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TMT Startups: What Investors are Looking for in Your Finances
April 13, 2022
Authored by RSM Canada LLP
Joel A. Humphrey, CPA, CA shared this article
ARTICLE | April 13, 2022
Understanding key metrics can help you pitch your company with clarity and direction.
As you seek financing to expand your tech startup company’s operations, there are certain metrics that financers will want to evaluate as they determine whether your business will be a beneficial investment. Such information can be especially important for later stage technology companies looking for funding in later rounds. We have explored some of these metrics below in two overarching categories: revenue and cash flow.
Part 1: Revenue and growth
Sales and total addressable market revenue
As a tech startup looking to gain the investment of those considering a financial interest in the company, potential investors are particularly concerned with sales growth prospects in their evaluation of the business. As startups are usually in a pre-income stage of the business life cycle, investors will want to see the potential for scalable revenues with limited barriers to achieving incremental sales growth. Potential investors will consider the year-over-year revenue growth in dollars, as well as the nature of the revenue model and total addressable market (TAM) of the business.
Investors will compare tech companies with similar revenue models to each other to gauge relative strength. For example, comparing Netflix’s subscription base to Google’s search engine usage may not be appropriate because the basis for earning revenue off each model is different in nature. Overall, investors will prioritize businesses that show they have meaningful, recurring consumer relationships. This translates to more reliable and predictable future sales projections compared to companies with less consistent customer relationships, regardless of the revenue model used.
Customer retention can be measured as the churn rate, which indicates the proportion of users who stop using the business’ offering over time. Businesses with recurring or subscription models will experience less churn than activity-based models. This increase in reliability of the consumer relationship may come at a higher cost of acquiring customers, but the lifetime value of expected revenues from these relationships may be higher than their non-recurring revenue model counterparts.
To evaluate the TAM of the business, investors will consider both the current demographics of the target market along with expected changes to customers’ consumption tendencies to analyze the long-term trends. This will help investors weigh the future growth potential of the business and consider whether the offering will remain relevant to fulfilling consumer needs and wants in the future when the business has matured.
Margins and scalability
While revenue is the primary factor for investors considering startups, profit margins should not be ignored at any stage of the business lifecycle. Investors will be concerned with the business’ ability to generate future profits as operations scale up and will evaluate the business’ efficiency in growing profits using their invested capital.
A simple way to evaluate efficiency of invested capital is to compare capital expenditure invested by the business to the marginal revenue increases earned from those investments into the business’ cash generating assets. If a business shows meaningful increases to its top line from those investments made, that indicates that the company efficiently allocates capital and that an investor’s contributed funds will be put to effective use. Because startups typically try to limit their usage of cash, such businesses can also compare marginal revenue increases to head count or salary costs to evaluate employee productivity and efficiency.
Part 2: Cash flows
Given that investment in tech companies typically requires significant financing to fund research and development, prototyping, and other exploratory and/or experimental efforts, cash flows are an area of significant interest to potential investors in their evaluation of a startup’s finances. As startup efforts are capital-intensive, investors will evaluate the burn rate of the company’s cash balance, and purposeful use of cash.
The burn rate is the rate at which a company depletes its cash pool in a loss-generating scenario. Burn rate in particular is a common metric of performance and valuation for startups, which are often unable to generate a positive net income in their early stages.
You can determine your startup’s burn rate by dividing the company’s total cash by its monthly operating expenses. Alternatively, you can calculate the net burn rate—which shows your bottom-line cash usage—by dividing your cash by monthly operating losses, assuming your startup is in a loss position.
Return on investment
Companies may demonstrate purposeful use of cash by disclosing the expected return on investment (ROI), or operating benefit of a capital purchase. As mentioned above, tech companies in the startup phase are likely making significant investments and capital expenditures to become operational entities. The ROI will measure how efficient or profitable an investment will be by comparing how much you have paid for an investment vs. how much you have earned on the investment.
The ROI is the percentage of your initial investment that is paid off within some time interval, such as annually. You can calculate ROI by taking your net income (or loss), divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned.
The break-even point—calculated by total fixed costs divided by contribution margin—outlines when an investment will generate a positive return. As a supplement, the break-even period measures how long it will take for your operations to generate enough of a profit to cover the initial costs.
Combining ROI and break-even figures can provide a more complete picture to investors about cash flow management. Indicating plans for cash inflows and outflows, as well as showing expectations on cash usage as discussed above, will help paint a more appropriate picture of how you are using your cash to benefit the growth of your startup.
Investors may be interested in specific cash inflows and outflows that correlate directly to the company’s action plan for growth. For example, customer acquisition costs are a cash outflow required for a company to acquire a new customer. Investors might compare these costs to revenue generated by customers to consider the growth and profitability trajectory for the company. To calculate your customer acquisition costs, divide your sales and marketing costs—including overhead expenses in these departments—for a given period by the number of customers acquired during that period.
It usually costs more to acquire new customers than to retain existing ones, so financers might also assess customer lifetime value; the revenue that one customer can generate for your startup over the lifetime of their subscription to your product or service. Investors may benchmark the lifetime value of your startup against similar established or up-and-coming tech companies to determine the viability of your revenue projections, the sustainability of profits, and customer acquisition costs. Where possible, investors may be pleased to see recurring revenues from a one-time customer acquisition cost.
Finally, seed stage investors or venture capitalists will want to understand the likelihood of customers wanting to repeatedly come back to your product. Investors will often look at frequency metrics alongside customer acquisition costs to gain insight into how often end consumers engage with your product within a certain period. Frequency metrics are particularly valuable when assessing anticipated growth or sustainability for subscription-based offerings.
Both revenue and cash flow are vital areas that will sway potential investors toward or against supporting your business. Providing details in these areas can help you gain the confidence of potential investors and help you pitch your company with clarity and direction.
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This article was written by Terry Booth and originally appeared on 2022-04-13 RSM Canada, and is available online at https://rsmcanada.com/insights/industries/technology-companies/tmt-startups-what-investors-are-looking-for-in-your-finances.html.
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