Is Your Revenue Real?
When Canadian founders ask investors what they must achieve to raise their next round, the advice often starts and ends with revenue:
“You need to get at least $25K in MRR”
“You need a minimum of 4 new clients and $100K+ in bookings”
“You need more than $250K/month in GMV"
But when it comes to raising from top Silicon Valley VCs, top-line revenue is just the tip of the iceberg.
A captivating picture of an iceberg from a management consulting deck
The best investors, particularly at Seed and Series A, focus on growth and growth potential when making investments decisions. They’re looking for early evidence of product-market fit and indications that the founders understand the needs of their customers. They want to know that if they invest, they’re adding fuel to a rocket that’s heading in the right direction 🚀
In order to do that, they need to understand how “real” your revenue is.
What Does that Even Mean?
Many first-time founders (and, sadly, more than a few investors) believe that reaching a certain level of revenue will instantly unlock the next round of funding. They expect to succeed at fundraising the same way they did at school: get the “correct” answers on the test and you pass.
When I grow up, I’m going to be a VC! 💪
Accelerators and startup personalities have compounded this misconception with overly simplistic concepts like “one metric that matters.” These approaches encourage founders to focus on a single metric (typically revenue) to the detriment of all others.
In theory, having the entire company focus on revenue is a great idea, but in practice it’s easy to get caught up in growth practices that are unsustainable. The top-line numbers look great, but they’re built on a house of cards.
Good investors understand this, which is why they dig deep.
Here’s what they’re looking for:
Let’s Start with the Basics
Note: The examples and definitions in this article are of SaaS businesses with monthly revenue, but the concepts apply to all startups.
Evaluating revenue starts with two metrics: the actual (current) revenue and the rate at which it is growing.
Revenue
Starting at the Seed stage, VCs almost always want to see a minimum level of revenue — whether they admit it or not. Depending on your business, that might be represented as MRR, GMV, bookings or something else, but every investor has a number in mind.
Paradoxically, the important part isn’t the revenue number itself — it’s the number of customers it represents. At each stage, investors are looking at how many people/businesses need your product badly enough that they’re willing to pay for it. Yes, the actual amount of revenue you’re generating from each customer is important (and we’ll get to that later) but investors first and foremost want to see evidence of product-market fit.
Revenue = objective evidence that you’re solving a problem that matters to someone
Revenue Growth Rate
The next thing investors want to understand is how fast your revenue is growing. Silicon Valley VCs are strictly in the business of “unicorn hunting” — investing in companies that can exceed a valuation of $1B in 7-10 years — and growth rate is key to achieving that goal.
In fact, having a numeric goal allows us to reverse engineer the rate of growth required to get there…
Let’s get out the calculator
Assume that your startup currently has $25K in MRR. You are trying to raise a Seed round from an investor who expects a valuation of $1B in 7 years. Let’s further assume that to achieve this valuation you’ll need to reach $100M/year in revenue. In order to do this, you must have an average monthly growth rate of:
$25,000 MRR x X^(12 months/year x 7 years) = $100,000,000 / 12 months
X^84 = 333.3333
X = 1.072 —> 7.2% MoM growth
This means you need to increase revenue 7.2% every single month for 84 months straight to reach your goal. 😅
The practical takeaway from this example is that top investors will typically want to see consistent double-digit MoM growth from early-stage startups. They understand that growth rate will ebb and flow (it’s okay to have off months while you’re fixing bugs and getting the product right), but the potential needs to be there.
Revenue Growth Rate = objective evidence that you’re solving a problem that matters to many people
So your current revenue is healthy and you’ve got consistent 20% MoM growth. Fundraising will be a slam dunk, right?
Not quite…
The Leaky Bucket Problem
Imagine you’re trying to carry water back-and-forth in a bucket with holes in it. You fill the bucket to the top each trip, but by the time you get to your destination only part of it is still there. That’s what happens with your revenue.
Something’s wrong here…
Each month, your team works hard to acquire new customers, only to find out that by the end of the month, some of your existing customers have churned. In the early days, this is a constant battle that highlights the evolution of three core functions:
Marketing - identifies potential customers (leads) and brings them in with the promise of a solution to their problem
Sales - converts them into paying customers
Product - fulfills their needs and keeps them happy
Revenue and revenue growth rate only prove the effectiveness of a company’s sales and marketing efforts. They demonstrate that the company has identified a meaningful problem (one that users/businesses are willing to pay to solve) and has figured out how to attract and convert customers. But without supporting evidence, they don’t prove that the company is actually solving the problem.
In fact, a poor product can be hidden for months — even years — by an effective sales and marketing function. As long as sales and marketing can bring in new customers faster than existing ones are churning, from the outside things look good.
Experienced investors have seen this many times, which is why they’ll dig into your churn next.
Customer Churn Rate
The first thing investors will look at is the customer churn rate — what percentage of existing customers are you losing each month?
At scale, your churn rate should only be one or two percent. For Seed and Series A startups, investors understand and expect it to be much higher. After all, the product is still really early. It’s likely missing key features and those that do exist are held together by duct tape.
The key question investors will ask: is the churn rate getting better?
Churn rate is a proxy for the quality of a product and its ability to solve customers’ problems. A decreasing churn rate demonstrates that you understand why customers are churning and are able to address those issues.
Customer Churn Rate = the percentage of customers who realize that your product doesn’t actually solve their problem
Revenue Churn Rate
Churn rate can also be calculated from a revenue perspective — what percentage of existing revenue are you losing each month?
This is a particularly insightful calculation when customers can generate different amounts of revenue (e.g. when a product has different pricing tiers, business customers can purchase multiple licenses, etc.).
The calculation for revenue churn rate is as follows:
X = MRR at start of month
Y = New monthly revenue from existing customers (upsells)
Z = Lost monthly revenue (from customers who downgraded and/or churned)
Revenue Churn Rate = ( Z - Y ) / X
Revenue Churn Rate = how happy are the customers who stayed relative to those who left?
Negative Churn (a revenue churn rate < 0) indicates that you are upselling enough to compensate for all revenue loss. In other words, your revenue is increasing even before you take into account new customers!
Net Revenue Retention (NRR)
Net revenue retention (NRR) inverts revenue churn rate. Instead of looking at the percentage of revenue you lost, it highlights the percentage that you kept — are you getting more new revenue from existing customers than you’re losing each month?
The calculation for net revenue retention is:
X = MRR at start of the month
Y = New monthly revenue from existing customers (upsells)
Z = Lost monthly revenue (from customers who downgraded and/or churned)
NRR = (X + Y - Z ) / X
If NRR > 100%, then you’re adding more revenue each month from existing customers than you’re losing (woo hoo!).
But wait…
Startups will often point to strong NRR as proof that they’ve got everything figured out, but it doesn’t actually do that. NRR > 100% is a great thing, but it can also be misleading, particularly in the early days when numbers are small, pricing models are changing, etc. It’s a start, but there’s more to dig into.
Net Revenue Retention = how leaky is your revenue bucket?
So How Real is Your Revenue?
After looking at churn, investors will turn their attention to the customers who stayed and the revenue they’re generating. How solid is that revenue?
Customer Lifetime
The first thing investors want to understand is how long, on average, are customers sticking around?
For an early startup, this isn’t an easy question to answer. It’s likely that a number of the customers who signed up in the first few months still haven’t left. That’s awesome, but it makes measuring customer lifetime quite challenging (and has led many a founder to overestimate how good their product is).
I find it helpful to think about three distinct cohorts:
New customers who fail to onboard or quickly realize that the product isn’t for them
Customers who stay for more than one renewal period and then churn
Customers who haven’t yet churned
Customers in category (1) consist of two main groups:
Customers for whom the product didn’t match marketing (they came because the marketing spoke to them, but the actual product didn’t solve their problem)
Customers who churned during — or shortly after — onboarding (they failed to complete the tasks needed to become an “active customer”)
Most investors will look at churn rate for this group but not include them in lifetime calculations — as they were never really customers. As a subset of churn analysis, understanding this particular cohort provides an indication of how effective onboarding is (including the initial impression new users/customers have of the product) and how aligned product and marketing are.
New User/Customer Churn = how good is your onboarding and does product deliver on marketing’s promise?
The second category (customers who renewed at least once and later churned) is the next step after NRR for analyzing progress towards product-market fit. How long did customers stay on average? Is that period getting longer over time? When customers do leave, why did they churn (and how easily can the underlying reasons be addressed)?
Customer Lifetime = how long before customers reach the limit of your product?
As founders, the more you understand this category, the better. During fundraising, presenting exit interviews/surveys, cohort analysis and other supporting evidence can go a long way to convincing investors that you’re on the right path, even if the numbers aren’t great.
Average Revenue Per User (ARPU) / Average Revenue Per Customer (ARPC)
The next piece of the puzzle is how much revenue are you generating per customer (user, business, etc.)?
The calculation here is fairly straight-forward:
For B2C SaaS businesses: ARPU = MRR / number of individual customers
For B2B SaaS businesses: ARPC = MRR / number of business customers
Average Revenue Per User/Customer = how much will customers pay you each month to solve their problem?
Lifetime Value (LTV)
The lifetime value of a customer (LTV) is how investors evaluate product from a revenue perspective. How much revenue, on average, is generated from each customer before they churn?
The basic calculation for lifetime value is as follows:
LTV = ARPU (or ARPC) × Customer Lifetime
But since we don’t actually know customer lifetime yet, we can approximated by inverting the customer churn rate:
LTV = ARPU (or ARPC) / Customer Churn Rate
Customer Lifetime Value = how much do customers value your product as a solution to their problem?
Is it Sustainable?
The final question on the minds of investors digging into revenue is one that is often misunderstood: is it sustainable?
As a founder, the mere existence of this question might seem preposterous — the success of startups is very much predicated on their ability to do things that don’t scale. But when it comes to revenue, long-term sustainability is crucial.
Returning to our leaky bucket analogy, investors ultimately want to know whether or not your ongoing efforts to “fill the bucket” can lead to long-term success. Given sufficient time and resources, can this business become a billion-dollar company?
This boils down to three questions:
Is there enough water to continue filling the bucket (is the market big enough)?
Can you make the bucket better (by improving the product and achieving product-market fit)?
Can you repeatedly fill the bucket in a sustainable way (is the business model long-term profitable)?
The answer to this final question is often the difference between an oversubscribed round from top VCs and struggling to raise anything.
Cost of Acquiring Customers (CAC)
The first metric investors will focus on is your cost to acquire new customers (CAC). This is the average cost to acquire each new customer, inclusive of both sales and marketing.
Customer acquisition cost is calculated each month, as follows:
CAC = (total sales costs for the month + total marketing costs for the month) / number of new customers for the month
For purely self-service SaaS businesses, there may not be significant sales costs. However, if anyone in your company (other than customer support) is actively talking to leads as part of the sales process, you need to include those costs in your calculation.
Cost of Acquiring Customers = how must do you spend to acquire each new customer?
LTV / CAC: The Ultimate SaaS Metric
Dave Kellogg once described the ratio of Customer Lifetime Value to Cost of Acquisition as The Ultimate SaaS Metric, and in many respects it is. This ratio tells us how profitable each customer is:
Assume that the cost to acquire each new customer is $100 and that the lifetime value for each customer is $500. This means that every new customer is worth $400 in gross profit!
LTV / CAC = $500 / $100 = 5
In the early days of most startups, LTV/CAC is less than 1. This reflects both a high churn rate (since the product is still very early) and a high cost of acquisition (having neither zeroed in on the target customer nor figured out how to acquire them cheaply).
Over time, investors will expect to see this ratio improve — however, this isn’t a case where bigger is always better. An LTV/CAC ratio of 3 is considered good. Too much higher and investors will worry that you’re being too cautious in your growth (once you reach a certain level, a portion of your marketing spend should always be directed at discovering new markets, which will increase your average CAC).
Putting it all Together
By now, you should have a sense of just how deep top investors will go to understand how “real” your revenue is. They want to understand:
How fast is top-line revenue growing
How “leaky” is your revenue bucket
Is your understanding of your customers improving
Is your ability to solve their core problems Improving (is product getting better?)
Is the problem you’re solving important enough that customers will pay a meaningful amount to solve it
Is your business model long-term sustainable
Investors don’t expect you to have it all figured out, but they absolutely expect you to understand and be able to articulate your progress on each of these questions. That means that you — the founder — need to deeply understand your revenue and business model, even if the numbers are still small.
Far too many founders think it inappropriate that early-stage VCs dig into revenue numbers in such detail. Hopefully, this post helps you to understand that it isn’t so much the revenue that’s important to investors, but what it represents:
Objective evidence that you might actually be able to pull it off.
