Across nearly every vertical of the investment industry investors and funds focus on a few key performance and return-oriented metrics, such as IRR and MOIC, to gauge the success of their work. But while these metrics are useful to investors, they provide little meaning to portfolio company founders. So, what should you as a founder be focused on? Key Performance Indicators (KPI’s) provide quick and easy objective windows into the real-time health of your business.
Operational KPIs tend to be a much less standardized form of performance measurement as they can vary wildly in their adoption and appreciation across industries and investors – while engagement rate may be a core focus in digital advertising, it’s not going to tell you much about how that manufacturing plant down the road is doing. On top of this, volatility in growth trajectories of early-stage companies can lead to very little continuity or predictability of these metrics. Public companies may not grow or shrink quarterly revenue by 50% at a time, but this can be commonplace for new founders where a new partnership can deliver overnight expansion.
That said, there are two prominent groups of metrics which emerge as consistent in their appreciation by investors across industries: Customer Metrics and Financial Metrics.
Three of the most universally adopted customer metrics are Customer Acquisition Cost (CAC), Customer Churn, and Customer Lifetime Value (CLTV).
Customer Acquistion Cost (CAC)
CAC represents the direct costs associated with acquiring a new customer. For an insurance company (an industry with a notoriously sticky customer base), this cost could comprise the marketing spend to get a customer interested in the company, the salary of the insurance agent who goes door to door, or any other marketing-related costs like materials and postage stamps associated with the onboarding process. For a food delivery company, these costs might include promotional discounts or local offers that the company pays for to entice you to use their service rather than the other five already on your phone.
Generally, as with all costs a business may incur, the lower the CAC the better. While a high initial CAC may appear unsustainable or unattractive, securing early clients bodes well for proving traction and product-market fit. Therefore, CAC should be taken with a grain of salt for early-stage companies seeking aggressive expansion and scale. Later stage companies with established sales processes, however, are better candidates to be held accountable to their industry-standard CAC benchmarks.
There are two competing philosophies for CAC: it should either increase or decrease over the long term. Both conclusions have merit depending on the industry vertical, client base, and growth trajectory.
Mature industries with stagnant customer bases may face rising CAC due to heavy competition from proven incumbents – many players fighting over a finite customer base. By capturing the low-hanging-fruit, each additional client will be more difficult to acquire. Conversely, new and emerging industries with expanding customer bases will lead to decreasing CAC. If the growth of customers outpaces the growth of service providers, then conditions may exist for limited competition for sales. Newer markets also have fewer incumbents, such that new market entrants can build brand value and trust within industry verticals without needing to displace nested behemoths.
Customer churn represents the rate of lost customers. This can be tracked on any basis – monthly and annual churn are the most common. These rates will vary by industry and also function differently depending on revenue models. For example, SaaS companies with annual contracts will experience high rates of churn on 12-month cycles when contracts expire. On the other hand, SaaS companies with 1-month contracts will experience varied churn rates throughout the year. The rate of resubscription may also be prone to seasonality and broader economic conditions.
Keeping with the insurance company example, customer churn could represent the proportion of customers who no longer pay insurance premiums one year after they paid their initial premium. Sophisticated analysis for established companies will look at churn rates over many years to identify issues with the retention structure and incentivize loyalty (e.g., incremental annual discounts on insurance premiums the longer a customer has been with the company).
Customer Lifetime Value (CLTV)
As the counterpart to CAC, which represents the cost of acquiring the customer, CLTV represents the value to the company of having the customer once they have been acquired. While CAC tends to be a relatively simple point-in-time measurement, CLTV is much more complex because it attempts to measure the value of a customer acquisition far into the future.
Because we are looking at value per customer, CLTV is a measure of lifetime contribution (profit, rather than revenue) each incremental customer is expected to bring to the company, measured in today’s dollars. Customer contribution from far in the future will count significantly less towards this measure than contribution received today, and anticipated churn rates decrease the value of these future contributions further by probability-weighting the likelihood that they occur at all.
A simplified five-month CLTV for an insurance company could be explored as follows:
|Premium Month||Periodic Churn Rate||Cumulative Retention||Average Premium||Ongoing Service Cost||Periodic Contribution||Discount Factor (at 2%)||Periodic CLTV|
|1||10%||90,0%||$ 100||$ 30||$ 70||1,02||$ 68,6|
|2||10%||81,0%||$ 100||$ 29||$ 71||1,04||$ 68,2|
|3||10 %||72,9 %||$ 100||$ 28||$ 72||1,06||$ 67,8|
|4||10%||65,6%||$ 100||$ 27||$ 73||1,08||$ 67,4|
|5||10 %||59,0 %||$ 100||$ 26||$ 74||1,10||$ 67,0|
|Total||$ 500||$ 140||$ 360||$ 339,2|
A general rule of thumb is that a company should not be pursuing a customer if the cost to acquire them is greater than the long-term value they bring to the company. In this example, if CAC is greater than $339.2, growth becomes unprofitable. Investors across industries use these metrics in conjunction with one another to identify companies with substantial high-margin growth prospects.
Where customer-oriented metrics rely on various assumptions and subjective judgements by management, financial metrics are the cold, hard (and mostly regulated) figures that constitute the lifeblood of operational analysis. The two most common families of these are Income Statement Metrics and Financing Metrics.
Income Statement Metrics
Because short-term revenue can vary significantly by month or season, investors tend to focus on revenue trends or growth over longer time horizons. Trailing Twelve Month (TTM) revenue provides a backward-looking snapshot of the past year’s aggregate revenue. Next Twelve Month (NTM) revenue is a forward-looking projection that investors will expect founders to have readily available. Lastly, run rate is generally expressed as a twelve-month extrapolation of a monthly or quarterly revenue figure.
Investors often focus on the Year-over-Year (YoY) growth rates of these revenue metrics. It is common for younger companies to sell to buyers at a price multiple relative to their TTM or NTM sales. Alternatively, more established founders that are operationally positive (but not necessarily earnings positive) often sell to buyers at an EBITDA multiple relative to their TTM or NTM EBITDA.
While investors prefer promising revenue-based metrics, there are other benchmarking options for earlier stage startups with limited monetization. For example, contract-based revenue models can use Signings as a benchmark, which represents the total value of new contracts signed in any given period, generally monthly or quarterly.
Financing metrics such as Burn Rate and Runway help both investors and founders accurately track operational health and fundraising needs. While burn rate has many varied definitions and methods of calculation, it all boils down to a measure of how quickly your company is using up its cash on hand. The higher the burn rate, the more substantial funding sources a company will need. Some useful proxies for Burn Rate are Net Income, Cash Flow from Operations, or Cash Flow from Operations plus Cash Flow from Investing. Cash Flow from Financing is typically excluded from this measure because it does not reflect operational cash needs and can fluctuate significantly month to month.
Funding and access to funding represent the lifeblood of entrepreneurs. Runway is simply the measure of how long your company has before it runs out of money to meet operational demands. This measure does not apply to cashflow positive companies and is simply calculated by dividing the current cash balance by either historical or anticipated burn rate. Good investors preserve capital for follow-on investments in their successful portfolio companies, so keeping existing investors abreast of updated runway and future funding needs encourages goodwill and continued engagement that may manifest repeat funding commitments.
While other KPIs such as Active Monthly Users, Gross Margins, and Monthly Recurring Revenue are widely employed, most are industry-specific, and investors will only judge these in the context of relative improvement over time and performance against peers. You should explore and determine which metrics are most relevant in the context of your own industry, and assume your investors will feel accordingly. Happy measuring!
Authors: Brian Pocock & Kyle Rose
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