Why traditional finance metrics don’t cut it for startups (and what you should track instead)
Tuesday, November 5, 2019/
Startups aren’t like traditional businesses.
Thank you, Sherlock.
It’s worth spelling out the obvious though because it’s why startups can’t just rely on traditional finance measures. Traditional measures, like balance sheets and profit and loss (P&L) statements, are too slow — by the time something shows up in them, it’s usually too late for lean startups to act.
You can spot problems and opportunities earlier by tracking the right startup metrics. This is also why investors want to see these metrics in your pitches.
Startup metrics at a glance
As well as simply tracking the number of customers, revenue and profit (if any), these are the key metrics you want to track as a starting point:
- Cash burn
- Cash runway
- Recurring revenue
- Customer acquisition cost (CAC)
- Customer lifetime value (LTV)
The metrics you need to track will depend on the stage your startup is at, and there’s also a whole other world where sales pipeline metrics, conversion ratios and cohort analysis live, but that’s too much for one article. So let’s focus on the first six instead and break them down.
1. Cash burn
This is also known as burn rate or just burn. It is sometimes confused with cash runway, but they’re different (more below).
Cash burn is how fast you’re spending your cash. It’s usually expressed as a monthly amount.
It’s especially important for early-stage startups, which often fail because they don’t leave enough time to raise funds or reduce expenses. We recommend tracking cash burn beyond the early stage too because it’s important to know how fast you’re spending your money.
To calculate your cash burn:
Take your cash spend from the last month from your P&L. Then adjust it for any abnormal spend that may have happened and for any future expected spend (such as if you’ve just hired a new developer).
It’s worth noting that while you’ll likely get this data from your P&L, the idea is not to get it strictly correct from an accounting perspective but rather to form a quick, somewhat subjective view of what you expect to spend going forward.
2. Cash runway
Your cash runway is how much time you have left (usually in months) before running out of money. It’s especially important in startup land where founders are often operating at a net loss while in development or set up mode.
To calculate your cash runway:
Divide the money you have in the bank by your cash burn (see above).
For example, if you’re spending $10,000 a month and you have $100,000 left in the bank, you have 10 months of runway left. This assumes all other things are equal in that 10 months, so if you have some bigger expenses one month, the runway would reduce. It’s not a perfect measure but it’s a quick snapshot worth tracking.
3. Recurring revenue
Not all startups will have recurring revenue but if you do, you need to track it. Investors love businesses with recurring revenue because they see them as buying into a ‘guaranteed’ future revenue stream, just like an annuity. Just watch out for churn as discussed further down.
There are two key types of recurring revenue:
- Monthly recurring revenue (MRR) — typically used for Software-as-a-Service startups (often with subscription-based models); and
- Annual recurring revenue (ARR) — where customers are charged annually.
Both MRR and ARR measure recurring revenue only, so if you’re charging customers a set up fee for example, you need to exclude that in these calculations.
How to calculate MRR
You’ll need to identify the nature of each product (one-off or recurring) in your billing system. Once you’ve separated it out, it’s easy to calculate your MRR.
As your startup becomes more sophisticated, you’ll also want to monitor changes in MRR, such as:
- New business: how much of your MRR in the latest month comes from new customers;
- Expansion or contraction: how much of your latest MRR comes from upgrades (for example, where someone upgrades from a bronze to a silver subscription) or downgrades; and
- Churn: there’s more on this below but basically it’s a lost customer.
How to calculate ARR
The slightly confusing thing about ARR is that it can stand for two things: annual recurring revenue and annualised run rate. Here’s the difference:
If your business just has MRR revenue, then on an annualised basis you’d expect that for each year going forward, at a given point in time, you would earn 12 times the latest MRR. This is the annualised run rate.
But, if you also sell products for an annual subscription — a quite common example is ‘buy 12 months upfront and get one month free’ — then these are really their own product type and you should identify and track them separately. So when presenting the recurring revenue for these types of products, you could show (for example):
- Monthly recurring revenue (MRR) = $10,000 per month
- Annual recurring revenue (ARR) = $25,000
- Annualised run rate = 12 x MRR + ARR = $145,000
Note: If you are receiving the 12 months of cash in advance, don’t make the mistake of calling all of this revenue. It gets technical at an accounting level, but you need to recognise revenue progressively over 12 months.
Churn means a lost customer. For example, a customer signs up for a subscription and then leaves you later on.
It’s like those times when Telstra tries to sign you up for your next 24-month mobile phone plan and you decide to change to someone else. Funnily enough, telcos are the first ones that really nailed how to track these kinds of metrics.
Churn can be measured in two ways: customer churn and dollar churn.
How to calculate customer churn:
Calculate the number of lost customers in a month and divide by the number of total customers in the previous month, then multiply the answer by 100 to give you the percentage.
For example: Two lost customers in January/200 total customers from the previous month = 0.01. Then 0.01 x 100 = 1% customer churn rate.
We usually recommend tracking monthly churn and also churn for the last 12 months, so you can zero in on any monthly spikes and diagnose their causes.
It’s worth noting that if you know your churn rate, you’ll know your retention rate too. For example, if your churn rate is 2% of customers monthly, you’re retaining 98% of your customers monthly.
How to calculate dollar churn:
Calculate your MRR* lost in a given month and divide by your MRR* at the beginning of the month, then multiply the answer by 100 to give you the percentage.
This will give you gross churn. It’s worth calculating net churn too, which is:
MRR* lost in a given month minus MRR* gained from upsells that month, divided by the MRR* at the beginning of the month, and multiplied by 100 for the percentage.
*MRR = monthly recurring revenue. You can replace this with ARR (annual recurring revenue) if that’s more appropriate for your startup.
5. Customer acquisition cost (CAC)
As the name suggests, this is the cost of gaining a new customer.
If you’ve validated your business model and you’re ready to hit the growth accelerator, you’re especially raising capital to cover these upfront customer acquisition costs. That’s why investors are interested in understanding this metric more.
Not all CAC metrics are created equal but there are two main ways to calculate it, and you should probably do both (especially if you’re talking to investors). The two methods are blended CAC and paid CAC.
How to calculate blended CAC
This is the simplest CAC measure. To calculate it take your total monthly acquisition cost (that’s everything you’ve spent, such as advertising, referral fees, credits or discounts), and divided it by the total number of new customers acquired across all channels that month.
How to calculate paid CAC
Take your total monthly acquisition cost and divide it by the number of new customers you acquired through paid marketing that month.
However you calculate CAC, make sure you clearly define what you mean by it and then track it consistently.
As your startup evolves, you (and any investors) are also likely to want a breakdown of paid CAC per advertising channel. For example, the CAC for a customer acquired through a Facebook campaign versus a Google Adwords campaign.
6. Customer lifetime value (LTV)
This is a prediction of the net profit from a customer throughout your entire relationship with them.
It helps determine the long-term value of the customer. The main reason to track LTV is so you know how much you can afford to spend on CAC. It also helps evaluate your customer value and the quality of the service you’re providing them.
There are a few steps to calculate LTV, as follows:
- Calculate revenue per customer (per month). To do this, take your average order value and multiply it by the number of orders;
- Calculate your average contribution margin (ie profit) per customer (per month). To do this, take revenue from customer and minus variable costs associated with the customer e.g. selling, admin and customer service costs (this takes some thinking);
- Calculate the average customer lifespan (in months). To do this, divide one by your monthly churn; and
- Finally, calculate your LTV by taking your average contribution margin per customer and multiplying it by the average customer lifespan.
Like all measures, LTV is not perfect and sometimes founders rely on it too heavily. Keep it in perspective and remember, it’s a tool not a strategy.
The bottom line is: if you’re not covering your upfront acquisition costs with your profits, then you haven’t got a sustainable business.
If you’re a SaaS startup …
You’ll probably know it’s all about the sales funnel. So as well as the main six metrics explained above, there are a few others to watch too, including:
- Leads — track the leads you’re receiving each month (and where they come from);
- Lead velocity rate — the monthly growth rate of your leads;
- Conversion rate — how many leads are converted to sales (sales / leads * 100); and
- Velocity — how quickly you’re generating revenue. This captures the amount of time it takes to turn your qualified sales leads into revenue and is expressed as dollars per time period.
The deeper you dive into startup metrics, the more you’ll uncover but don’t worry about measuring absolutely everything from day one.
Commit to tracking the basics and you can always evolve from there, especially if you’re planning on raising capital from investors who’ll want to see that you’re really in the driver’s seat of your startup.
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