A heuristic (from the Greek ‘I find, discover’) is any approach to problem solving that employs a practical method that is not guaranteed to be optimal nor perfect, but is nevertheless sufficient for reaching a goal. Heuristic methods are used to speed up the process of finding a satisfactory solution (Wikipedia). In short, a heuristic is a simple thinking strategy that allows us to make judgments and solve problems efficiently.
When analyzing an investment in a subscription-based late stage startup, Fabrica Ventures usually makes use of a three-rule heuristic to rapidly separate the “wheat from the chaff”.
1) Rule of 3:
The lifetime value (LTV) to customer acquisition cost (CAC) ratio should be at least three.
LTV is calculated as the gross profit per client, multiplied by its lifetime. Lifetime is calculated as one divided by the churn.
A higher than three LTV/CAC ratio may not be an advantage, as it could mean that the startup is not spending enough on marketing and sales while the competitors are. Hence, in this case, the odds are that growth is being hampered, and that the startup is losing market share.
On the other hand, if the startup LTV/CAC ratio is lower than three, investors will rightly question the growth scalability of the business and the needed marketing and sales’ future spending to propel growth.
2) Rule of 40:
EBITDA margin (in %) plus annual growth (in %) should sum up to 40% or higher.
Balancing profitability (operational dimension) with growth (market dimension) is an imperative in any business.
For instance, for an EBITDA margin of -5%, the startup should be growing at a 45% rate or higher.
As most SaaS tech startups are not profitable, they would require a growth rate of above 40% to survive in the long term.
3) Rule of 4:
The growth to churn ratio should be four or higher — churn is the percentage of clients who leave in a period of time.
Balancing sales aggressiveness with customer care quality is an imperative in any subscription-based business.
For instance, a 30% growth rate can accommodate a 7.5% churn rate.
Typically, enterprise B2B SaaS startups have lower churn rates than the ones focused on SMEs.
No doubt the business world is complex and there are many more riches and intricacies to consider in any SaaS startup.
But, by experience, the three-rule heuristic is a pretty good (filtering criteria) starting point.