The One Metric That Can Unmask Bad Revenue

Vanity metrics are the modern-day tricksters we all have to watch out for.

For McMansions, the vanity metric is square feet. Maybe it’s not such a great deal after all.

For sports teams playing in a weak division (hello Boston Celtics), it’s win-loss record. Are they really that good?

For app developers, the vanity metric is downloads. How many times have you downloaded software that you used for only a short period and then forgot about?

For startups, the potentially most misleading vanity metric is the one you’re most likely to trust above all others…

It pains me to say it, but it’s revenue.

It’s the one thing I always ask founders: How much revenue do you have? How fast are you growing it?

I mean, doesn’t it prove that customers see value in their product?

Doesn’t it indicate that the company has found at least the semblance of market fit?

Doesn’t it show that the company can sell?

As long as we’re not talking about really low sales figures here (less than $10K), the answer is yes, yes and yes.

Unless…

The startup is using revenue as a vanity metric to impress you and separate you from your money.

It could do this simply by spending its way into growth.

A company could have the most stupid products… or, for that matter, the most stupid management team… but if it’s loaded up with cash, you can be sure it’ll be able to sell product.

This is why I like the 40% rule. It’s not my rule. It’s Brad Feld’s. Brad is the founder and managing director at Foundry Group, a venture capital firm specializing in early-stage information technology companies. And he is also one very smart dude.

A Simple Shortcut

The 40% rule requires your growth rate and your profit to add up to 40%.

So if you’re growing at 10%, you should be generating a profit of 30%. If you’re growing at 30%, you should be generating a 10% profit. If you’re growing at 70%, you can lose 30%.

It helps you figure out the growth vs. profit tug of war.

All companies aim for profitability in the long haul. But how much profit you eventually make often depends on how fast you grow in the early-to-intermediate years.

And to grow, you need to spend. Spend more… grow fast… but profit less.

Or spend less… grow more slowly… but profit more.

I know where I come down.

I want companies to grow as fast as possible. But I also want that growth to be real. Spending $2 for every $1 of revenue isn’t real growth.

The 40% rule establishes a reasonable balance between growth and spending.

Using the 40% Rule

Unfortunately, I wouldn’t recommend using this rule for seed-stage companies. First off, profit doesn’t even enter into the equation this early. And revenue growth, if there is any, should be much higher than 40%.

I’m looking for at least 100% annual growth. And the startup’s spending at this stage may not even be focused on sales. For example, it could be directed to product development.

But you could use it at times for companies raising under Regulation A+. These companies have typically been around for a few years, pulling in decent revenue (from several hundred thousand to several million) and focusing on growing sales.

Tom Tunguz, a partner at Redpoint Ventures, made a chart that tracks growth plus profit metrics for public companies in years three through 16 – dating from their founding year.

(Editor’s Note: These are companies that were successful enough to go public. They represent the upper tier and, as such, their revenues and profits are higher than what is representative of startups as a whole. This is probably even more true regarding the early years.)

The chart shows that up to year five, revenue growth is too high for the 40% rule to be effective.

As you can see, after year nine, it becomes much tougher to achieve 40% growth plus profit. These years are a good proxy for late-stage startups.

Years six through nine – where startups are hovering around the 40% level – would be equivalent to a startup’s middle-stage years. This is where the 40% rule would prove most useful. There would still be a large number of companies achieving the 40% metric.

The rule is most useful when companies are scaling and when marketing and sales costs are stabilizing as revenues accelerate. Scaling usually happens post-Series A. So it might be a little too early for most Reg. A+ companies.

To refresh your memory, a majority of companies raising under Reg. A+ do so in a Series A round. But some do it in the later rounds.

There is no set rule for this. I expect Reg. A+ raises to happen more frequently in the later rounds moving forward. Two developments will lay the groundwork.

  1. Founders will better understand the advantages of raising from the crowd.
  2. The portals will do a better job of raising larger sums of money.

Since I’m making predictions, here’s another one.

The 40% rule will soon morph into the 50% rule. For one, costs are plunging. The cost to start a software company has come down about 95% in the last 15 years.

With billions of internet users and with consumers and companies being more receptive to technology adoption than ever before, scaling isn’t nearly as hard as it used to be.

Generating massive revenues without a huge spend is easier than ever.

That’s good news for early investors. Along with soft metrics like user growth, brand reputation, market excitement and founder reputation, there’s one old-school hard metric emerging… profitability.

In the meantime, be careful with revenue. It’s not so straightforward. Do what I do. Research how revenue is generated. Understand the spend and why it’s growing. And focus on unit economics like cost of customer acquisition and churn rates.

And where the fit is right, use the 40% rule.

Invest early and well,

Andy Gordon
Founder, Early Investing