How to build a growth equation
'Ah! I thought we were closing in on the first cut of Valuation today' - the start-up founders I was working with said with a smile when I pulled up the Growth model on the Zoom screen. Not so fast, I said, a good test would be to see if both of you are exactly on the same page with the growth assumptions and cost of growth. And by growth, I don’t mean just customer acquisitions.”
The two co-founders of Health-tech e-commerce were certainly not prepared for this, while I was looking forward to my version of Game theory. I gave them a moment, just in case Zoom was buffering.
While our conversation trailed off in the zillions of zoom meetings and data transfers happening on the Internet at any given point of time, I realised how for-granted we take Growth. And how often, we look at Growth only in retrospect.
I could hear Prof. Damodaran’s voice ringing in my ears - To build a valuation platform, you must show the founders the inconsistencies in their assumptions. And growth was one area where there are inconsistencies abound. You should tell them what is impossible, implausible and improbable.
It was important for me to distill my learnings to build a growth model, considering Growth is the most important aspect of any company. In the following article, I have distilled my learnings building growth model which feeds to the Valuation model in our platform.
What is a growth model?
A growth model is an imperfect, yet helpful model that represents the tools and mechanics required to grow for a company. In essence, it is a spreadsheet that captures how the users are acquired, what channels are they coming through, and how much does it cost for you to acquire your customer.
Growth model might look like a simplistic theory, but the second order effects of having a growth model are greater. Once you have a handle on how growth is happening, you can use it to work backwards on a growth goal (e.g. finding your 1000 true fans or identifying product-channel fit), you can simulate scenarios and most importantly, how understand much does this growth cost you?
It also helps you answer the million dollar question - is your Lifetime Value (LTV) greater than your Customer acquisition cost (CAC)?
In order to build a growth model - let us look at how growth traditionally is captured.
The Incorrect Growth assumption:
From my prior experience in consulting with the CFO office across companies around the world, growth (or sales) has mostly been a domain of sales and channel partners. And the traditional way of estimating growth has been on historical performance and / or how the economy is currently performing. While these are good places to start with, it does not cover the entire gamut of causes for growth. Moreover, this way of growth (and goal) setting has an agency problem. If my payout is linked to my performance on a sales target, I would rather play it safe or better still, underperform and overdeliver, right?
And this sales forecasting-led model for growth in most companies continue till date, with many-a-times people questioning - how come the company did well last quarter?
The New Growth Model
When the Internet brought scale into the game, this traditional sales model started to change. From word-of-mouth and sales channel partners, we had more channels than one can count on a single hand.
Terms like "growth-hacker" started entering the contemporary lexicon from the companies that were able to maintain growth over a period of time (Facebook, Amazon, Airbnb and others). A quick check on Facebook shows there are currently over 2250 jobs on Growth (source). It's no wonder that the company’s products are being used by ~3 billion people in this planet.
So, let us look at the two most common growth equations and see how we can build our own growth equation.
The Basic Growth Equation
Chamath Palihapitiya, ex-Facebook Growth Lead and founder of Social Capital used a basic growth equation, which he still uses to filter which companies should be funded.
Traffic (no. of people coming) x magic response x the value that a product is offering = Sustainable Growth
Deconstructing the broad equation and see how it applies to a couple of companies:
This equation might be too broad for comfort, but the key thing it captures which is not so visible in other equations is the Magic-moment. It is an intangible yet most profound addition to the Growth equation. In the busyness of growing, we sometimes do not capture and identify what is the magic moment that causes Growth.
In Chamath’s own words: …we were testing and iterating and the single biggest thing we realised is to get any individual to seven friends in ten days... that was a keystone in our understanding and if you see, there is not much complexity..
Another important qualification in this equation is the core product value. This nuance separates good growth from bad growth. Are the customers utilising the the core product value? According to Sarah Tavel, Greylock Partners - what matters is not growth of users. It’s growth of users completing the core action. If the user is signing up for the product but is not using the product, those are just empty calories - it feels good, but it is not good for you.
Make sure you are focused on the right core action. Ask yourself: what features would we build if we optimised for people completing this action? Is that the right roadmap?
Amazon’s Growth Equation
Let us look at how Amazon articulates it’s growth equation:
Just to draw parallels from the earlier equation:
How does it help me? - Finding Growth Levers
Assuming you have already chosen the market and industry to be in, the best way to start building your growth model is to look historically at what are the channels through which the customers are coming and how is the rate of conversion across these channels. Once you have identified the channels through which growth is coming, you can optimise those channels to increase growth.
Let us take an example:
If you are tracking how your customers are coming, you should be able to baseline an initial conversion ratio. It can look something like this:
Source: iBanker platform
The world is made of funnels - Jack Conte, CEO - Patreon
The wider the funnel in Contacts, leads and marketing and sales channels are, the better are the chances that it results in sales. Getting the digital marketing costs can help you identify the most profitable channels and also calculate your cost of acquisition. If you are able to get a rough estimate of your customer acquisition cost and identify which channels are most helpful, you are much ahead in the game.
The information above would help you identify your best channels not only in terms of conversion and cost, but with proper segmentation you can identify which channels give you the most stickiest customers.
Source: iBanker platform
Once you have the baseline stats, it is a game of optimising for the best channel. The tactics for better conversion can really make all the difference in shooting up the numbers and helping you create a flywheel for growth.
Finally, this will help you plan your growth for you near and long term future. Based on your conversion ratio, you can identify the number of contacts you need to reach out. It will also give you a handle on the cost required to acquire those customers.
How does this all help?
Ultimately, this helps build a narrative or a story for growth. A story that is painted by your vision and backed by the objectivity of numbers which continually get refined by the assumptions.
It helps you do a what-if analysis and see how you can increase your growth.
Fundamental Strategic Equation with Scenarios
From baselining your growth, you can answer the million-dollar question of where can you get to if you focused on it? And lastly, how growth can change over time? What are the sensitivities that you need to account for growth.
This would help build a strategic and fundamental growth equation for your company which would also impact your valuation.
Higher growth commands higher premiums and better multiples for valuation.
While no model can be perfectly accurate and usable, there can be a fine balance between usefulness and accuracy. Build out models to give a clear understanding of your growth, and also as a better way to communicate with your employees, investors and other stakeholders.
Understand that there would be changes, once your plan meets the messiness and ambiguities of reality, but the models would help you find opportunities which otherwise might be difficult to find.