February 28th, 2017 | By: Phil Nadel | Tags: Planning
It is critically important for the founders of a company to intimately understand the company’s Key Performance Indicators (“KPIs”). Founders cannot hope to grow a company in any meaningful way without an almost obsessive focus on its KPIs. Why? Because KPIs, if constructed correctly, give management and potential investors a cold, analytical snapshot of the state of the company, untainted by emotion or rhetoric. This focus must not be limited to the KPIs themselves, for they are merely measurements of outcomes. We look for founders to have an understanding of what levers can be pulled and what tweaks can be made to improve the business, which will then be reflected in its KPIs. So the focus should not be on the KPIs themselves, but the meaning behind them and knowing what impacts each one.
Let’s review some of the KPIs that we feel are important for founders to thoroughly understand and for which they should have a strategy, or set of strategies, for optimizing. Please note that some KPIs are not relevant to some types of businesses. Finally, I am not going to go into very much detail on each metric and how to calculate it as (a) that is beyond the scope of this article, and (b) that information is readily available from other sources.
CAC is the amount of money you need to spend on sales, marketing and related expenses, on average, to acquire a new customer. This tells us about the efficiency of your marketing efforts, although it’s much more meaningful when combined with some of the other metrics below and when compared to competitors’ CAC.
Acquiring new customers is one thing, but retaining them is even more important. Your Customer Retention Rate indicates the percentage of paying customers who remain paying customers during a given period of time. The converse to retention rate is Churn (or Attrition), the percentage of customers you lose in a given period of time. When we see high retention rates over an indicative time period, we know the company has a sticky product and that it is keeping its customers happy. This is also an indicator of capital efficiency.
This is the measurement of the net value of an average customer to your business over the estimated life of the relationship with your company. Understanding this number, especially in its relation to CAC, is critical to building a sustainable company.
We consider the Ratio of CAC to LTV to be the golden metric. This is a true indicator of the sustainability of a company. If a company can predictably and repeatedly turn x into 10x (note: 10x is just an illustration and not mean to imply any sort of minimum or standard), then it’s sustainable.
This KPI measures how long it takes for a customer to generate enough net revenue to cover the CAC. CAC Recovery Time has a direct impact on cash flow and consequentially, Runway.
Whereas CAC measures the variable expenses attributable to acquiring customers, Overhead measures the company’s fixed expenses incurred irrespective of the number of customers acquired. Overhead relative to revenue is a reflection of the capital efficiency of a company (i.e. all things being equal, a company that generates $1M in revenue on $200k in Overhead is twice as efficient than one that generates $1M in revenue on $400k in revenue).
Understanding your revenue and monthly expenses (fixed and variable) enables you to calculate the company’s Monthly Burn. This is simply the net amount of cash flow for a month when net cash flow is negative. If the company starts the month with $100k in cash and ends the month with $90k in cash, its burn rate is $10k. If a company’s monthly net cash flow is positive, it is not burning cash.
A keen focus on Runway is critical to the survival of any startup. Runway is the measure of the amount of time until the company runs out of cash, expressed in terms of months. Runway is computed by dividing remaining cash by Monthly Burn. We prefer to view a conservative estimate of Runway that calculates the Monthly Burn utilizing current revenue and projected expenses (after accounting for the increased expenses to be incurred post-investment). We require an absolute minimum of 12 months of Runway, but have a strong preference for 18 months or more. Short Runways cause entrepreneurs to by myopic and not to have the liberty to tweak and iterate when necessary. It also forces them to almost immediately focus on the next fundraising round instead of on growing the company.
Expressed as a percentage, Profit Margin tells us how much your product sells for above the actual cost of the product itself. Put another way, it reveals how much of the selling price is “markup.” This invaluable metric allows us to consider the return on investment on the cost of the product and is significant in understanding the scalability and sustainability of the company.
We consider Conversion Rate to be a very telling KPI in that it reveals a combination of the company’s ability to sell its products to its customers and the customers’ desire for the product. It is particularly instructive to track and review Conversion Rate over time and regularly run experiments to improve it.
Certain businesses find that revenue may not be the most informative indicator of their financial performance. This is especially true for marketplaces for which revenue (i.e. their take rate) represents a small portion of overall transactions. Gross Merchandise Volume (“GMV”) can be a useful KPI in these cases. GMV is the overall dollar value of sales of goods or services purchased through a marketplace.
For companies that have apps, online games, or social networking sites, Monthly Active Users (“MAU”) is an important KPI. MAU is the number of unique users who engage with the site or app in a thirty day period. Understanding MAU is helpful in determining the revenue potential of a company or how well it is currently monetizing.
When we speak to founders to learn more about their companies, we ask them for these KPIs along with their narrative and other information. It is a quick way for us to understand the current state of the business and we have serious concerns about founders who do not know their KPIs. We find that the most successful founders tend to be those who have an obsessive focus on their KPIs and the drive to constantly experiment and optimize them.