — and that’s the real value — not revenue — that should be used when you’re calculating LTV.
Now let’s look at the customer acquisition cost side of the equation.
A Look at Customer Acquisition Cost (CAC)
Conversely, it can be easy to underestimate your CAC without a close and careful look at an accurate and well-kept set of books.
A simple way to formulate CAC is to take everything you spent on customer acquisition over some period, and divide it by the number of new customers gained over that period.
For example, if our SaaS company spent $500,000 one year on customer acquisition, and gained 500 new customers, then its CAC was $500,000 / 500, or $1,000.
Our SaaS founder may have done a quick-and-dirty estimation to get to that $500,000, simply adding up their company’s advertising costs, wages of sales and marketing employees and contractors.
In reality, though, that’s probably not enough. What about the meals and entertainment expenses that weren’t just for company outings, but were for taking potential customers out for pitch meetings? What about the travel expenses the VP of sales incurred to get to that meeting?
A great set of books won’t group those “Meals and Entertainment” and “Travel” expenses all together — rather, they’ll be tracked separately for those that are related to customer acquisition (like traveling to the meeting) and those that aren’t (like traveling to a board meeting).
How to Ensure Your Bookkeeping is Accurate
One way to do this would be to create multiple categories that serve those different purposes. You could have “Travel – General” and “Travel – Customers.” When it comes time to calculate your CAC, filter and add up all of the expense categories that you’ve set up specifically for customer acquisition, and in a few clicks in your Quickbooks (or an alternative like ours), you’ll have an accurate-to-the-penny CAC value.
Back to our example. Let’s say that after including those expenses in for the year, the number is actually $600,000 — not $500,000. That means, after we divide the new value by our 500 customers gained (unfortunately, the number of new customers didn’t increase along with our increased acquisition expenses), our CAC just increased from $1,000 to $1,200.
Let’s now put this all together and talk about why accurate bookkeeping matters for startups.
Why Accurate Bookkeeping Matters for Startups
What just happened to our unit economics when we adjusted our numbers?
With our original, overestimated LTV and underestimated CAC, we’d come out with an LTV ($3,000) to CAC ($1,000) ratio of 3:1, which had us feeling pretty good and indicating that we just might be ready to raise capital and really start scaling.
With our new, accurate LTV and CAC (let’s use the more optimistic LTV and we’ll have $2,400 and $1,200, respectively) we come out with something very different: a ratio of 2:1.
At 2:1 as opposed to 3:1, this is a really different business. You’ll have a harder time raising money, a harder time scaling, and a harder time becoming very interesting to potential acquirers.
You may be thinking you don’t like the new definition very much — might as well stick to the old one! After all, investors are going to be much more excited about 3:1, and you’ll figure it out as you go, after putting together that nice Series A.
But using a lazy definition without the benefits of accurate bookkeeping isn’t just problematic for investors — it’s really problematic for the startups that do this. After all, the narrative you tell often is the one you’ll start to believe.
The 3:1 will leak into your financial projections, and the expectations you have of yourself and that your board has of you. When the success foretold by that ratio doesn’t come to pass, you’ll find yourself in an uncomfortable position: with disappointed and agitated investors, a cash balance running short more quickly than you thought, and a team that’s getting nervous that things aren’t going as planned.
Disciplined Bookkeeping Reveals Your True Unit Economics
When you use a disciplined bookkeeping practice to get to the reality of your unit economics, you’ll make better decisions. If it’s 2:1, and it needs to be 3:1, then you’ll focus on actually increasing lifetime value or actually decreasing acquisition costs through operational improvements or innovations. And then, when you get where you need to be, you’ll be ready to raise that money, build out your sales team, finally scale within that new vertical — whatever your goal is — and have confidence that your business is ready for it.
Stay on Top of Your Books
Bookkeeping may seem passé or a necessity to simply outsource and forget about, but that’s far from the truth. In reality, bookkeeping more essential than ever for startups whose prospects are determined by very specific values that show the reality of their business situation.
Stay on top of your books — not just in timeliness, but in specificity and accuracy — and I’m confident you’ll see long-term rewards from doing things the “old fashioned” way.
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