Startups Venture

How To Spot Red Flags In Your Startup’s Business With Quantitative Tech Evaluation 

Illustration of businessman climbing falling graph lines-red.

By Itay Sagie

Running a tech company or investing in one can be a thrilling journey filled with potential rewards, but it’s equally fraught with risks.

While some people might rely mainly on their intuition, there is immense value in assessing the financial well-being of a tech company, a practice that proves beneficial for entrepreneurs and investors alike.

Using quantitative metrics offers a data-driven and objective approach to evaluation, but it requires a keen eye to uncover hidden strategic insights.

First, ask: What is the purpose of the evaluation?

For entrepreneurs who are sometimes too close to the subject matter, the evaluation helps them take a step back and make smart, objective decisions about their growth strategy and their company’s financial health. It can also help them identify risks.

Photo of Itay Sagie, founder of Sagie Consulting
Itay Sagie, founder of Sagie Consulting

For investors, this evaluation can help assess potential opportunities and gauge the health of their existing portfolio. Active investors may need such evaluation and analysis to be reported on a regular basis, and some may choose to step in and offer assistance where possible.

In this exploration, I aim to delve deeper than the fundamental key performance indicators, or KPIs, like various margin rates, burn rate, runway and the basic unit economics KPIs such as the LTV/CAC ratio, Rule of 40 and growth/churn ratios, which I discussed in a previous unit economics article.

Instead, I will try to uncover hidden strategic insights using quantitative benchmarks.

Balance growth with your CAC payback period

While the prospect of rapid revenue expansion is alluring, it is essential to conduct a thorough examination of your company’s customer acquisition cost, or CAC. An excessively high CAC can eat into profitability significantly.

It’s not uncommon to see tech companies devote months of their sales team’s efforts to chase after customers yielding only $100 in annual recurring revenue, or ARR. The cumulative expenses, encompassing budgets and salaries, incurred in acquiring such customers can amount to tens of thousands of dollars. Clearly, this approach is unsustainable.

One pivotal benchmark to keep in mind is that the CAC payback period should ideally fall within the range of 10-12 months. So, if your average customer acquisition cost is $12,000, the corresponding ARR should ideally range from $12,000 to $14,400.

Strategic insight: When the ARR and CAC fail to align, it’s prudent to reconsider the business model or the company’s go-to-market strategies.

Take your time, avoid short-term metrics

It’s crucial to avoid placing excessive reliance on short-term metrics, such as monthly revenue or even short-term CAC, as they can obscure a startup’s long-term sustainability.

A sudden revenue spike from a single project can distort the overall financial picture, and extended sales cycles may conceal the effects of specific sales efforts that have been maturing over extended periods. Depending on a company’s business model, the customer lifetime value, or LTV, often remains concealed until annual churn data becomes available. That’s why it’s advisable to embrace a more comprehensive, long-term perspective.

Strategic insight: To gain a genuine understanding of the company’s overall financial health, be sure to focus on longer-term KPIs.

Beware customer concentration risk

Elevated customer concentration presents a notable risk scenario, wherein a significant proportion — say, 80% — of the total revenue is derived from a limited pool of customers, while the remaining 20% originates from a diverse customer base.

The inherent danger lies in the potential loss of a key customer responsible for a sizable portion of the company’s income, which could lead to a substantial devaluation and even transform a profitable company into a loss-making one.

This point is not meant to discourage entrepreneurs from pursuing large customers — rather, it underscores the critical importance of crafting a contingency financial strategy to ensure the company’s resilience in case such a pivotal customer terminates their business relationship.

Strategic insight: Stay mindful of your customer concentration, recognize its risk profile in the eyes of potential investors, and proactively address it with contingency plans to maintain financial stability in the event of a significant customer departure.

Retention is high, but is it the right one?

In contrast to customer retention, which gauges the ratio of retained customers versus churned ones, net revenue retention, or NRR, provides insight into dollar retention. When you lose a customer who contributes $1,000 annually, it’s less impactful than losing one who brings in $10,000 in revenue. That’s why you should focus on NRR.

NRR underscores the company’s ability to monetize its customer base, highlighting the significance of upselling and cross-selling (expanding customer value).

Ideally, a tech company should aim for an NRR exceeding 120%. Calculating NRR involves constructing a cohort analysis of revenue per customer over time, a task that may not be straightforward but is crucial.

NRR’s close relative is gross revenue retention, or GRR, which does not account for customer expansion. A strong GRR for enterprise sales typically hovers around 90%.

Strategic insight: Not all customers are created equal, and this relates to the previous point on customer concentration. It’s important to understand the importance of retaining dollar value of customers, and beyond that, increase the dollar value of your existing customers over time. This is called a farming strategy.

Even more important than attracting new customers is a hunting strategy. Unless you know how to retain and monetize your existing customers (land-and-expand strategy), allocating more resources to attract new customers may not be the most prudent use of capital.

By comprehensively evaluating these quantitative metrics and being aware of potential red flags, entrepreneurs can maintain a keen understanding of their business’ dynamics, while investors can acquire a holistic perspective on the health of a tech startup.

Nonetheless, it’s essential to bear in mind that no single metric offers a complete narrative. Qualitative elements such as the team’s morale and competence, market alignment and the competitive environment should complement the quantitative analysis.

 Itay Sagie, a guest contributor to Crunchbase News, is a seasoned lecturer and strategic adviser to startups and investors, specializing in strategy, growth and M&A. You can connect with him on LinkedIn for further insights and discussions.

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