Evaluating Early Stage Startups — The Three Metrics that Matter

A framework for thinking about SaaS investments

TL;DR: the earlier the company, the more important it is to remain laser focused on growing as fast as possible to prove out a market opportunity. From there, “learn from churn” to better understand your customers with an emphasis on retention and upselling. Once product/market fit has been proved out (defined by high growth and low or negative net churn), then focus on the business model to drive up gross margins and show the company can (eventually) make money.

2018 is shaping up to be one of the biggest years ever for venture capital, with over $84 billion already invested with a full quarter yet to go. News reports of $100 million venture rounds are seeming commonplace. Automation Anywhere, a leader in the hot robotics process automation (RPA) market brought in $250 million earlier this year — for their Series A!

Yet for all the VC activity and optimism, data indicates a large percentage of the early stage startups raising money this year will ultimately fail, and most of the remaining ones will substantially adjust their product and/or market focus (aka, pivot) in order to survive and hopefully thrive.

So this begs the question, what exactly are investors and lenders looking at when deploying all this capital and trying to determine what companies are “financeable.”

Obviously the exact metrics and data points are very contextual. The economics of assessing a business are vastly different for hardware companies vs. enterprise software vs. consumer, etc. etc. There are always lots of intangibles (e.g., the founding team), as well as more quantitative data (e.g., the total addressable market opportunity).

This post is meant to provide a simplistic view for how to assess early stage SaaS companies. It assumes that a lot of other things are in place such as having a compelling team, technology, investors, market opportunity, etc. But given these prerequisites, here are a few of the most important metrics for early stage SaaS companies to focus on based on their lifecycle:

1) Growth (Seed/Series A): if a startup is growing fast, then it means the company is solving a problem in the marketplace. Or at least, there’s the perception the company is addressing a gap in the market which is leading customers to sign up.

Defining “fast growth” depends on stage, but for early (Seed or Series A), growing 100% YoY is typically pretty solid. Paul Graham (PG) famously looks for 5–7% weekly growth for companies in Y Combinator, and his rationale is pretty simple: “a company that grows at 1% a week will grow 1.7x a year, whereas a company that grows at 5% a week will grow 12.6x.” When you consider the compounding effects of this growth, it means a company starting with $1,000 in revenue and growing at 1% will be at $7,900 per month four years later, whereas the company growing 5% per week will be bringing in more than $25 million per month.

As PG also references, focusing on growth as the key metric also keeps a business nimble and constantly adjusting to meet customer needs. This helps explain how YouTube evolved out of a dating site initially called “Tune In, Hook Up,” or how Instagram started as a Foursquare competitor called Burbn.

2) Churn (Series A/B): if you’re growing fast but constantly churning customers (e.g., people are cancelling or not renewing), then it means your sales pitch addressed a need, but your product or service didn’t deliver. Or more simply, your product/market fit wasn’t right. However, there are a few different ways of measuring churn, with the three main metrics being customer churn, revenue churn and net churn.

Customer churn results from people or companies signing up, but then deciding to cancel. Or rather, the # of churned customers / # of total customers = churn rate. This metric is important, but it can also offset the fact that perhaps you’re offering a free trial or have an intentionally broad marketing campaign, so perhaps churn is expectedly high because you’re casting such a wide net.

Revenue churn is closely related, but this factors in the percentage of paying/revenue generating customers that leave over a given period. It might not be a big deal if you’re churning out customers trying out the product on a free trial, but are retaining all the customers who are paying for the service.

The best way of assessing this metric is net churn, which factors in customers that start spending more or upsizing their contracts. Another way of thinking about this is that it’s often “better to be everything to someone, than something to everyone.” Identifying and focusing on these core customers will help the company focus, prioritize, and further differentiate in the market.

3) Gross Margins (Series B and later): OK, so the company is growing fast and has negative net churn, so the future is bright, right? Maybe. In the enterprise software world, it’s expected that almost all Series A and B companies are still going to be burning cash as they continue to grow as fast as possible and grab market share. But eventually, the business model and profit margins start to become more important. Ultimately VCs and lenders want a return on their investment and will not indefinitely subsidize a startup’s customers.

For a current example from the consumer market, consider Uber which has raised close to $18 billion and is reportedly worth more than $72 billion. In Q2 2018 Uber reporting losses of nearly $900M while they continue to subsidize rides and launch in new markets, however Uber is apparently profitable in more developed markets so investors have faith the company will be able to flip the profitability switch eventually. The same can be said about WeWork and their new “community adjusted EBITDA” metric.

To link this back to the first point on Growth, some investors look at “The Rule of 40” as a helpful metric in assessing the health and viability of SaaS startups. This is calculated by adding a company’s growth rate + gross margins (so for instance, a company growing at 100% but with -60% margins would equal 40%, the same as a company growing at 20% with 20% margins). The idea here is that anything beyond 40 is worthy of investment, and this seems to be at least partially supported by data from recent SaaS IPOs.

At this point, it’s worth pointing out there’s an important nuance between looking at these metrics from the lens of doing equity investing vs. debt financing.

While these metrics are important for assessing each, there are also differences. Debt financing for early stage startups is heavily weighted towards assessing a company’s ability to raise future equity rounds. This is because by definition, most of these early stage startups are still burning cash even while they build enterprise value (in terms of products, teams, and markets). One of the key assumptions debt lenders make is: if the company continues to grow at X%, then investors will likely be willing to put more capital in which increases the likelihood our loan will be paid back.

Many of these startups are banking on raising future equity rounds to continue financing their growth, and if that capital dried up, they’d have to dramatically refocus from “growing as fast as possible” to “losing the least amount of money as possible” to hopefully make it to cash-flow positive territory before the funds run out. This is also one of the reasons why solid financial planning is so important for startups to understand how much runway is left before the company will run out of cash, assuming no new capital comes in.

It continues to hold that the best time to raise capital is when you don’t need it, so startups should always be thinking about options for how the next round will come together and the associated contingency planning.

But for those startups that are able to i) grow quickly, ii) demonstrate strong product/market fit by reducing churn, and iii) show a path to profitability via a strong business model with healthy gross margins, then you’ve done all you can to set yourself and your company up for success.

Please note: views my own and may not reflect not those of my employer