04 Feb #AlternativeMetrics: Going Beyond Common Startup Performance Indicators
“You get what you measure.” A concept that seems simple enough, yet even the world’s best businesses get wrong. Measuring the wrong things drives poor decision making and undermines performance. Simply put, using a metric the wrong way is as bad or worse than not measuring anything at all.
Let’s take a look at a few metrics that are useful when assessing the health of a startup but might not always be what they seem from an operational perspective. Before we begin, it’s important to note that these are just examples, and each metric is worthy of a deep dive. For our purposes, we are just looking to highlight a few metrics that can be perilous if other factors are not taken into consideration.
Customer Lifetime Value (CLV or LTV)
What it actually measures: Effectiveness of acquisition channels or marketing programs to acquire similar customers
How it’s misused: Comparing the cost of customer acquisition with the cash flows that come from the customer over time, often mistaken as the margin made on a customer and relaxing the drive for near-term profit. Lifetime value is extremely useful, but should be used in combined with metrics like payback period to ensure a startup won’t have to choose between cash flow and growth.
What can go wrong: CLV doesn’t account for revenue timing, i.e. cash flow implications for SaaS businesses. It is inherently uncertain via discount rates and attrition which imply assumptions about future market conditions . If LTV > cost of acquisition, many will justify “pouring gas on the fire”
Let’s take an example. A customer costs you $50 to acquire and pays you $4.99 on a monthly subscription, it will take over 10 months to breakeven on this customer leaving a lot of time for uncertainty. Even if the customer stays, it will take 13 months to make 30% margin on just the cost of acquisition which doesn’t account for the overhead of the business itself. The other issue to consider here is supply and demand. As you work to buy more customers, the price will go up and the payback period will be pushed out. It’s highly unlikely to get more efficient the more you spend, typically the outcome is the opposite due to competition and the removal of first adopters which are always cheapest to acquire.
What it actually measures: Churn can be measured in two ways, customer churn or revenue churn. For the purposes of this post we’re looking at churn as the percent of customers lost monthly. It is inherently a measure of customer satisfaction and a startup’s ability to retain customers through renewal campaigns.
How it’s misused: A startup focuses only on the percent of churn instead of combining the measure with the rate of new customer acquisition. Instead of looking at the percent of churn, it becomes important to look at the actual number of customers lost. When % churn stays steady, there becomes a point where customers acquired = customers lost and growth slows to a halt.
What can go wrong: Startups recognize the problem too late. As the number of customers churned grows, two things happen. First, the cost to retain becomes high through marketing spend and /or operational overhead to put systems in place for retention. Second, the cost to acquire new customers to replace the churn AND grow becomes burdensome at scale.
Let’s use an overly simple example, last year a startup acquired 5,000 customers at a $100 CPA for a total of $500,000 spent. This year it needs to grow year over year 70% to 8,500 customers acquired for this year and a goal of 13,500 total customers under contract.
Assuming the CPA stays constant (remember from the CLV discussion this is unlikely), new customer acquisition will cost $850,000 to reach the goal of 13,500 under contract. But what happens when 20% of last year’s customers churn? Now, we have 1,000 less customers and need 9,500 to meet our goal meaning we’ll spend an extra $100,000 to meet our growth numbers.
To drive the point home even further, here is an extreme example. This week Facebook announced it has 1.23B daily active users as of December 2016. If they churned 0.5% of users in January 2017, they would lose 6.1M users.
This concept seems simple enough (we use compounding interest in finance all the time), but as a startup focuses on growth and scale it is easy to forget about churn. The goal is optimal net customer growth, the optimal spend of acquiring new customers and the reduction of churn.
What it actually measures: In its simplest form, revenue is the income a business receives from operating activities, but like most things it is much more complicated in practice. For our purposes, revenue can actually be divided into three parts: booked revenue, recognized revenue and collected revenue. These three are often referred to as the flow of revenue. Depending on the business, booked revenues can be realized and collected immediately or spread out over a period of time.
How it’s misused: It is perfectly fair to champion “bookings,” “annual recurring revenue” and other numbers that often exceed actual revenue, as defined by generally accepted accounting principles because they are often better indicators of a companies growth prospects. However, monitoring the flow of revenue becomes just as important as a startup grows. Startups should dedicate as much attention to the rate, both time and frequency, at which they are collecting revenue as they do to booked and realized revenue.
What can go wrong: The (un)realization of revenue. In some industries, bookings do not always turn into revenues. Marketplaces are one such example of an industry where bookings are often materially different than realized revenue. The marketplace doesn’t actually realize revenue upon signup or booking, but instead is compensated when the customer uses the actual service.
If your business is booking revenue at a high rate, but not collecting it you’ll be carrying a high accounts receivable balance and hinder your cash flow. In this case, yield becomes an important indicator of performance. While this is just one example across one particular type of business, revenues / cash flow are the lifeblood of any business so it’s critical revenues are measured the right way.