Investors in startups are weird: they don’t like to lose money. A funny quirk no doubt, but that’s how they roll. They pass on most offers. And the few deals they make? They usually don’t work out as planned. In fact, Ben Horowitz (celebrity venture capitalist) says in any given year, only 15 companies will go on to mass success. Of course success is a relative term. But can you really blame investors for being a little skittish about writing checks? Well, yeah, you could, but bitterness isn’t a great look.
Think about it. What would you do in their shoes? Wouldn’t you look for the safest bet? A company tackling real (not make-believe) problems? A product that’s been tested and validated to some degree? For founders who are intelligent and scrappy?
OK, then, it’s settled. Investors are just like you (minus the ramen noodle diet). They wanna attach their name to something great and hopefully… hopefully get paid in the end. So before putting too much time and tears into your company, start preparing now for that day in the future when you’ll ask strangers to open their wallets.
Get into the habit of imagining your startup from an outsider’s perspective. You know, the whole forest-instead-of-trees thing. It may sound corny but that mindset works. Investors like founders who think big and strategic, like a CEO. They avoid founders who act like dorkville bean counters.
First Things First
If your startup is still in the early stage, where all you have is an idea or Minimum Viable Product (MVP), your top priority should be studying the market and identifying potential customers. This is the essence of product/market fit. Or to put it in Lean terms, you learn first, build and then measure.
You’ll learn some things during your research that will change your product. Some of that will come from the internet, some from talking to potential customers. You’ll probably end up dropping a cool feature… or three. It could even mean scrapping 90% of your initial assumptions. Pivoting like this is inevitable and it does kinda suck, BUT it’s sooo much better than launching a product nobody wants. And that will happen unless you invest enough time and money into studying market conditions.
Finding people who are experiencing the problems you’re solving for and asking them to share that journey is invaluable. You’ll find plenty of help from the types that love the idea that their stories will be considering during the creation process. Of course it’s still nice to thank them with a tweet, a high-five or a bro hug. Keep in mind, these people might turn into the early adopters who help launch your product when it’s ready.
Now if you’re already up and running but hope to pitch investors eventually, there are definite metrics you’ll be asked about. Monitor these numbers closely and they’ll direct which way you should go (kind of like The Force). Investors love to see company founders who can properly interpret metrics and harness them into a coherent, attractive, and ambitious pitch. Here are those metrics:
Cohort Analysis –not a metric per se, but it’s the foundation for nearly every data point in the life of a startup. A cohort is a group of people who have shared an event over a period of time. For example, the people who moved to a new city in the last month. Tracking the number of times these people ate out in the month following their move would be a cohort analysis. It’s a way to tag customers so that you can observe their behavior.
What kind of startups use cohort analysis? All of them — marketplaces, social media, apps, e-commerce, platforms. All industries, too — education, health care, finance, media, etc.
Margins — gross margins are the first question investors will ask you about. If the profit margin for your product is low, you’ll have a much harder time trying to win them over. That is unless you have a bulletproof method for scaling up.
You calculate gross margins by subtracting the cost of goods sold (COGS) from revenue, divided by revenue. Sounds complicated, but it’s not. Margins are industry specific. A few examples: cloud storage can have margins around 90%, SaaS averages about 70%, consumer goods usually under 50%. Potential investors will know the margins for your industry. If your margins are pathetically below average, you’ll have to fix the problem before pitching anyone or have a REALLY good explanation.
Customer Acquisition Cost (CAC) — the cost of getting a customer to buy or use your product. It’s probably the second thing investors will ask you about. There’s no hard number for acquiring a customer; again, it depends on the industry. For example, a discount beauty supplier might only spend $2 on Pay-Per-Click advertising to land a customer, whereas a financial brokerage company might spend $250 to land a customer (banner ad, complimentary newsletter, six follow-up emails, 45-minute phone consult, etc.).
You can also break CAC out by specific channels: public relations, SEO, PPC. Some channels will work better for you than others. Track what it costs to acquire a lead, and then track the cost of each conversion step, until the lead becomes a customer. Drilling down like this will help you decide where in your funnel to spend less money and where to ratchet it up. CAC goes hand-in-hand with customer lifetime value.
Customer Lifetime Value (CLV) — the profit a customer will generate for you during the entirety of your relationship. Just so you know, no customer likes to hear you speak about your “relationship” with them… it just sounds a little needy.
CLV correlates directly with CAC. You cannot stay in business for long — in any industry — if CAC > CLV. Investors like to hear from companies who can pay back their CAC in less than a year. If it takes more than a year, it means that your startup will need LOTS of money to grow. Many investors would rather put their money in a less vortex-like business.
Monthly/Annual Recurring Revenue (MRR/ARR) — measurements of revenue streams such as subscription and maintenance fees. They don’t include one-time fees. Like the other metrics, MRR or ARR can be broken down further:
- MRR from new sales
- MRR from renewals
- MRR from upgrades
Recurring revenue is VERY attractive to investors because it cuts down on CAC. Investors will be interested in the trend, the growth momentum. If you sell a subscription service, MRR and/or ARR should be tattooed on your fingers. Both metrics are (roughly) an inverse to your churn rate.
Churn rate — the attrition rate for subscription services. That is, the percentage of customers who — in the relationship analogy — break up with you at any given time (usually measured on a monthly basis). Getting dumped hurts, but more importantly a high churn rate negatively affects your CAC and CLV. Customers who leave you have to be replaced. A high churn rate could signal to potential investors that your company has a problem with customer service, value perception, competing offers, or switching costs.
The answer to reducing churn is to make it either easy for customers to stay or hard for them to leave (high switching costs). You can accomplish both by constantly updating and improving your product’s features, getting customers addicted to it through habit, and offering discounts for long-term commitments (i.e. annual subscriptions). Calculating monthly churn can get a little hairy once your company is growing. For example, do you count people who sign up for free trials — and then quit before the trial period ends — as customers?
Start measuring churn rate using simple numbers (100 customers on April 1st and 95 on May 1st = 5% churn). As you grow, you can refine the metric. Be warned, though, churn formulas can easily morph into equations straight out of calculus hell!
Check out how Andrew Chen measures annual churn: 1 – (1-churn_rate) ^12. If you can tell me what “^” stands for, I’ll buy you a venti iced skinny macchiato.
The whole point in critiquing your startup like an investor is to keep you focused during the ups and downs of startup life, until the day you start raising money. A few metrics will determine your product’s long-term viability. Getting funded is not the end game, it’s just one BIG part of what it takes to scale an awesome or almost-awesome product.
All the money in the world won’t save a bad idea! If you need proof of that, just look at what the government spends money on. Your future investors have been around the block and have seen enough to know — at minimum — what it’ll take for a product to succeed.
So what sez you about the critiquing process, metrics, or iced skinny macchiatos? Let us know at @newhaircutco