enture capital investors have a difficult task when it comes to evaluating the numerous opportunities that come across their desk. Many startups will end up creating entirely new markets with very few comparable companies. Startup founders often do not have a lot of experience and most startups only have a limited financial history, making it tough to evaluate their financial performance and how consistent it will be.
There are things that will stick out and catch your eye. For instance, some companies may have already raised VC funding, giving them some level of credibility, while others may boast lots of user growth.
These are achievements, of course, but they also don’t provide the full and complete picture. In order to make a confident investment decision, you’re going to need a lot more information. Here are seven ways to really measure a startup’s traction and determine if it is really headed in the right direction.
This one is obvious but also a good starting point. It’s of course always a big focal point for investors looking to find disruption. If you’re looking at the next big social platform then you are looking at the sheer number of users on the platform. If it’s a B2B company, you are likely more interested in the number of paying customers, MRR, and what kind of customers these are in terms of their size and importance in the industry.
It’s also not just a number. If a company has 1 million users, that’s great, but what does the growth trajectory look like? Did that company grow users 60% last year and only 30% this year? If so, you need to investigate why. Once you see clear growth, then it’s time to figure out the quality of that growth and what’s driving it.
2. Burn rate
Burn rate essentially looks at how much money a startup is spending each month on overhead and variable costs. Startups are normally not profitable in the very beginning and even if they are, they usually want to keep investing back into the business to achieve growth while they’ve got momentum.
This is a big reason startups raise capital from investors and VCs, which typically gives them 12 to 18 months of runway to really drive growth. So, if a startup raises $1.5 million of funding and is spending $350,000 per month, that’s not great because it means they’ll be out of cash in about four or five months.
It’s typically a good idea for startups to have at least six to 12 months of expenses on hand, so if a startup raised $1.5 million of financing a better burn rate would be $100,000 or $150,000 per month. Keep in mind that a lot of investors will look at the net burn rate, which also takes into account revenue. If you’re spending $100,000 per month but making $60,000 of revenue, the net burn rate is $40,000, which will help maximize financing.
3. Customer acquisition cost (CAC)
This is a great way to evaluate traction because it shows how much a company has to spend to acquire customers. For instance, if you have a social media platform that has 10,000 users but had to spend $800,000 on marketing to obtain those users, then you customer acquisition costs are $80 - pretty high. But if you have 10,000 users and spent nothing on marketing that tells you that your company has legitimate traction. This might mean that people liked your product and likely told their friends about it. Word of mouth is and has always been the most cost-efficient form of organic growth.
4. ARPU (Average Revenue Per Year)
ARPU, or average revenue per user, is also another great way to evaluate traction. There are a lot of investors out there, especially in current market conditions, that will only invest in companies with a viable path to profitability. While growing users is great, not all users are profitable. In fact, some users may end up costing the company more money than they’re worth.
For instance, if you run a high-traffic website, you’ll need to buy more servers to handle the congestion from more users. Your costs are going up, which puts pressure on the company to generate revenue. Think about the company Twitter. It’s a great platform with tons of engagement and hundreds of millions of users. But the company has always struggled to monetize the platform and generate a profit.
As mentioned above, getting new customers is not always easy and it might require a large investing in marketing. Even if a company is seeing massive growth, you’ll want to try and figure out how long customers are sticking around on the platform and also whether or not they are returning. Are customers actually engaging on your platform or with your product? If they are purchasing a product or service or driving usage, are they doing it more than once? Are they customers that generate annual and monthly recurring revenue? This will tell you how sticky your product or service is.
6. Marketing efficiency
Similar to customer acquisition costs, marketing efficiency essentially measures how effective your marketing efforts are. Not every company is the next Facebook, where things go viral without much marketing or customer education. While marketing cost money, it does often turn out to be a positive contributor to the business if managed correctly.
There are various ways to measure marketing but a good one is to look at how much revenue a company is making per marketing or advertising spend. This can be broken down several ways. For instance, let’s say there is a digital fintech lender specializing in personal lending. One way to see its marketing efficiency is by dividing total loan volume by marketing spend. Then you can compare this to peers and see how the company stacks up.
This may not apply to every company but it does when the business model is based on sales. For instance, many B2B software companies are constantly trying to get large companies to use their service. You’ll want to make sure this company has a healthy pipeline of promising leads in their pipeline that have a good chance of turning into customers.
Most startups these days often have different designations for different parts of the sales process, so make sure you inquire to see how far along certain leads are. Are these leads where the prospect has just returned a cold email or has someone on the sales team met with a decision maker at the company you are prospecting. Understanding the sales process and how long it normally takes is important when evaluating a startup and its pipeline.
While there is no one-size-fits-all approach to measuring traction, there are several key metrics that investors (and founders) can use to gain insight into a startup's growth and potential. By tracking these metrics and regularly reevaluating their progress, investors can more effectively navigate the challenges of the early stage investing. And with a strong focus on measuring traction, founders can increase their chances of success and achieve their long-term goals.
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