Assuming the meeting went well, you are on step three — where investors start asking for a variety of financial and market data.
As you share data, it is helpful to understand the top five priority metrics investors care about and how to frame the numbers.
1. ANNUAL RECURRING REVENUE
As an entrepreneur, you are used to calculating the revenue of your business. But all revenue is not valued equally. Recurring revenue that will contractually repeat every year (in the absence of a cancellation) is valued much more highly than one-time revenue — typically project or implementation work. You will quickly be asked what “your ARR is,” i.e., how much annual recurring revenue do you have? As you run the business, it’s important to document and calculate the different types of revenue — recurring, repeat and one-time. Investors will want to know both your ARR and what percentage of overall revenue is recurring. For example, in Tyler Technologies’ November 2020 public filing, they referenced that 73 percent of their revenue is recurring.
2. THE RULE OF 40
The “Rule of 40” is highly valuable as it actually combines two metrics into one. As most entrepreneurs soon realize, there is a direct trade-off between your margins today and how much you are reinvesting into the business to grow it. To “normalize” this dynamic across companies with different growth and margin strategies, the Rule of 40 simply adds the year-over-year revenue growth rate plus the EBITDA margin of the business. Anything over 40 on this metric is generally considered good, but there can be several paths to get there. The business could be a fast grower at 50 percent growth but a negative 10 percent EBITDA margin (with, for example, heavy investment in sales and marketing driving both the growth and negative margin), or a more conservate grower at 10 percent annual growth but with a 30 percent EBITDA margin. Keeping track of this metric over time can help you calibrate and benchmark how effective your investments in the business are in generating the corresponding growth versus peers.
3. NET DOLLAR REVENUE RETENTION
4. TOP 10 CUSTOMER CONCENTRATION
Investors get worried if a few customers represent a large percentage of your total revenue. A change in leadership or priorities or a tough RFP process could mean you lose a large chunk of your revenue. This is especially true for government customers that rely on large federal or state contracts, but often less so in those dealing with local governments. A simple metric many use to measure is top 10 customer concentration — what percentage of total revenue do your top 10 customers represent? Ideally, this number is under 20 percent.
5. TOTAL ADDRESSABLE MARKET
As an entrepreneur, you are probably used to getting asked the question “What’s the TAM?” TAM (total addressable market) is a quick tool to understand what the dollar potential is for the business if all relevant customers bought all your products fully across all relevant parties. Investors want a data-driven approach to TAM — not just “There’s 90,000 local government agencies that we could sell to and therefore it’s a billion-dollar market.” A refined TAM would be: “Our focus is on mid-sized cities and counties in the 25,000-250,000 population range, of which there are 5,000 in the U.S. Our contract value for that population is $20,000 for our full package. So our focused TAM is $100 million.”
Generally, it’s good to start with a targeted TAM (often called SAM, for serviceable market) and highlight that piece and then show expansion markets as expanded TAM. For example: “In addition to our core TAM, there are 100 Canadian cities in our targeted size range and 900 relevant special districts — which adds an additional $20 million TAM.” Depending on the size of your business, venture capitalist investors are generally looking for at least $1 billion TAMs, while many private equity investors are more accepting of $200 million-$1 billion TAMs, especially if there is efficient growth and a clear path to grow TAM over time.
BONUS
This is just the beginning. Other relevant metrics are NPS (net promoter score — how much customers love your products), gross margin (how profitable the service is), sales efficiency (how efficient you are at growing sales) and more. However, if you have a clear grasp of the top five metrics and have good numbers, the rest are details that fall in place.
What’s your favorite metric not on the list? If you are an entrepreneur navigating these decisions, please reach out at Linkedin.com/in/ressler or sressler@gmail.com and I’d love to pay it forward.
Steve Ressler is a serial gov tech entrepreneur and investor.