This article was originally published by Accounting Web on February 19, 2018. Click here to view original article.
Startup companies may go through various stages of external funding throughout their lifecycle. Typically, the first stage consists of seed funding, which is usually earmarked for developing the company’s product or technology and achieving marketplace fit. Seed stage companies usually raise $500,000 to $1.5 million and typically do not have institutional capital or venture funding. Seed funding is generally easier to raise, due to the smaller investment size and lower risk profile to the investor.
Series A funding is significantly more difficult to raise due to the larger round of financing required and higher risk profile. Typically, investors in this round are focused on the management team, progress made with the seed capital, and revenue projections and financial metrics.
A typical Series A company has developed a repeatable sales process and achieved product or technological market fit. They generate revenue, but are not normally profitable. Companies ready for Series A financing have a strong understanding of their unit economics (users, licenses, or whatever other nonfinancial data drives their growth) and can develop and forecast revenue projections. Typical Series A rounds generally range from $1 million to $7 million, depending on how capital intensive the company is. Series A rounds also normally have higher valuations, which leads to increased expectations during the investor pitch.
At this stage of financing, companies need to focus less on their products and focus more on revenue and sales. The sophisticated investor understands the market for your product or technology. Companies need to demonstrate, in a quantifiable way, how they can capture that market share.
Key Financial Metrics
Key metrics to focus on in the investor pitch include:
- Monthly recurring revenue (MRR), or annual recurring revenue (ARR) if your business operates with a yearlong contract model
- Bookings and related sales funnel
- Cash burn
- Churn projection
- Lifetime Value/Cost to Acquire ratio (LTV/CAC)
A common mistake for company management in preparing these metrics is using disparate data points. Companies that show bookings on an annual basis, churn on a monthly basis, and cash burn on a quarterly basis demonstrate a lack of understanding on the key metrics and how they relate to each other. It also makes it difficult for investors to determine the exit value of a company, and once a pitch deck becomes difficult for potential investors to understand, they quickly lose interest.
Bookings and the related sales funnel. This should be one of the first items presented as this is the basis for all other metrics. Bookings should start with a sales funnel that takes a top-down approach and clearly demonstrates leads->qualified leads->opportunities->closed sales. Pitches that only have sales targets but no quantifiable process on how the company gets there are not reliable and demonstrate a lack of maturity. Actual marketing data and assumptions applied to how this can work at scale should be included. The company should also have demonstrated that it understands its sales cycle and simply needs more capital to increase the inputs at the top of the funnel.
MRR/ARR. Information on the recurring revenue model should follow this, as sales are the driver for the recurring revenue model. Traditionally, software-as-a-service (SaaS) companies have used MRR as the key metric for measuring their business. More recently, companies have begun using ARR. This reflects a move away from the traditional monthly subscription model to an annual subscription model. A general rule of thumb is, if your company utilizes annual contracts, be sure to present the revenue in an annual recurring model format. MRR is also typically used to predict cash break-even. In a business that focuses on ARR and upfront billing, cash break-even comes at a much earlier point than in the MRR model.
Cash burn. Another key element is gross and net cash burn. Gross cash burn represents total cash out of the company, while net cash burn represents the net of cash in and cash out of the company. This figure is typically netted when presented to investors, but showing it grossed up can be favorable for a company that leverages negative working capital. Negative working capital in this sense relies on customers paying annually or quarterly upfront rather than in arrears.
Due to the fact that early SaaS companies used the monthly model, the standard metrics are always stated in terms of monthly recurring revenues, monthly cash flows, and monthly churn. Later iterations of SaaS companies began the shift toward the annual contract model/annual billing/annual churn which allowed companies to recoup their investment in the cost to acquire and cost of service during the contract period, giving companies a chance to break even or become profitable on a customer-by-customer basis, before the customer had the opportunity to churn.
Churn projection. Churn should be presented on the same basis as sales and revenue, which is monthly, annually, or sometimes quarterly. A typical SaaS company with annual contracts should expect to have a churn of no more than 10 percent, and approximately 5 percent projected churn should be the goal. Investors are extremely focused on churn and will analyze your churn number closely. Companies at this stage should have enough data to make strong assumptions of the churn at scale and use those assumptions to predict the expected life of the customer. A predicted churn of 8 percent translates into a customer life of 12.5 years as opposed to a predicted churn of 5 percent, which translates into a customer life of 20 years. The expected life of a customer is the driver in the LTV calculation, and small variances in churn make a significant difference in the ultimate value of the customer.
LTV/CAC ratio. This can be considered the most important metric in a pitch because it puts the revenue and cost to acquire that revenue in context. For instance, if your LTV/CAC ratio is 10/1, that means company revenue increases $10 for every $1 spent on customer acquisition costs. An LTV of $100,000 per customer is essentially meaningless without an understanding of the cost to acquire that customer. The higher the CAC ratio, the easier to reason that additional capital will fuel growth at a favorable margin and show venture capitalists that they will receive a higher return on investment.
This is the item to spend the most amount of time on during the investor pitch, as a strong LTV/CAC ratio will definitely get the attention of any potential investor. The nuances of the LTV/CAC ratio merit their own article, but all successful SaaS-based businesses will have a strong LTV/CAC ratio.
One of the biggest mistakes that companies make is underestimating how long fundraising takes and that raising capital is a huge investment of time and energy for the management team. Expect this process to take at least four to six months for a Series A round, and plan to have enough runway to get the actual wires in the company’s bank account, not just to a term sheet. Nothing is final until the money is in the bank.