How Angel Investors Should Analyze Startup Financials
Angel investing in early-stage startups (pre-seed and seed) is much different than investing in a public company or growth-stage startup, and therefore requires a different methodology for assessing the current and future financial performance. Balance sheets and income statements from the early stage do not necessarily paint the best picture of performance and future growth, as there is little to no historical data to analyze. This makes it difficult to evaluate companies using the same lens that one would for a publicly traded Fortune 500 company that has large amounts of historical data available. When evaluating early-stage startups, consider the three separate financial metrics outlined below.
Revenue & Growth
One of the most common metrics to review is revenue. The monthly or annual recurring revenue shows the amount of predictable revenue during this time frame basis. A growing MRR or ARR demonstrates that the market cares about the problem you are trying to solve and also that the team is able to execute and make this problem scale.
However, it is important to include growth rate when reviewing revenue metrics as revenue without the growth rate is out of context. A business doing $1M of revenue per year but not growing at least 2x year over year is much less valuable (and not angel investable) compared to a company that went from $250k -> $500k -> $1M -> $2M very quickly. Three major levers for terminal valuation during acquisition or at the public level that trickle down to venture are revenue, margins, and growth rate.
Revenue Run Rate
Revenue Run rate is a methodology of projected future revenues based on current revenue and growth. This can be found by taking the revenue in a period of time and multiplying it by the number of periods in a year. Run rate is a helpful indicator of financial performance for companies that have only been operating for a short amount of time. It can be calculated by using only a few weeks and/or months of data — this leads to an accurate measure of the company’s expected performance. It is important to note one of the downfalls of the metric is that seasonal industries (such as products that would see a sales increase during the holiday season) can experience a skewed run rate that may inflate future performance.
Gross Margin
Gross margin is important to track at an early startup as it shows how well a company can spend money and get a return on this spend. It can be found by [total revenue] — [cost of good sold (COGS) ] / revenue. This can be summed up as saying it is the amount of money the company keeps after it removes direct cost and is a useful metric that makes sure a company is operating with maximum efficiency. A “good” margin will vary from industry to industry. We at Early Light look for software companies with 70%-80%+ gross margins.
Financials (especially for pre-seed startups) are not the only indicators for determining whether to invest in a compelling company or not. There are many other quantitative metrics to continue to look into and explore that are equally (if not more important) to consider, which will be explored in future articles.
Overall we look for companies that have at least $100k in annual recurring revenue, high capital efficiency ratio, and 70%-80%+ gross margins. That being said, these are only guidelines to reduce risk. There are plenty of companies that are pre-revenue, slow growing, or with low margins that still make great investments.
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