When judging a startup as a potential investment opportunity, there are plenty of angles investors should consider. Of course, there’s the business idea in general, the market fit, the business model, and the team, just to name a few. While those are all very important elements, they aren’t necessarily calculable.
In order to get into the nitty-gritty of how a startup is doing, it’s important to be able to read and digest financial statements. When examining a startup’s financial statements, here are a few key metrics to home in on.
Cash/Burn Rate
For a very early-stage, pre-revenue startup, having cash in the bank can mean the difference between being able to pay rent or not. With no revenue, and money going out the door each month the clock is ticking. Running out of cash is cited as the second most common reasons startups fail, so it makes sense that investors would pay special attention to a startup’s burn rate. Startups should have a good idea of how much time they have left (also referred to as runway) with the cash they have now as well as how close they are to breaking even. Once a startup begins to increasingly generate revenue, having some amount of burn each month becomes less risky over time.
Net Income
Net income is equal to revenue minus all costs incurred. If this number is negative, it’s considered the burn rate. Net income dictates how much a company needs to raise in order to reach profitability.
Revenue
Once a company begins to generate revenue, the focus typically moves away from cash and towards growing that revenue. For investors, revenue growth can show how fast a company can grow under current conditions. It’s a good indicator of potential, as well as revenue cycles. Is the growth steady, or does it cluster?
How to Read a Term Sheet
Customer Acquisition Cost
Customer acquisition cost (CAC) measures how much it costs to gain a new customer. The lower the CAC, the better. The simplest way to determine CAC is to select a time period – say a year – and divide the number of customers gained during that time by how much was spent on marketing/sales during the same time.
Of course, average CAC varies by industry, so again, knowing what the industry average is can be helpful in determining how a company’s CAC stacks up. For some industries, it may be $100, and for others, it could be $1,000.
Churn Rate
Churn rate, also known as retention rate, measures the percentage of customers who are repeat customers within a set period of time. One way to measure churn rate would be to pick a certain time period, subtract new customers from total customers at the end of that period, and then divide that by how many customers the company started that period with. If at the beginning of the quarter a company has 100 customers, and at the end, they have 95 customers, the quarterly churn rate would be 5%. Obviously, companies want high retention and low churn. If a company is struggling with these metrics, heed that red flag.
Understanding Internal Rate of Return
Salaries
Like many of these metrics, a good way to gauge salaries is to see what the market rate is. A company who is paying excessively high salaries will blow through its runway a lot quicker than a company that is closer to the market average. Equally important, if a company is underpaying employees, they may struggle with keeping talent.
Gross Margin
Gross margin is the bottom line. Basically, it’s how much it costs to make something. To take it back to accounting class, gross margin is equal to revenue minus the cost of goods sold (COGS) and operating expenditures. Not including companies that are early-stage and pre-revenue, if a company’s revenue does not exceed COGS and operating expenses, that’s not a good sign. When considering a company’s gross margin, find out what is typical within that industry and compare.
There are more metrics to dive into than just the ones we’ve listed here, but these are a few that can give potential investors a pulse on where a startup’s financial health currently stands and where it is anticipated to go. Of course, optimal numbers and percentages will differ among industries. The best way to make informed decisions is to complete your own due diligence, research the industry, and go from there.
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
