Traditional financial metrics like profit margins, working capital ratios, leverage-related ratios, returns on capital and assets, and cashflows derived from financial statements are vital for tracking company performance and form the basis for analyst recommendations as well.
These don’t work for startups though because—well—startups are different. Three shortcomings of traditional financial metrics are:
- Timing: A startup lives in a dynamic environment. Suppose you base your business decisions on metrics from your quarterly financial statements (basically relying on three to four months old information). In that case, you’ll certainly come up with an innovative way to crash and burn.
- Purpose: Besides using more recent information, a startup’s metrics also need to have more predictive value rather than show analysis of past performance.
- Relevance: Most startups take time to breakeven; sustained profitability takes even longer. Since most traditional metrics focus on profitability and returns, they are almost irrelevant for startups.
Here’s what you should track instead, even in your sleep. These metrics—covering cashflows, revenue, and customers—are about knowing how you are doing, and trust me, your potential investors will be very interested in them. Don’t step out to pitch without having these in your deck.
- Gross Margin
Even if revenue growth is your paramount goal and profitability a distant one, it pays to keep track of your Gross Margin. The only way to grow if you spend more to produce your product than what you get for it is to keep burning capital—not much of a ‘growth’ strategy. The objective, almost always, is to have a reasonable and growing Gross Margin, calculated as:
Gross Margin %=Revenue-Cost of Goods Sold÷Revenue
The focus here is on lowering the cost of production and/or improving realizations.
2. Burn Rate
Burn Rate is the amount of capital your startup is spending to keep running, usually calculated as a monthly number. Simply put:
Burn Rate=Monthly Expense-Monthly Revenue
Burn sounds bad, and it is. However, an early-mid stage startup is expected to spend a lot to grow. The rule is that it should not be too much too soon or for too long and should change with your stage.
Your fundraising rounds will be the plug for your burn, and the Burn Rate will be the key determinant for the next metric you need to track.
The Runway is the number of months your startup has left before running out of cash. It is simply:
Cash on hand/Burn Rate
Runway helps you to plan your fundraising rounds. If your Runway is not long enough to reach your fundraising milestone, you have to either reduce expenses or somehow get more revenue. Your financial forecasts need to keep the Burn Rate and Runway front and center.
Once you have broken up your expenses into fixed and variable costs, you can use this information to calculate the breakeven point. This is one metric of equal interest to both business owners and investors. It can tell you the business volume at which you begin to earn profits, EBIT, EBITDA, or cashflows.
To calculate breakeven, you will need your contribution margin first:
Contribution margin per unit=Revenue per unit–Variable cost per unit
Total $ contribution margin=Revenue–Total variable costs
Next, your breakeven point:
Breakeven point in units = Fixed costs/Contribution margin per unit
Breakeven point in $ sales=Fixed costs/Total $ contribution margin
Breakeven’s main use is in planning and target setting. In most cases, breakeven is a business’s most important milestone.
Average Revenue Per User (ARPU) is a great metric for various startups. Its evolution is a testament to how well you are doing in upselling, cross-selling, product upgrades, the performance of your sales channels and team, and so much more. If an investor does not ask you about your ARPU trend and plan, you will not get anything from such an investor other than his money!
ARPU=Total revenue / No. of active users in the period
6. Customer Activation Rate
This is a key metric that looks at how well your customers are engaging with your product or service. It'll tell you a lot about how your churn will shape up and whether you need to intervene before you lose the customer. The activation rate is also a reflection of your marketing, business development, and customer targeting efforts–if the activation rate is consistently low or falling, you may need to relook at whom you are selling to. Activation rates are calculated for each milestone the customer is supposed to complete once onboarded:
Activation rate=(Total users completing said milestone/Total users) × 100
Churn causes Burn. Revenue churn is the percentage of weekly/monthly/annual revenue you lose from your existing customers. Monthly is the most common calculation frequency. The calculation is seemingly simple—if you started the month at $100,000 revenue and lost $2,000 through cancellations, downgrades, or defaults, your revenue churn rate is 5%. Alternatively, you could also calculate a customer churn rate (number of lost customers), though this will not capture downgrades, which will miss out on how well you are doing on the product mix.
While calculating churn, be mindful of calculating it at a gross level, i.e., ignore revenue from new customers added in the month. However, revenue from upselling to existing customers can be netted against the revenue lost.
Revenue Churn=(Revenue lost from cancellations and downgrades/Previous month's revenue) × 100
A useful insight can come from comparing revenue churn rate with customer churn rate. So, let’s say you are suffering a high customer churn rate but a relatively lower revenue churn rate. That could be a great place to be in; it means you are losing customers with lower realizations and are doing well at retaining the golden gooses.
Investors watch Customer Acquisition Cost (CAC) like hawks. This is usually the Waterloo for most startups that chase revenue growth at any cost. As the name suggests, CAC is the money you spend to acquire a customer—sales, marketing, distribution, discounts, freebies… it’s all in here. At early stages, CAC is expected to be high given that you need to establish yourself as a new entrant or disruptor, you are figuring out your target segments, and entering new markets. Over time, CAC needs to come down, and ARPU needs to go up.
Life Time Value (LTV) is the other important indicator of how well your product is doing. Customer LTV is what your average customer is worth to you over the expected period of the relationship. The components you need for calculation are:
- Average revenue
- Average margins
- Average relationship period
- Probability of losing the customer
LTV= (Average Monthly Recurring Revenue per customer ×Average Gross Margin) / Churn Rate
So, if your average monthly subscription is $1,000, you earn a Gross Margin of 30%, and on average you lose 3% of your subscribers each month, then your LTV is:
($1,000 X 30%)/3% = $10,000
Both LTV and CAC are vital metrics on their own. They go hand-in-hand, though, and when combined into the LTV/CAC ratio, provide a metric that is your ‘make or break’ predictor. This ratio essentially tells you how much more you’re getting out of your customer compared to the cost of acquiring her. If your ratio is, say, 1:3, it means you are in an unenviable position where you spend 3 times what you get. You want to be above 1:1, but it isn’t enough to have LTV > CAC. How soon you recover your CAC will make a massive difference to your cashflow position, which will impact valuations materially.
There are also other domain-specific metrics and KPIs that are important, such as:
- E-coms need to focus on Gross Merchandise Value and Average Order Value.
- SaaS and other subscription-based businesses would do well to focus on MRR.
- Tracking Monthly Unique Visitors is vital for websites
- And so on.
Spare adequate thought on coming up with the right metrics, track them regularly, and de-risk your business. Without them, you are effectively driving blind. Trust us, the odds are stacked heavily against startup success in any case; why make them worse?