There are a variety of metrics, numbers, and measurements that venture capitalists use to judge the overall health and profitability of any startup venture. The only problem is, venture capitalists and startup entrepreneurs often have very different ideas about how to calculate these metrics, as well as what assumptions should be taken into account when running the numbers. With that in mind, here’s a closer look at the key metrics that startup founders and venture capitalists often have the most significant differences over how to calculate.
Revenue vs. Recurring Revenue
To the casual entrepreneur, all revenue looks the same. Getting a one-time user to pay $120 for a product is the same as convincing one user to pay $10 per month for an entire year, right? But venture capitalists see things differently. What they care about is “recurring revenue,” which is revenue that you can count on, month after month. That’s why a single user who pays $10 per month, every month, is more valuable than a random customer who pays $120 one time only.
Based on this notion of recurring revenue, venture capitalists have constructed a whole variety of other metrics – such as ARR (Annual Recurring Revenue), ARR per customer and MRR (Monthly Recurring Revenue). Of these, MRR is the most important. How much is your business bringing in monthly – and is this figure sustainable? Answer that question to the liking of a VC, and you’ll be rewarded handsomely.
Customer Acquisition Costs
Startup entrepreneurs also may not recognize the importance of Customer Acquisition Costs (CAC). There is a cost associated with bringing in a new customer, even if you are not running a full-scale marketing campaign. For example, maybe you are paying a referral fee to people who bring in new customers. Or perhaps you are offering steep discounts or one-time fee waivers to attract people. All of those should be considered part of your customer acquisition costs.
Moreover, venture capitalists will also differentiate between “blended” and “paid” costs. (“Blended” costs consider both unpaid and paid acquisition, and as a result, will always be lower than “paid” CAC) In this case, it is more instructive to look at paid acquisition costs, because it gives you a much better idea of whether or not a business is scalable over time. What venture capitalists realize is that acquisition costs will go up, the larger a company becomes. For example, your CAC might only be $1 for the first 1,000 users you sign up – but it might rise to $2 for the next 1,000, and then increase to $5 for any user over 10,000. The easiest way to think about this is in terms of low-hanging fruit. Once you’ve collected all the low-hanging fruit, it becomes much harder (and more expensive) to find new customers.
Life Time Value (LTV)
This metric is defined as the present value of the future net profit from the customer throughout the relationship. That might sound simple enough, but there’s a lot here to digest. For example, entrepreneurs often define this metric as the “future net revenue” from a customer, and not as the “future net profit.” But as we’ve already seen above from the discussion of CAC, there is a definite cost involved in acquiring new customers.
Moreover, entrepreneurs often mistakenly assume that the lifetime of a relationship is “in perpetuity.” By this way of thinking, once a customer, always a customer! But that’s not true – you have to take into account customer churn rate. That’s why VC investors will take into account the monthly churn rate of your customer base, to calculate the average duration of a relationship. Based on this, the average lifetime of customer = 1 / (monthly churn rate).
Here is where entrepreneurs and venture capitalists often have the greatest disagreement. How, exactly, are you supposed to define the word “active”? For example, if a user has downloaded your app, is that user “active”? Entrepreneurs would answer this question by saying “yes,” while most venture capitalists would probably say “no.” VC investors would want to see greater evidence of engagement – such as the use of the app for at least three times per month – to count as “active.” Complicating matters even further, venture capitalists will often break “active users” into Monthly Active Users (MAUs) and Daily Active Users (DAUs). From a VC perspective, DAUs are where it’s really at – it means a customer has a daily relationship with your product or service.
In today’s digital world, it’s very commonplace to hear that something has “gone viral.” Entrepreneurs often think of virality in these very subjective terms, merely to describe a product, concept or idea that is starting to attract a lot of attention. But venture capitalists take a much more mathematical approach to virality. They define virality as the speed at which a product spreads from one user to another. The relevant metric here is the viral coefficient, also known as the k-value.
The way to calculate this k-value is by measuring how many new users sign up as a result of invitations from current users, and then dividing this number by the current user base. A k-value above one is considered “viral,” and anything below one is not considered viral. Say, for example, that you have 1,000 users, and that each of them sends out, on average, five invitations to other friends to sign up. If the average conversion rate is 15%, that would mean that 750 new users sign up. (750 = 5000 invitations * 0.15) Is that viral? Entrepreneurs would say “yes.” But if you measure the k-value, the metric is only showing a value of 0.75, which is not viral.
As you can see, entrepreneurs and venture capitalists may be trying to measure the same things, but they often are approaching the measurement from a different perspective. Taking a big picture view, entrepreneurs often view the glass as being “half-full,” while venture capitalists often view that same glass as being “half-empty.” Since VC investors hold the purse strings, it’s up to you as the entrepreneur to adapt your thinking to match that of these VC investors. That way, you’ll both be on the same page when it comes to talking about VC financing.