Financial statements are a Rosetta Stone for startups. They reveal the strategies and the tactics of how to bring a product to market. These are the ten metrics I look at when sifting through a startup's operational model, whether when considering an investment or in a board meeting.
Revenue growth indicates how quickly a company can grow under the current way of doing business. The top line shows whether the market affords steady growth (SaaS) or lumpy revenue growth created by the long sales cycles of big customers (Telecom) and whether the company must sell one product or a collection of complementary products. The revenue growth projections indicate the potential of the business.
The Net Income, aka bottom line or burn rate if negative, is the revenue minus all the costs incurred. Net Income dictates the minimum amount a startup needs to raise to become profitable. By comparing Cash, Net Income and Revenue, I can calculate when a startup will need to raise its next round, what its financial profile might be when it does go to market and get a sense of follow-on financing risk.
Gross margin is a measure how expensive it is make the product. It's calculated by taking the revenue and subtracting all the COGS (costs of goods sold), which in software businesses includes serving and hosting costs, software licenses used, and revenue share agreements in the case of ad networks. Most software businesses have gross margins of 80% or more, which make them very attractive. On the other hand, grocery stores operate at 30% gross margin. Gross margin is the glass ceiling of profitability because the net margin can never exceed the gross margin.
Contribution margin measures profit per unit, without considering fixed costs. To calculate contribution, take the total revenue generated by selling one unit and subtract the variable costs to sell that unit. Selling and marketing costs tend to form the bulk of contribution margin costs in software companies. The greater the contribution margin, the more profitable the business on a unit basis, the more sales and marketing dollars can be spent to acquire customers and fuel growth. Contribution margins range from 5% to 25% depending on the sector. Of course, contribution margin has to be put into context. The contribution margin of producing a kilowatt of energy from a fusion reactor might be nearly 99%, but the fixed costs are measured in the billions. Contrast that with a 15% contribution margin ecommerce business which requires only $25M to become profitable. Which is more attractive?
Customer acquisition payback period or sales efficiency is a gauge for how aggressive a company can be marketing and selling its services. The longer the payback period, the greater the risk that a customer churns and the marketing dollars paid to acquire the customer are lost, and vice versa. The most efficient businesses I've seen recover their customer acquisition cost in 6 months. A 12 month recovery window is more typical. In SaaS startups, the payback period tends to be the driver for moving from monthly pricing to annualized contracts because it eliminates the profitability risk of a customer.
Churn quantifies the revenue potential of each customer. A 3% monthly churn rate, which is typical of public SaaS companies, implies most customers will only hang around for 2 years. The greater the churn, the more challenging revenue growth becomes over time. This often means a company will stimulate demand using paid acquisition, decreasing contribution margin and impacting profitability.
The single biggest expense for most startups is salary. By looking at salaries across functional areas, I can get a sense for how a startup pays its employees relative to market rates. Low salaries could spell employee retention questions in the future. Excessive salaries reduce the company's runway. I compare salaries to a set of benchmarks across venture backed companies as a litmus test.
Sales quotas provide indications of how easily the product is sold and how well run the sales team is. Inside sales quotas vary from $150k to $600k per year and enterprise sales quotas vary from $1M to $2M, depending on the product. At the early stages of a startup, I tend to value consistency: smaller deal sizes but more predictable deal velocity (number of customers closed per week).
Non-personel marketing spend is the most significant controllable expense in a business. It typically includes ad spending and event spending. This expense bucket can be turned on and off from month to month unlike salaries or rent. It's important to me because it provides an indicator of how well understood the marketing process has become. For most startups I've seen, demand generation budgets range from 5 to 20% of total expenses. The optimal ratio depends on the payback period.
Revenue per employee. The beauty of software businesses is their leverage. Google's market cap is 40% larger than Walmart but it has only 2% the size of Walmart's employee count. Revenue per employee is a measure of how efficient a business is in using technology to bring their product to market. Some sectors and products intrinsically need more people to be sold.
16 December 2013