How likely is it that the product being developed by the team is going to be the clear winner when it comes to solving the problem? Is that even necessary? The hard part during due diligence on the product is that it almost always changes over time as the company integrates customer feedback, new entrants to the market arise, and markets ebb and flow.
This ties in closely with management due diligence because it takes founders who are mentally flexible in order to distill all the information and feedback regarding the product into an actionable plan for the company. It is important therefore that VCs start assessing the product’s potential by understanding its path to that point. How much has it changed since inception? How did those changes develop and what processes are in place to receive, track, evaluate, and implement new ideas?
Let’s dive into the key areas of focus for product due diligence.
There are two paths to products: creating a new market or creating a better one. The degree to which a company’s product is revolutionary points to the former while the latter would be better classified as an evolutionary one. The evolutionary route, given its unreliance on creating brand new markets, is often the most common one, and a perfectly acceptable one if the case. While it may be tempting to forgo these investment opportunities in favor of revolutionary companies, know that these opportunities are few and far between (meaning VCs risk letting capital sit idle) and ventures that tackle problems in existing markets have an added benefit of getting to revenues (and potentially profits) and, which is to ultimately say, success more quickly and with higher probability. The downside, of course, is that the upside potential is relatively limited, so it becomes a numbers game for the GPs. Should you specialize? Should you set aside some capital for existing market opportunities and some for new market opportunities, like an investor who prefers to ‘barbel’ their risk on both sides of the extremes?
A key here is understanding just how revolutionary a product may be. A little better is far from enough. We’ll walk through how VCs can build a framework to assess if a company has the 10x improvement potential within existing markets and for those in new markets, how to understand the product’s demand in an exciting new market.
Supply and demand. The only two critical axis for product development. Knowing these two figures can help companies set the right price point, manage inventory, set marketing budgets – if only it were that simple. Product demand is predicated on almost an infinite number of ever-changing variables, many of which are not able to be measured at the point when companies are raising capital. That’s why in addition to generally accepted product KPI’s every VC needs to know, we will look at how a company moat is generated to keep competitors at bay.
Below we provide an overview of the critical KPIs and performance metrics for VCs:
Monthly Recurring Revenue (MRR): The total contractually obligated revenue to be collected in a given month. Contractually obligated means customer revenues from subscriptions. VCs like MRR because it’s a known entity and therefore projectable, which offsets other risks. SaaS companies typically are built around subscription models, so MRR is a key revenue figure. If a company has 80 customers with annual subscriptions valued at $24,000 per contract, the MRR figure is $160,000 (80 customers * 24k / 12 months).
Annualized Run Rate (ARR): Working the other direction, ARR is the annualized monthly run rate, so the MRR * 12. This is an important figure for budgeting and valuation when revenue based multiples are appropriate.
Churn Rate: How many customers has a company lost over a certain time period as a percentage of beginning of period customers? For example, a company with 500 customers at the beginning of the year and 400 at the end of the year (therefore losing 100 throughout the year) would have experienced a 20% churn rate – (500-400) / 500 = 20%. Churn rate is important not only to assess the product demand, but can be used to compare levels of demand across different geographies, target audience segments, or other groups.
Burn Rate: Whereas churn rate calculates the amount of customers lost over a given time period, burn rate is used to assess how much of the available cash (typically invested capital) has been chewed up. The goal here is to understand how quickly a company is using up cash and to project how long the runway is for the company. To calculate the burn rate, take the difference between the beginning of period cash and end of period cash and divide by the relevant number of months. For example, a company that raised $500,000 8 months ago that now has $150,000 remaining has a burn rate of $43,750 per month. The burn rate can be compared to the predetermined financial proformas and industry peers to understand if the company is on track. In this instance, the runway is calculated as $150,000 / $43,750 = 3.42 months. Might be time for another capital raise!
Dollar Revenue Retention (DRR): Particularly important for SaaS and subscription based platforms, DRR measures how much dollars are retained from a customer. Businesses that sell products in pricing tiers (basic, premium, professional, for example) will have customers move between tiers, which result in different revenues per customer but do not count as churn (because they’re still paying customers).
For example, a company with Customer A pays $100 per month for a premium subscription and Customer B, who pays $50 for the basic plan. In the current year, the total revenue is $150. Next year, Customer A boosts their plan to the Professional at $200 while Customer B cancels their plan, and therefore total annual revenue in year two is $200.
The DRR is simply the ratio between the two: $200/150 = $133 DRR. While there was a 50% churn rate, the company improved when it comes to revenues, as measured by DRR. Therefore, it is important to view these metrics together as either alone can tell a misleading story. Clearly, of course, a high churn rate and low DRR is a major red flag.
Customer Lifetime Value (CLV): How much revenue can be expected from a customer over the estimated length of the relationship? CLV is used often in marketing to understand how much a company can spend to acquire a customer (by comparing that figure to the amount of money the customer is likely to bring in). CLV is one of the more subjective performance metrics in a VCs toolbox given the reliance on estimating how long exactly the “lifetime” is.
Introductions to the Due Diligence Process, Management, Product, Financial, and Technical Due Diligence
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Most companies after years in operation can generate an estimate of the average length of time someone is a customer. For early stage VCs, however, this information can generally be sourced from industry reports or comparables. For a retail shop, for example, CLV can be calculated as the average customer spend per week (or month) and annualized then multiplied by the expected customer lifetime. If a shop tracks an average weekly purchase value of $30/customer, multiplying this figure by 52 provides an annualized value of $1,560. Multiplying this figure by an industry standard of say, 10 years, yields a CLV of $15,600. From here, companies can back out the cost of goods sold or other expenses to provide a net revenue per customer figure and margin to judge how effectively marketing dollars are being spent to acquire customers.
This is where customer stickiness comes into play as a competitive advantage. Businesses with high switching costs have longer customer lifetimes, meaning they can pay more to acquire customers. Businesses that have high churns, on the other hand, face more challenges in efficiently scaling – important considerations for VCs.
Customer Acquisition Cost (CAC): As previously mentioned, the cost to acquire customers plays an important part in putting together marketing budgets. CAC is simply the amount of money spent on customer-acquiring costs (marketing, advertising, and PR) divided by the number of new customers acquired. For example, a food delivery app that spends $500,000 on SG&A expenses and acquires 1,000 new customers with that spend experiences a CAC of $500 (500,000 / 1,000). As long as the CLV is greater than the CAC, the company is efficiently acquiring customers. The net or percentage between the two is a measure of just how efficient the company is and should be measured as well. Knowing CLV and CAC can help companies project, for example, how many customers they can expect to acquire with specific advertising budgets or inform how well new price points, marketing channels, or products are performing.
CAC Payback Period: A challenge for companies is that marketing expense (CAC) is often spent quickly, while revenue (CLV) is acquired over longer time periods. How much, therefore, should a company be willing to spend to acquire a customer given there are real opportunities costs of using this capital? This can be measured through the CAC payback period.
To calculate this metric, divide the CAC by the monthly CLV. The monthly CLV is the total customer lifetime value divided by the lifetime length. For example, a company that expects to generate $14,400 over 48 months (or $300/month) and spends $1200 to acquire that customer has a payback period of 4 months ($1200/300). Typically, payback periods of 12 months or less are preferred, meaning the company should spend no more than $3,600 ($300 * 12 months) to acquire a customer. This of course means that after 12 months the company has “paid off” the cost to acquire the customer – so the sooner the better.
Now that we have a framework in place to review performance, we will turn next to how companies can build sustainable competitive advantages to maintain (and hopefully) improve these metrics.