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A VC Reveals the Metrics They Use to Evaluate Startups 鈥斅燭he Startup Tapes #031 - YouTube
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- So how long have you worked for Scale?
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- A little over four
years, now. So I'm entering
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my fifth year.
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- Yeah. And now you're VP, right?
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- Yes, mm-hm.
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- And so you're doing this
thing of looking at all
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the companies that are coming in
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and helping us figure out what
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to invest in and what not to invest in.
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- Uh-Huh, yep, mm-hmm.
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- So, on an average year,
what does that look like?
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- Yeah, yeah.
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- You know, for a VC like
Scale, it's like a hundred
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selling companies that
you look at in some way,
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shape, or form.
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- That's right.
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- Then, yeah.
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- Mm-hmm, that's right.
We typically look at
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hundreds of companies,
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and then we do deep dives
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into maybe tens,
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depending on the year.
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- Right. And so, at that
stage, this is a place where
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maybe they're on the second
meeting, and you're asking
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to see financials. You're like,
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"What does that look like internally?"
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And so, I've always wondered,
I'm from the outside.
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What do you have to do during that phase?
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Because all I get is
the partners telling me,
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"You're great, we'd love to
invest in you. Let's just look
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at what's happening inside."
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- Send us all your data!
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That's right. So, typically
what we're looking for
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in terms of financials is we
want to make sure you have
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product market fit.
And there are typically
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a couple of metrics we look for.
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The first I would say is
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we like to make sure
that there is AR growth,
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meaning if you're looking
at AR for the last, maybe,
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eight quarters, we want to
make sure that net new AR
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is growing over time.
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So you want to see a curve like this.
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Right? Yeah. That's
usually a very good sign.
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There's a lot of demand for
your product, a lot of interest,
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so your company is growing very quickly.
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- [TIM] So that's kind of
people's annual recurring revenue
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that you want to see?
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And what's a rough benchmark,
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like what's really bad territory,
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and what's really amazing territory
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as far as you're concerned?
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- Yeah, that's a good question.
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I would say you want to make sure
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your net new AR increases over time.
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So let's say you add 10,000
net new AR last quarter.
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The next quarter after that,
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you want to make sure you add 20,
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and then the quarter
after that maybe 40 or 50.
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You just want to show that
there's a trajectory of growth.
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- Right. And so that makes
a lot of sense, and again,
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this idea that it's kind of
the first thing to look at,
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because if you have sales
momentum that buys you
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so much freedom in terms of
a bad quarter, a bad hire,
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or any number of things that might happen.
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If you have that sales momentum,
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you can afford to do a lot of mistakes.
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So what are some of the
other things you look at?
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- So the other thing I
think is very important for
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SAS businesses is making sure
there's good sales efficiency.
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So for us, our metric is
looking at the magic number.
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And what the magic number
does is it looks at,
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based off of your sales
and marketing slant
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for the last quarter, what
new revenue are you adding
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for the next quarter?
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- Okay.
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- So there's kind of
this fine balance between
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what you spend in terms
of sales and marketing,
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and what new revenue you're generating.
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So that also ties into AR, of course, too,
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because that's the bookings portion of it.
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- Right.
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- Typically we like to
see magic numbers of one.
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- So what would that mean intuitively?
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- Sure. One is like if you spent a dollar
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in sales and marketing,
you want to generate almost
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a dollar in revenue.
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If the company is ramping very quickly,
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as in they're investing more
in sales and marketing spend,
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this will often come
down, but it's something
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that we expect as you grow.
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But typically we like to
see one when we invest,
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and that's the metric that we look for.
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- So again, it's this sense
of growth and trajectory.
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So we know we're just about--
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- Well, not spending too much money.
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So that's where the sales
efficiency number comes in,
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is you have this growth, but
you're not overspending for it.
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It comes a little bit more naturally.
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- Right. So let's dive
into sales efficiency.
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How do you measure that,
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and what's a good benchmark
for that, usually?
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- Sure. So, like I mentioned,
the magic number is one way
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that we track it.
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Generally, we want it to be one,
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and just keep it around there if you can.
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- Okay, that makes sense.
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So what are some of the
other things you look at?
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- Sure. I think our top
two really is the AR growth
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and the magic number,
the sales efficiency.
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We also look at gross margins,
so you want to make sure
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you're in line with other SAS companies,
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so typically around 60, 70%.
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You want to make sure that your
cogs are not out of control,
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because it is very important to make sure
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you have enough cash, because if you don't
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have enough cash, you're
basically going to go out
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of business, and nobody
wants that to happen.
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- Right. So this idea that
if you're really not able
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to capture a margin on
your current pricing now,
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it's unlikely to change
in the future, right?
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And you've got to stay within
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a certain benchmark to
have a good business.
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And so, in long term, I
think there's also something
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that maybe isn't telling
so much about the house
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or the company, but is important to VC,
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which is your potential
return, as well, right?
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So is that something you also look at
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when you look at companies?
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- We definitely look at potential return.
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But the return part is a
little bit tricky, right?
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Because we look at a whole bunch of
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different factors for this.
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So, financial is only one aspect of it.
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We also look at market size and all that.
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So, essentially, what we're looking for is
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how big can your company
become, and, based off of that,
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what can we potentially
make on the company?
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So generally, the higher
return the better,
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but it depends on stage.
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So if you're investing in
a more early-stage company,
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then the return, we expect
it to be a lot higher.
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If the company is more
leader stage, then we expect
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the return to be a bit lower.
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And we like to have a
balance in terms of having
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a certain number of early-stage companies,
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and then a certain number
of late-stage companies.
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- Right. So that could be
a financial consideration
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that's really not saying much at all about
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your company's health, but might lead a VC
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from passing on a deal,
just because they're not
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going to get a big
enough outcome out of it.
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- If you feel like you're not going to get
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a big enough outcome and you
have this model that you have
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for your fund and it doesn't
fit, then, most likely,
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the VC won't invest.
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- Right. But it could be
that another VC or another
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financial institution of some
sort would take that deal
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because you're performing
well, and they don't have
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as high of expectations in terms of
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the return they're going to
make on the overall investment.
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- Yeah.
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- Are there any other things,
any other considerations,
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that come in? Any other
metrics you look at?
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- Yeah. I would also look at
cash, because when we invest
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in a company, you want to make sure
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you don't spend too much, because, again,
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you don't want the company
to go out of business.
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And if you run out of cash,
then you're out of business.
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For SAS companies, you have
to invest money to make money.
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So we want to make sure,
when we invest in companies,
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that the cash will last
them at least two years.
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Yeah, so generally that's
why we spend so much time
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looking at your sales efficiency metrics,
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and your gross margins,
too, is to make sure
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that you won't run out of cash.
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- So what's the idea of
two years versus a year?
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I know companies have different
kinds of mental models
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about that.
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- Yeah. You know, I think
that's a very good question.
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Generally, we like to
think of it in two years,
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because if you can make
the money last two years,
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the company will hopefully
be big enough where they can
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raise at a bigger valuation, and that's
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what we're looking for.
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A lot of companies, especially
in the last couple of years,
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they've raised a little bit sooner.
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So they'll raise after a year.
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How often you can raise, it
depends on a mixture of things.
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Like the capital market,
so I would say funding
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came a little bit easier in
the last couple of years,
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now it's getting a little
bit more challenging,
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so the cash has to last
a little bit longer.
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But if you're thinking about
how much you're going to spend
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for the next year because
you're doing annual planning,
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this definitely should come into play.
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So if you think you're not
going to be able to raise
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for another year, then
you should probably spend
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a little bit less.
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But if you think you can
raise money in the next year,
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then you can probably
spend a little bit more
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and get higher growth.
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- But otherwise the prototypical
gross curve would be,
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you're able to take this
influx of funds, right,
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and really grow your company,
and get to the next benchmark,
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the next order of magnitude,
in that two-year period.
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- Right, yes, that is the goal.
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- And do another round, right?
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And some companies grow a
lot faster, and they're able
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to raise faster, and some of
them are never able to raise.
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- That's right. If you're
more capital efficient,
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then the cash will last you even longer.
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And we love finding companies
that look like that.
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- Yeah. Which is actually a
little bit atypical, right?
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I think a lot of people
just would rather have you
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on that kind of curve
and growing explosively,
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and just keep getting
new funding all the time.
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- That's right. I feel
like the market has changed
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a little bit, where at lot of
VCs now value profitability,
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a path to profitability, versus
the insanely high growth.
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Ideally, you can find
companies that have both,
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but it is really rare.
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Generally, the companies that do have this
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have some sort of virality.
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So there's some portion of
it that can make it go viral.
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Most traditional SAS businesses
are just not like that.
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You have to invest money
into sales, and marketing,
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and sales people in order
to drive the growth forward.
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- [TIM] Right, like they
grow fast, but not like--
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- Yeah, not like
exponentially. That's right.
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They're not consumer companies,
they're different models,
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after all.
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- [TIM] Makes sense.
Anything else you feel like
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we should cover?
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Anything else go through your mind
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when you review companies?
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- Yeah. I would say financial
is just one aspect of it.
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We also take a lot of other
things into consideration.
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At our stage, it is good
to use financial metrics
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as a filter, because we'll
get many companies, right?
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And if you have more than a million AR,
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then the financial metrics
are a good way to gauge
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the health of the business,
but at the same time,
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we also take things like
market size, team, et cetera,
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into consideration.
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So I would say financial
metrics are important,
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but it's only one factor that we look at.
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- Okay. Is there one gigantic
red flag or pet peeve
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when you get data from
companies that makes you go,
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no, no, no, no, no?
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- That's a good question.
You know, I like to get
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the underlying data.
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So oftentimes we'll have
people calculate metrics for us
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and present it to us that way.
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Sometimes I find that it might
not be calculated correctly,
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and I just want to get
the raw data and then
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figure it out myself.
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So if people were to send
us data, I would prefer it
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if they just sent us all
the raw data and have us
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figure it out, versus
calculate the magic number.
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I appreciate the effort, though,
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it shows you did your homework.
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- Yeah, but now they
know. Thank you so much!
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- Yeah, thanks!
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