Entrepreneurs routinely ask me what my one or two go-to financial metrics are, beyond the standard revenue, gross margin, net income and cash ratios. I usually demur, saying that business models wildly vary and an effective analytical tool in one sector might not be much use in another. A product company or one that sells perpetual licenses might not be too concerned with its customer churn rate, but a services company might be right to obsess over it.
In truth, I am sympathetic to the interest in innovative metrics. I love baseball and the data deluge associated with what, at first glance, is a simple game. But after decades of building companies, the addiction to detail was replaced by a ravenous hunger to identify the two or three unique levers of control in a business.
As a result, I do have a couple of favorite metrics that I keep an eye on beyond the standards. They by no means capture every angle of a business, and they are fallible, but I find them universally useful in evaluating and comparing companies and their progress. I’ve also highlighted two problem areas that always seem to create confusion.
My favorite metrics:
Revenue per Employee
In most technology companies, gross margins are relatively high and salaries are the biggest single cost. Cost per employee for technology companies in the U.S. is surprisingly consistent at just above $100K. So revenue per employee gives you a very efficient way of comparing overall efficiency of and between businesses.
Revenue per dollar of sales & marketing spend
I like to see how much revenue generated by each dollar inserted into the company’s sales and marketing machine.
More particularly, I track the change in this metric quarter-over-quarter, because that shows the rate at which sales and marketing is becoming more efficient (hopefully). Like a golf handicap, rates will differ a lot between, but you still want to beat the course by always getting more efficient.
These days, I see lots of entrepreneurs that have significant sources of recurring revenue. That’s great. However, many entrepreneurs are unsatisfied simply reporting their revenue, because it doesn’t give them credit for the full value of a long-term contract. Some instead report total bookings, which, at the other extreme, can be equally misleading. I always recommend reporting what I call Adjusted Annual Recurring Revenue each quarter (the “AARR”). The AARR is the annual revenue run-rate of your recurring revenue multiplied by your average renewal rate. This gives you a probability-adjusted, annual recurring revenue number that your board can sink its teeth into. It’s nice knowing what you have in the bag for next year!
When you’re selling different products or services with different gross margins, or selling both perpetual and term-based licenses, it is essential to explain the effect of the changing mix of revenues and associated costs over time. Most boards, and sometimes management teams, tend to underestimate the significant impact a change in that mix can have on a company’s financial profile. You often see this when a perpetual license software vendor shifts to a software-as-a-service model. Avoid nasty surprises by forecasting carefully.