More than 90% of all startups ultimately fail.
At the end of the day, startups die because they are not built upon healthy business models that can be sustained over the long term.
Economic growth is essential to startup success: companies that do not scale do not survive.
How, though, can you ensure that your business model is sound, that it will allow your startup to expand over time? This is where measurement comes into play.
In this article I’ll discuss 4 key financial metrics of which all startup founders should keep close track.
1. Fixed vs. Variable Costs
One of the most important pieces of financial data you as a startup founder have to amass (and continuously update over time) is the total cost of running your business.
Your total cost consists of the aggregate amounts of your fixed costs and your variable costs.
- Costs that do not vary with a company’s volume of production, i.e., costs that remain steady regardless of the amount of goods or services that a company produces;
- Examples can include rent, loan repayments, insurance, and office supplies.
- Costs that do vary with a company’s volume of production, i.e., costs that change in accordance with how much of a good or service a company produces;
- These costs increase (i.e., become more expensive) as production goes up and decrease as production goes down.
- Examples can include direct material costs, direct labour costs, sales commissions, and server costs (sources: 1, 2).
Understanding your total cost is crucial for various reasons, including the fact that the amount of money your business spends impacts whether, and if so then when, you can turn a profit (and how much that profit will be).
Outgoing money (i.e., costs) also heavily influences the length of your startup runway, i.e., the amount of time for which your company can survive without bringing in stabilizing revenue.
You can calculate your runway by taking your cash balance, i.e., the amount of money that your startup has to fund burn, and dividing it by your burn rate, i.e., the monthly rate at which your business is losing money.
- Runway = cash balance of $125,000 / burn rate of $25,000 per month
- Runway = 5 months (until you run out of money) (sources: 1, 2).
In addition to the fact that burn rate explicitly reminds you that your startup will indeed run out of money at some point in the future if you don’t eventually start bringing in sufficient revenue, it’s also a crucial metric to measure in terms of attracting investments. As Rosemary Peavler explains:
“Investors look at a start-up company’s burn rate and measure it against future revenues of the company to decide if the company is a worthwhile investment. If the burn rate is greater than forecast or if the company’s revenues are not growing as rapidly as they are forecast to grow, then investors may think the company is not a good investment. It may be too risky and so they may not invest their money.”
How can you effectively extend the burn rate of your venture? Here are 3 tactics:
- Operate as lean as possible by keeping your costs as reasonably low as you can: maintaining a low burn rate will maximize your financial options, thus allowing you to abort, adjust or restart one or more processes before reaching the end of your runway.
- Try to make your fixed costs more efficient: e.g., utilize new technologies — such as Google Docs, Quora, Skype, and Slack — to communicate with your customers and co-workers/partners, to collect data, and/or to conduct research more cheaply as compared to more traditional forms of market research, advertising, and communication.
- Increase your revenues: one method for doing this is to ensure that you’re maximizing the monetization of your startup.
2. Breakeven Analysis
The U.S. Small Business Association provides a succinct and helpful description of “breakeven analysis”, stating:
“Breakeven analysis is used to determine when your business will be able to cover all its expenses and begin to make a profit. It is important to identify your startup costs in order to determine your sales revenue needed to pay ongoing business expenses.”
Your company’s “breakeven point” is the point at which your revenues (i.e., the amount of money you’re bringing in from sales) exactly match your expenses (i.e., the amounts of your fixed and variable costs).
The point beyond your breakeven point is where you begin to accumulate profits, i.e., financial gains that exceed expenses, costs, and taxes.
There are many advantages to calculating your breakeven point. By understanding where your break-even point is, you are able to work out:
- How profitable your present product line is
- How far sales can decline before you start to incur losses
- How many units you need to sell before you make a profit
- How reducing price or volume of sales will impact on your profits
- How much of an increase in price or volume of sales you will need to make up for an increase in fixed costs
Here’s an example of what a completed breakeven analysis can look like:
Mathematically, the breakeven point is calculated like this:
Breakeven point = fixed costs / (unit selling price — variable costs)
The Queensland Government offers an interactive webpage on which business owners can calculate their breakeven points.
After completing your breakeven analysis, it’s important that you prudently consider the following key questions:
- Is this a realistic sales target?
- When do you anticipate being able to hit that target?
- Which resources will you need to get there?
- How much cash will you burn through in the meantime?
Answering these questions is crucial to gaining insight into a) how much money will you have to raise and b) the length of time for which will you need to invest such funds before breaking even.
3. CAC & LTV
Serial-Entrepreneur Steve Blank defines a startup as “an organization formed to search for a repeatable and scalable business model.”
As I’ve recently pointed out:
“The creation of a repeatable and scalable business model is the point in the start-up lifecycle where a new venture finds ways to consistently acquire new customers for less money than the revenue they are expected to bring in, thereby generating profit.”
Creating a repeatable and scalable business model is fundamental to a startup’s vitality because it makes it possible for a startup to achieve its most important objective, i.e., grow and scale.
Why is this the case?
Because companies that successfully implement repeatable and scalable business models then begin securing true sales and marketing efficiency.
This efficiency is measured in accordance with two key metrics:
- Customer Acquisition Cost (CAC): The total cost of convincing a potential customer to buy a product or service. Calculated by dividing the costs spent acquiring new customers (marketing, advertising, etc.) by the number of new customers acquired during the period in which the funds were spent. Example: if you spend $5,000 a month on promotion and you acquire 20 customers then your CAC is $250.
- Lifetime Value of Customer (LTV): The projected revenue that a customer is expected to generate during his/her lifetime. In the simplest of cases, calculated by multiplying the yearly cost of your service by the number of years for which a person is expected to remain a customer of your company. Example: if your service costs $100 per year and your average customer stays 5 years then your LTV is $500.
LTV can be difficult to estimate accurately during the earliest months or years of your startup when you lack concrete data. If that happens, consider looking to similar companies in your industry for an idea of what you LTV might be.
Why is it so important for startup founders to understand these two metrics and calculate them for their specific businesses?
Because getting these numbers wrong can be absolutely deadly to a new startup.
The 2012 Startup Genome report, which analyzed 650 Internet startups, revealed that “premature scaling is the most common reason for startups to perform poorly as they tend to lose the battle early on by getting ahead of themselves.”
In essence, premature scaling is an attempt to massively expand and grow your new company before you have successfully hammered out the intricate details of a repeatable and scalable business model.
In other words, failing to nail down the specifics of your CAC and LTV can facilitate premature scaling and, thus, startup failure.
The general consensus amongst many venture capitalists and entrepreneurs seems to be that profitable business models are those in which LTVs are at least 3x higher than CACs:
Furthermore, in order to grow sustainably your startup should pursue the ambitious goal of recovering the expense of your CAC within one year of spending the cash.
This may seem like a simple task but it’s actually very difficult to achieve in the 21st century, especially given that the Internet is now completely saturated with advertisement, products/services, and tech startups.
4. Cash Flow Forecast
The fourth key metric that all new companies must measure is “cash flow”, i.e., a comparison of the amount of money coming into your business versus the amount going out.
Positive cash flow refers to a situation in which your business takes in more funds than it spends whereas negative cash flow refers to the opposite, i.e., when the amount of money coming into your business falls short of the amount going out.
Cash flow is the blood of every startup organization: no cash flow = no business operations — period.
In a recent article, I provided a detailed explanation of the need for startups to understand and consistently track their cash flow numbers, noting that all prudent entrepreneurs should regularly practice cash flow forecasting (otherwise known as cash flow projection).
Cash flow forecasting is a projection technique used to determine the ‘financial health’ of your business.
The U.S. Small Business Administration explains exactly why forecasting is so important:
“Forecasting gives you a clear look at when money comes in, when it goes out and what money you are left with at the end of each month after you have paid your expenses and recorded your income. Knowing your numbers in terms of cash flow projection allows you to see potential pitfalls within the cash-in and cash-out flow of your business.”
Forecasting, thus, provides you with the key data you require to ensure that your startup doesn’t burn money faster than what you need in order to stay in business.
Many first-time entrepreneurs tend to confuse profit with cash flow.
Profit refers to income minus expenses but the problem comes with misunderstanding that “income” is not always synonymous with “cash in”.
As I previously explained this situation using the following hypothetical example:
“It’s entirely possible to have a ‘booming’ business but still be cash flow negative:
- You’ve begun selling your product;
- Your customer base is growing substantially; and
- Your long-term sales potential is massive
- You’ve taken on lots of debt in order to reach this point (i.e., to hire your employees, develop your MVP, market your product, etc.); and
- Your monthly expenses (e.g., rent, payroll, etc.) surpass the amount of revenue you’re generating
- If you don’t start bringing in more money than you’re spending then you’re going to run out of cash and be forced to close shop.”
Cash flow projections can’t, of course, predict the unpredictable but they can alert you to foreseeable potential hazards.
Whilst it might be best to let a professional account carry out the quantitative analyses, it’s still important that you as a founder grasp the principles of cash flow forecasting.
The most basic form of cash flow forecasting involves using a spreadsheet that lists monthly income and monthly costs alongside annual totals for each.
For added detail, you can break the costs down into different categories, which can be quite helpful in identifying seasonal variations in expenses (e.g., your heating bill will probably go up in the winter if you rent an office).
An example of a cash flow forecast spreadsheet:
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Originally published at http://www.appsterhq.com