Over the past couple of posts, I have highlighted metrics to consider to measure product engagement and customer acquisition. For the final article on metrics, you will learn more about indices of your venture’s financial performance. These metrics fall into three categories: Revenue, Profit, and Funding. The post ends with a discussion of the One Metric That Matters.
There are several relevant metrics associated with a venture’s selected revenue model. Inevitably, these metrics tie to your growth over some time. For example, depending on your business model and industry, you may be required to measure revenue growth per day, week, or month. In addition, the timing of revenues may depend on the typical sales cycle associated with your industry or product category.
The sales cycle is determined by mapping the time it takes to move a customer from awareness of your offering to actual procurement or use. Often illustrated as a funnel, the customer may move through the sales process at varying lengths of time. It is standard for customers to take longer to decide whether they want to purchase expensive or expensive products or services that commit them for long periods. Ventures offering products and services to other businesses, often B2B, may experience long sales cycles. Extended sales cycles in organizational environments may result from complex procurement policies or multiple decision-makers.
When monitoring revenue growth, entrepreneurs may want to measure sales generated by new customers versus existing customers. For example, your business model and financial sufficiency may depend on acquiring specific numbers of new customers and revenues generated from existing customers. You may need a particular ratio of new versus existing customers to generate projected margins due to differences in marketing costs between the two customer types. A similar principle applies if you offer multiple products and your financial model relies on specific revenue growth percentages per product. Many innovative enterprises aspire to a certain percentage of revenues from new products versus older or legacy products, thus indicating a constant level of new product innovation.
Monthly Recurring Revenue. A standard revenue metric is the measurement of monthly recurring revenue. This metric measures how much revenue your customers generate in one month. You can look at this metric for both new customers as well as existing ones. To calculate your venture’s average monthly revenue, add all the revenue you receive from paying customers each month. While straightforward, variations of this metric may be more applicable to you based on your business model and industry. In the early stages of your venture, you will focus on revenue generated by new customers each month, called new monthly recurring revenue (NMRR). Watching NMRR provides a good indication of how much revenue is being generated by your customer acquisition strategies.
Similarly, you can monitor the monthly revenue generated by existing customers. This cohort analysis helps you understand customers’ purchasing patterns once they have been active for a while. Are they buying more products, adding features, or upgrading memberships? In conjunction with this metric, you need to monitor the churn rate from a revenue perspective, called revenue churn rate. This rate is the degree of monthly revenues lost due to customer attrition. The reasons for your customer may vary, so you may want to further divide by the types of attrition, from customers downgrading plans or leaving the company altogether.
The sum of these three recurring revenue metrics provides a complete picture of your venture’s sales performance. If you have a negative net MMR, where your churn rate is higher than new monthly revenue, there is a reason for concern.
Another critical way to look at recurring revenues is per customer. This metric looks at performance on a monthly and annual basis. If your MRR or ARR per customer is not growing, you will review your upselling or cross-selling strategies. You want to see growth in the number of sales generated per customer.
A related metric, average revenue per user (ARPU), works well for most business models. You calculate this metric by dividing total revenue by the number of users for a specific period. Again, a simple but powerful metric allows you to segment your customers in revenue generation and growth.
The next category of start-up metrics concerns indicators of profitability. An important starting point for understanding new ventures’ path to profitability is the contribution margin of an individual sales transaction. Sometimes referred to as unit economics, this metric looks at a particular sales transaction, takes the revenue generated from the sale of one product or service unit, and deducts the costs directly associated with the individual unit transaction. These specific costs are usually accounted for as costs of goods sold and include any labor, raw materials, or other expenses incurred only when the unit sale takes place. This calculation provides information about the amount of profit the sale of the unit in question contributes to the gross profit of the start-up, profit before any fixed operating costs applied, which will lead to the calculation of net profit or loss. A start-up will never become profitable unless the unit economics work unless each sales transaction contributes profit to operating costs.
Breakeven Point. One of the most critical metrics for a start-up is your breakeven point. Generally, breakeven occurs when the sales volume reaches the level where a product or service will be profitable. Typically, this involves dividing the total fixed and semi-variable costs by the contribution obtained on each service unit. Before calculating breakeven, define each of the components adequately.
The first thing to address is what you consider an individual sales unit. The definition of the “unit” depends on your venture’s business model and what drives revenues. A unit may be a specific product or service. But often, the unit is defined as the customer, client, user, or beneficiary. For some business models, it may be a physical outlet, such as a rental space, a chair, a kiosk, a desk, or a retail store.
The second factor is how your business defines “sales” based on your specific revenue model. For example, is there a difference between new and existing product sales for individual products? For example, do new products have a higher or lower cost of goods sold associated with them? If your unit is a customer, are you defining a sale as one transaction or a new subscription? When a location is a defined unit, are you measuring at the store level or maybe by square foot?
The next factor in need of definition is the variable costs per unit. For physical products, this is usually straightforward and consists of the cost of producing the product (commonly labor and materials). However, services and software can be more challenging to determine the best way to account for specific costs. For example, software businesses must consider development costs variable or fixed. For start-ups and smaller enterprises, one way to decide is whether the developers are salaried employees or outside contractors paid by the project. It is common practice to account for “salaried” employees as fixed expenses, as they receive compensation even when there are no sales. On the other hand, project-based developers may be a variable cost if hired to design a project already sold.
Once you have defined the unit and the associated variable costs, you can calculate the contribution margin. This metric represents the amount that venture’s revenue will contribute to gross profit and the amount of cash each sale contributes towards fixed expenses (or overhead). This measure demonstrates to the entrepreneur the profitability of individual products, product lines, and business units.
Contribution margin calculations:
revenue – variable costs = contribution margin revenue – variable costs/revenue = contribution margin %
BE (per unit) = fixed costs/revenue per unit X variable cost per unit (contribution per unit)
BE (in dollars) = revenue per unit X breakeven point in units
Months to BE = breakeven point in dollars/average monthly revenues
The breakeven analysis helps the entrepreneur determine whether a specific sales volume will result in a profit or loss. The point at which breaking even occurs is the output volume at which total revenues are equal to total costs. To use this analytical method, you need only to know the fixed costs of operation, variable costs of production, and price per unit.
Cash Flow Metrics. Two other profitability indicators important for new ventures are burn rate, the total amount of money spent on operations, capital expenditures, and time to break even.
The burn rate is when a new company uses its cash to finance overhead before generating positive cash flow from operations. In other words, it’s a measure of negative cash flow. The burn rate is when a new company uses its cash to finance overhead before generating positive cash flow from operations. In other words, it’s a measure of negative cash flow. Keeping close track of your cash on hand allows you to make timely decisions about where to increase spending and cut costs. In addition, close monitoring will enable you to take timely action before your company runs into trouble. You calculate your burn rate by taking the total amount of money at the beginning of the month and subtracting the total amount you end up with at the end of the month.
For this calculation, consider all available and expected cash, including all bank accounts plus forthcoming money from customers, suppliers, and other accounts receivable. If the business intends to borrow to access some money (e.g., bank credit line or revolving fund) or receive cash from investors, you should include the amount of any interim payments due. Additional considerations include quarterly or semiannual charges, such as tax installments or advertising. Include a pro rata of these expenses in the calculation.
A corresponding number is your runway, the months the company has before running out of money. This metric is a vital indicator of when you will need more funding. As we will discuss in the next section, fundraising takes time. By paying close attention to the rate you are spending your available funds, you can project how long the money will last before you need the next series of funding. To calculate your cash runway, divide your cash balance by your monthly burn rate.
You can readily measure and monitor these metrics through your cash flow statements. The burn rate is determined by looking at the cash flow statement. The cash flow statement reports the change in the firm’s cash position from one period to the next by accounting for the cash flows from operations, investment, and financing activities. Compared to the amount of money a company has on hand, the burn rate gives investors a sense of how much time is left before the company runs out of cash—the runway.
All these profit metrics are of great interest to funding sources and will be very much part of any conversation a founder has with potential investors.
Funding Acquisition Metrics
The final category of start-up metrics is associated with funding requirements. Many of these indicators are associated with the sources and uses of cash. Funding metrics focus on how much money is required and when it is needed. You may want to consider this as monitoring key cash flow events. How much money does the venture need during each stage of the start-up’s evolution? When do you need the funds? Are the projected monthly payables and receivables on track?
Investors will be interested in many of the above start-up metrics. Entrepreneurs must be ready to identify, measure, and monitor the key indicators associated with the specific business model and industry. One recommendation is to identify one or two of the most critical metrics in the above categories and create a one-page “dashboard” to communicate timely performance information to internal and external stakeholders.
The One Metric That Matters
While it is imperative to monitor specific metrics at each phase of your venture’s development, there is usually one metric that you must achieve before you transition to the next step. Focus is key to start-ups’ success. It helps to pick the one metric vital to success at your present stage of venture development. For example, new ventures reach a point when they need to focus on early customer acquisition, so it might be critical to monitor how many new customers are visiting your website and taking action, such as joining as a member or paying for a subscription. The metrics you focus on change over time. In the early stages, it may be on customer acquisition rates per channel; later, you will focus on retention (churn rates). The one thing you want to avoid is focusing on a metric before your venture is ready. For example, you often see founders starting to focus on vitality before they have proven that the product demonstrates steady active customer engagement. The proper focus lets you articulate goals and venture status to all stakeholders, from employees to investors.
For the past three posts, I have focused on various ways to measure your startup’s performance. The metrics you apply depend on the venture’s stage of development. In the early stages, you must be hyper-focused on customer engagement. Once you validate your customer’s active attention to your product, you transition to metrics associated with customer acquisition and growth.
For more on this subject and other entrepreneurship topics, get a copy of Patterns of Entrepreneurship Management, 6th Edition.
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