Nothing seems to grab headlines more easily than a company that raises, say, $50 million and is valued at $2 billion. No revenue? Never mind. Doesn’t matter. Then there’s the promising young company that actually has $20 million in sales but only manages to eek out a valuation of $200 million. Sounds like en episode of “VCs Gone Wild, ” doesn’t it?
But, when you look deeper, it’s all about metrics -- and maybe not the metrics that you, the entrepreneur, are most focused on.
That’s why business owners have to know how venture capitalists think. Key metrics for growth-stage companies can vary as much as their products and services. Nothing is more important than calibrating an appropriate valuation for your company. Most entrepreneurs think the correct valuation is the highest one they can get. Nope. You want the valuation that sets achievable expectations. Let's face it: If the term "down round" doesn't strike fear into your heart, it should.
Traditionally, revenue and profit have been the gold standard metrics. But those metrics rarely reveal what really makes growth-stage companies tick. That’s because they are in expansion mode and will be operating at a loss and burning cash. In addition, the metrics venture capitalists focus on have evolved over the years. And the competition for good deals can drive prices up too.
To help out with all this voodoo, here are some of the most popular metrics that venture investors consider.
Investors who love the sound of a predictably-ringing cash register pay a premium for businesses who can achieve this. The subscription revenue model used to be limited to domains such as magazines, pay TV, phone companies and fitness centers. Now the entire software industry has moved in this direction with the introduction of “Software as a Service,” or SaaS, where you pay a monthly fee and get free updates rather than buy a specific version for a set price.
The beauty of this model: once the costs of acquiring a subscriber are established, and you've figured out how long they stay (life time value) and what the cancelation rate or “churn” will be, investors can predictably calculate how each dollar invested will increase the value of the business. Who doesn’t love predictability?
If They Come, We Will Build It
Audience growth is eye candy to venture capitalists, especially for Internet companies where dramatic audience growth has drawn breathtaking valuations even before there was a penny of revenue. The presumption is that if you have something that the masses are flocking to, ultimately you'll figure out some way to monetize it. The social trinity of Facebook, LinkedIn, and Twitter, followed by Instagram, Tumblr and Waze, have all garnered nosebleed valuations yet this way. These successes have driven valuations of the next wave--Pinterest, Snapchat and so on--right into orbit.
Freemium is a go-to-market approach that allows customers to try a product before buying. Customers who like buy the whole thing, or maybe some extra features (common in games such as Candy Crush). This model often goes hand-in-hand with recurring revenue, since the free version may convert into a subscription. Here VC’s will focus on conversion rates: what percentage of free users ultimately start paying.
So there you have it: three popular models VCs love. But consider this: expansion stage investors care most about the growth rate of the metrics most relevant to your business model. How fast you get profitable may be less important than you think. Dramatic growth is the real gold standard. If you can demonstrate annual--and sustainable--growth rates of 100% or more in your key metrics, you will have no shortage of investors knocking at your door with buckets of cash.