How to evaluate a startup’s traction and performance
If you’ve been following along in my VC 101 blogs, you should now know how to create a thesis, size a market, source deals, and evaluate a startup. As we continue our journey further into startups and private investing, we will get heavier into some quantitative aspects of a company’s performance. I mentioned in my post about evaluating startups that traction matters. We want to invest in companies that are measuring their performance and increasing growth. This week, we will walk through some key metrics that many startups will use to evaluate performance. Different industries will often focus on other performance KPIs (Key Performance Indicators), but the below callouts will be pretty standard across most early-stage companies.
Monthly Recurring Revenue (MRR)
How much revenue are you generating each month? A company’s MRR answers this by calculating all revenue generated in a monthly timeframe contractually obligated to recur the following month. This benchmark is essential for understanding top-line revenue growth and is likely the first thing an investor will look for in a startup.
- Calculation: # of subscriptions/transactions multiplied by the dollar value of that subscription/transaction.
An important thing to note is that this metric only considers committed ongoing revenues and not one time transactions. For that reason, we find it primarily in subscription-based businesses.
Annually Recurring Revenue (ARR)
How much revenue are you generating in a year?
- Calculation: MRR multiplied by 12 months
Simple enough, right? There are a couple of callouts here. First, this metric is only a snapshot in time. Each month you can be adding new customers. A startup should consider their monthly growth in their forward projections, but it would not be recognized revenue. Second, remember that VCs are looking to generate outsized returns in their portfolio. To do this, a company needs to hit a specific size and valuation. A rule of thumb used today is that if a startup hits $100 million in ARR, then you may have a unicorn in your hands.
How many customers do you lose in a given period? Companies can use this metric for other purposes (employee churn or dollars retained), but their primary goal is to understand customers. Doing so helps us determine how sticky the product is and expect our revenue to grow.
- Calculation: Customers lost in a given timeframe divided by customers at the beginning of that timeframe.
A lower churn rate is better than a higher one, but this is an industry-specific metric. Generally speaking, anything below 7% or a .58% monthly churn is acceptable.
How much cash are you using in a given period? In the startup world, cash is king. Remember, these early-stage companies are typically unprofitable. If they were generating profits, they probably wouldn’t need VC money in the first place! This metric helps us understand how the company manages its investment dollars and how fast they are “burning” through it.
- Calculation: Money spent in a given timeframe divided by a specific # of actionable months.
Another significant result from this calculation is a company’s “runway,” or how much time they have until they run out of money. This information helps determine the optimal time to raise another round of venture funding. Typically, a startup should raise 12-18 months of runway in a venture financing round.
Dollar Revenue Retention (DRR)
How much revenue are you retaining from your customers over time? This metric helps show a bigger picture of our customers and revenue trends, and software companies or companies with tiered pricing strategies often use it.
- Calculation: Revenue for period one divided by revenue for period two.
Using this metric helps us look beyond MRR and Churn Rate. Some companies can have higher than average customer churn but a positive DRR, which focuses on customers in a higher pricing tier. For a simple example, if a company has two customers but loses one, they have churn. If the remaining customer ends up paying a higher price, however, DRR would be positive. It’s crucial to keep perspective.
Customer Lifetime Value (CLV)
How much money will each customer bring in during their lifetime as a customer? We want to know this metric because companies spend money on sales and marketing to acquire customers in the first place (see CAC below). We want to calculate how much we are getting for that customer investment. This metric is a little more nuanced to calculate.
- Calculation: 52 * Avg. Customer Value * Avg. Customer Lifespan * Avg. Profit per Customer.
- Fifty-two weeks in a year.
- Avg. Customer Value = avg. customer revenue * avg. # of visits per week.
- Avg. Customer Lifespan is determined internally by the company based on their data.
- Avg. Profit per Customer is also determined internally based on company data.
If we are spending more to acquire a customer than their CLV (CLV/CAC ratio below), then we could be losing money over the long term.
Customer Acquisition Cost (CAC)
How much does it cost to acquire a new customer? Costs usually associated with this metric include advertising, pay and commission for salespeople, and onboarding costs.
- Calculation: Sum up all costs on the income state involved in acquiring a customer and divide it by the # of customers acquired.
Generally speaking, the lower the CAC is, the better.
CLV / CAC Ratio
This metric combines the above two calculations to determine how much money we generate from a customer for each dollar we spend to acquire them.
- Calculation: CLV divided by CAC
There is a balance to this metric. If it is too high, say 5:1 (or we earn $5 for each $1 spent), we might not be spending enough on our advertising efforts, thus leaving value and growth on the table. If too low, we need to reevaluate our marketing strategy as we are spending too much money for little value in return. The sweet spot is a 3:1 ratio.
Startups KPIs are one of the most critical aspects in determining performance. Metrics help founders navigate strategies for fundraising, product features, pricing, and marketing. For investors, they help us determine if a team is successfully executing a business plan. One important note for founders: do not lie about your metrics. It will be found in due diligence and ruin your reputation. Do know these numbers intimately and be able to talk about them in detail.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.