Unlocking the Secret of the Perfect Payback Ratio for Startups

Many of us at Headline have always assumed that the perfect customer payback period for a business operates around the 12-month mark. As we define it, 'payback' is the duration in which a business generates equal cumulative gross profit per customer, or Life-time Value (LTV), relative to the expense incurred to secure that customer, the Customer Acquisition Cost (CAC). In essence, it's the breakeven point where CAC equals LTV, measured in months.

However, we must remember that this is merely a guideline, derived less from scientific, financial or quantitative principles, and more from the practices of successful businesses. Thus, this article is more of an exploratory study using a forecast model that I have designed for a portfolio company, aiming to bring some clarity to the complex issue of 'the perfect payback time for a business.'

The model, an extension of the synthetic forecast model, uses four primary assumptions:

1. A higher year-over-year (YoY) ARR (Annual Recurring Revenue) growth percentage means a higher ARR valuation multiple. For this model, I used the valuation/growth pairings from the chart below - but this can be easily applied to other metrics of your choosing

2. It takes into account that an aggressive scale-up of S&M spending usually increases the CAC, assuming diminishing marginal returns. For this, I used an exponential growth curve which gets the business in question to a CAC of $366 if they grow S&M spend 5% MoM, a $444 CAC at 10% MoM growth, and an $886CAC by 20% MoM growth. This is the primary driver of the model and should be edited to check various scenarios.

3. We assume that classic factors of the synthetic forecast model like Retention, ACV (Average Contract Value), Gross Margin, Fixed Cost Margin retain the same.

4. We presume a $3.5M cash on hand for the business

By charting these values against each other, we gain insights into the optimal payback lead-time to maximize the company valuation once cash hits zero. We find that aggressive S&M spending reduces the capacity for ARR growth, but increases YoY ARR Growth percentage up to a peak point. The Payback (or Core Ratio) keeps increasing as the CAC rises due to escalated S&M spend. However, the aspect we truly need to focus on is the Ending Valuation in relation to Payback, and we observe that the optimal Payback, in this case, is around 11 months, while growing S&M spend at 10% month-over-month (MoM).

Under these assumptions, I Insert a range of S&M growth and CAC scenarios into the synthetic forecast model to read off the following metrics:

• Runway, how long does the capital last, until the business hits cash $0
• Ending ARR, what ARR will the business have reached when they hit $0 in cash
• Ending YoY ARR Growth %, what is the YoY ARR growth % when the business hits cash $0
• Payback, what is the Payback at the assumed CAC
• Ending Valuation, what is the valuation when the business hits cash $0, calculated by taking the ARR multiple from the assumptions (1.) and multiplying it with Ending ARR

By charting these values against each other, we gain insights into the optimal payback lead-time to maximize the company valuation once cash hits $0.

We find that aggressive S&M spending reduces the capacity for ARR growth.

This is because the higher the S&M growth rate is, the shorter our runway is. And thus gave the company less time to grow its ARR. On top of all these, the company’s CAC is also going up, so each dollar spent becomes less efficient/creates less growth.

Nevertheless, the faster one scales the S&M spend, the higher our YoY ARR Growth % would be the moment the business runs out of cash. Interestingly, this does max-out though between 7% and 10% MoM S&M growth, due to increasing CAC causing the growth rate of the company to slow.

From a Payback perspective, the faster the company scales the S&M spend, the longer it would take to pay back the cost to acquire its customers. (Below chart the Y-axis represent the Payback  time in months)

When plotting the YoY ARR Growth % over the Payback months, it becomes clear that the highest ending YoY ARR Growth % would be achieved at a payback of around 11 months.

The most important number we are trying to solve for is the Ending Valuation the business would get compared to the Payback at which it operates. Plotting out the valuation based on the assumptions above over the Payback scenarios, one can read that the optimal Payback time in this scenario would be about 11 months.

To link this back to the primary input, depending on how fast the business is scaling S&M Spend Month Over Month (MoM) (the primary driver to CAC and therefore Payback), the highest valuation would be reached when growing S&M spend 10% MoM.

Note that it is pure coincidence that the perfect Payback to optimize for a valuation around 11 months here. If one changes any of the assumptions, this value would not be 12.

It's crucial to understand that these numbers are purely hypothetical and may not entirely reflect real-life situations. The model suggests that to maximize valuation, startups can't solely rely on aggressive S&M spending if that leads to a high CAC. Instead, businesses need to find a balance between perfect CAC and S&M Growth rate, taking all other factors into consideration. That brings us to the key question – how does the startup's CAC scale compared to increasing S&M spend? That's a matter of understanding the depth and flow of the business's customer acquisition channels, presenting a unique challenge for each startup. It's essential for businesses to adapt this model to their individual circumstances for it to be applicable in the real world, leading toward a path of sustainable growth."

As always, one thing is for certain, the assumptions above will not be 100% reflected in reality. The model really just indicates that there is an optimal Payback Ratio to operate at (when holding all other factors except S&M spend growth and CAC stable). The model suggests that to maximize valuation, startups can't solely rely on aggressive S&M spending if that leads to a high CAC. Instead, businesses need to find a balance between perfect CAC and S&M Growth rate, taking all other factors into consideration. 

That brings us to the key question – how does the startup's CAC scale compared to increasing S&M spend? That's a matter of understanding the depth and flow of the business's customer acquisition channels, presenting a unique challenge for each startup. It's essential for businesses to adapt this model to their individual circumstances for it to be applicable in the real world, leading toward a path of sustainable growth."

As discussed in this article, there are a many of different CAC and S&M Growth scenarios that can be pasted into the model to read off different outputs. It is all about figuring out what is most accurate for a business to make the model above applicable in the real world. We provide few examples below.

All above scenarios, along with their Ending valuation vs Payback charts, are shown above. You may notice, the highest Valuation vs payback generally occurs around the 12 month mark no matter the CAC scenario.