MELINDA ELMBORG • JUNE 13, 2018
Investing in startups is exciting and can offer great returns. When you invest in a startup, you can be part of an amazing journey that has the potential of revolutionizing an industry. On the other hand, investing in startups can be difficult. As we all know, it is a risky business and that risk is very hard to avoid. Even the best venture capitalists only succeed with a small part of their investments. The best way to manage that risk is spelled due diligence — which means that you research the team, their market, competitors, clients, and, of course, KPIs.
Before knowing which KPIs that we want to include in our due diligence — we need to know why we measure. Here, I think most of you can agree with me that it is the potential of the startup that we want to identify, what will their future look like? Obviously, a time machine would be preferred but since we don’t have that, we can measure past performance to get an idea of the future.
Another issue of tech-oriented startups is that their economics differ a lot from companies in traditional industries, which means that we also need to evaluate them differently. Looking at EBITDA doesn’t make any sense for startups since it includes the development of the technical product as a cost and not an investment. Usually, in tech startups, we see high development costs in the beginning, but potentially larger margins as you scale thanks to the lack of variable costs.
To better study the realistic potential of a startup, we will look at two essential areas:
Depending on the stage the startup is in you can focus more or less on one of the two different areas which matter the most at the moment. For early-stage investments, value creation is gonna give you the best indication while at later stages you look more at the financials.
Before going into detail on the exact KPIs, I would like to cover the concept of AARRR Pirate Metrics — a concept developed by Dave Mcclure and which has given clarity to many startup founders. It is a model explaining every step of the customer’s journey and stands for:
Acquisition: is about attracting potential customers, driving traffic, or identifying leads.
Activation: is about the potential customer showing interest by interacting with your product or your salespeople.
Retention: is about returning users. If achieved, it is proof that you create value for your users, if they keep on coming back it means that your product is needed and loved.
Revenue: is about monetizing on your customers, if you create large value for them, they should be ready to pay you for the service you offer.
Referral: is about network effects and word of mouth to attract new customers.
1. Measuring Value Creation
When we look at the value creation of a startup, we want to focus on activation and retention. Depending on what their product is, we want to look at several numbers that can indicate however the product is needed and loved by their users. If the startup seems to create high value for its users, it will most probably also be able to charge for the service. The most important KPI among value creation is of course retention and churn, where we identify the number of users who start to use a product and actually stays. When we look at Saas products, a typical benchmark is a 5% monthly churn. When studying B2C apps, 25 % retention or more after two months is considered good.
We can also look at engagement rates, how much time does the average user spends on the site or in the app, and how many times per day/week/month do the user come back? Regarding engagement metrics, it’s hard to offer a relevant benchmark since it completely depends on what the product does. If it’s a messaging app, you would expect your users to open the app at least once per day and spend a few minutes at it. If you’re offering a bookkeeping software, you would probably want to see that it’s used at least once per month.
For marketplaces or e-commerce, it might be fairly tricky to see a clear retention or engagement rate. Then, we instead have to study the repeat rate. How many customers seem to come back a second time or even regularly? Again, you will have to benchmark this with what is expected depending on the product. If the startup offers meal delivery, you would probably expect happy customers to come back once per week or month. If you’re instead offering a vacation service, you would expect the user to come back once per year, which can be very tricky to identify in a startup’s early days.
It is obviously best to study these metrics after a startup has officially launched, but maybe before even starting to charge their users. Anyhow, even very early in a product’s development, you might be able to identify some early indications of these metrics. Maybe they have MVP users or beta testers?
2. Measuring Financial Performance
After a startup has launched and started charging the users, we can add the analysis of their financial performance. This is very important since a higher efficiency means higher margins which ultimately results in more means to invest in growth. If we see a startup with negative gross margins, it will depend heavily on external financing and the captable will quickly be diluted.
If we look back at the Pirate metrics, we’ll now look at all of the steps in the customer journey to compare the cost of acquiring the customer with what we earn. To do that we will calculate something called the Customer Acquisition Cost (CAC) which reflects acquisition, activation, and referrals and the Life-Time Value (LTV) of a customer which reflects the retention and the revenue. CAC is a pretty straightforward calculation as you take all the marketing and sales costs and divide it by the number of new customers, including both paid and organic acquisition.
LTV is a bit trickier to calculate and depends largely on the business model. In large, we want to find out the revenue that the average customer will generate during its lifetime minus any direct costs (for example discounts, shipping, installation, or customer service). If the startup uses subscription as a business model it is a fairly straightforward calculation, you take the average fee per month and multiply it by the expected lifetime. The customer lifetime is most accurately calculated by dividing 1 by the churn rate.
Regarding marketplaces and e-commerce, this calculation gets trickier. The easiest might be to just exclude or assume the lifetime of the customer. If you have any proof of repeat purchases this can be included in the calculation. As an example, you might earn 100 euros from each purchase and there are 10 % of buyers who come back for a second purchase, then your customer lifetime value would be 100 + 100 * 10% = 110 euros.
To find out the final financial efficiency of the startup, we will calculate the LTV-CAC ratio simply by dividing LTV by CAC. The most optimal is to have an LTV 3 or 4 times larger than the CAC, this will allow for a healthy margin to reinvest in marketing, which would then, in theory, provide you with 2–3 new customers. However, early on it is common to see startups at ratios closer to 1,5–2, but with a clear path on how to increase that ratio. The most important, however, is to be above 1, so you don’t spend more on marketing than you earn in return.
If you find a startup that passes these different thresholds and on top of that has achieved a good monthly growth rate (15%+ for a marketplace, 20%+ for a SaaS, 1–2 years after launch), it’s a very positive sign for the future. Of course, analyzing the KPIs of a startup does not replace the rest of the due diligence. It is still very important to consider the team, market, and client referrals. Even if the startup doesn’t achieve all the KPIs according to this guide, it might still be a good investment after considering the other parts of your due diligence. Guaranteed is that you will get a much better understanding of the startup’s dynamics and definitely come up with good questions for discussion after checking these KPIs. In the end, you will be able to make a decision about your investment with improved confidence.
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About the Author:
Melinda Elmborg was a Venture Capital Investor at the French VC firm Daphni. To help founders build, grow and raise capital to their startups, she switched careers to become a startup coach. In 2018, she started Startup Action.
Based on her learnings, she has developed The Startup Action Framework that guides startups from launch to exponential growth.
So far, over 400 founders have already joined one of her workshops and thousands of founders have taken advantage of her templates and guides to succeed with their startup.