How Investors Evaluate Your Business
What is your business worth to a potential investor? If it sounds like a complicated question, it is. Business valuation can vary a lot by market, vertical, business type, and even individual investor preference.
Regardless of your business’s specifics, however, there are some common metrics investors are likely to use to evaluate your business. It’s a good idea to have a strong familiarity with these before you start thinking about fundraising (and even if fundraising isn’t on your to-do list, they’re good to know!).
Key Performance Indicators (KPIs)
What it is: Key performance indicators (KPIs) are metrics that lead to your financial results. Your specific KPIs will vary based on your market, industry, and business model, but they’ll reflect the things that are connected to your business growth. For example, Google might consider the number of searches per day and the number of ads clicked per day – both activities that lead to their revenue generation.
Why it matters: Your KPIs measure the things critical to your business’s health, which is why they’re an important part of any investor-led valuation process. If these things are trending negatively, it’s a sign you need to look into what’s going wrong. Because they measure specific things that lead to revenue, KPIs can also help you isolate possible problems. Going back to our Google example, if searches were holding steady but ad clicks suddenly went down, that would be an indication that the breakdown was with the ads themselves.
Young companies sometimes struggle with these, which is actually another indicator of business health. If you can’t identify your KPIs, it’s a sign you need to get more familiar with what actually drives your business.
Examples: Once again, these will vary between companies and industries. For SaaS businesses, CAC and LTV are often KPIs, as is churn. For ecommerce, examples might be average order volume (AOV) or cart conversion rate (CCR).
Customer Cohort Analysis
What it is: A cohort analysis studies a group of people who have something in common, over a period of time. Examples of cohorts could be a group of children who entered kindergarten together, or people who all started work at a certain firm the same year. In terms of your customers, what they have in common might be something like the date they made their first purchase, the channel they used to find you, or their geography.
In the analysis, you track your cohort over a period of time to see how the group acted, and what their results were. Is there a difference in spending between customers who come in through pay-per-click vs. organic search? What about customers who bought this year vs. customers who bought last year?
Why it matters: Cohort analysis is a good indicator of product-market fit and customer experience. If your cohorts are showing consistently strong purchasing or renewal patterns, it’s a promising sign that your product is a good fit for your customers’ needs. It also indicates that you’re providing a good customer experience, since they’re happy enough to stay with you.
If there’s a significant shift in your cohort performance, then that implies a shift in how you’re serving your customers. New customer cohorts with positive gains (more renewals, higher-value purchases, etc) indicates that you’re improving. If your newer cohorts have lower results than your older cohorts, however, that’s cause for concern, and a warning sign that you need to investigate further.
Examples: Different industries typically focus on different metrics with their cohorts. For SaaS companies, customer cohort analyses often examine things like ARR, net churn, and gross churn. Ecommerce companies might examine things like return rates, repeat purchase rates, and basket sizes over time.
Customer Acquisition Cost (CAC)
What it is: Your customer acquisition cost (CAC) is a measurement of how much it costs your company to gain an average customer. CAC typically includes advertising costs, sales commissions, referral fees, and other marketing expenses. To get your CAC amount, you usually take your total related costs and divide by the total number of acquired customers.
Why it matters: CAC is the key to sustainable growth. If you consistently pay more to acquire customers than you get back from them in revenue, that’s a sign your economics aren’t right. If that’s the case, you might look at how to improve your marketing efficiency. This is why you’ll often see CAC compared with LTV (see below).
Examples: If you spend $1000 on marketing, and you get 200 customers, your CAC was $5. If you spent that $1000 on marketing and instead got 2000 customers, then your CAC was $.50.
Customer Lifetime Value Analysis (LTV)
What it is: Your customer’s Lifetime Value (LTV) measures the amount of gross profit you receive from them over the course of your business relationship.
Why it matters: It’s not enough to just have a high volume of customers – those customers need to generate enough income to cover your costs (just ask any startup that imploded by focusing on building a huge user base, with no revenue plan). In addition to your basic unit economics (i.e. can you sell your product for more than it cost to create it), comparing your LTV to your CAC is a good indicator on whether you’re growing sustainably.
Examples: Say you sell a subscription service for $100/year, and it costs you $20/year to provide the service, leaving you a profit of $80/subscriber. If a customer stays subscribed for 3 years, then their LTV is $240 ($80 yearly profit x 3 years = $240).
You could then compare your LTV to your CAC. If you spent $100 on marketing to acquire that customer, you would still have $140 profit. If the CAC was $500, however, then you’ll want to take a closer look at your growth channels.
What it is: Most of us are familiar with benchmarking – measuring something against peers or competitors to judge performance. In this case, you’re benchmarking your company against other companies of similar size and market position.
Why it matters: The metrics we’ve talked about can help you (and your investors) understand the health and opportunities for your business. In a vacuum, however, it’s not always clear what a “good” number looks like, particularly if your company is not yet profitable. Benchmarking against other companies similar to yours helps you get that bigger picture.
Example: SaaS companies can check their metrics against these benchmarks to get an idea of how they compare to their peers.
Having a solid understanding of these business valuation metrics will help you on and off the fundraising trail. When you’re talking to investors, they’ll want to see these numbers – and know that you’re comfortable working with them. But even if you’re not planning to raise funds for awhile (or at all), keeping a close eye on your valuation metrics will help you better understand and manage the health of your business.
And remember – you don’t have to do it all by yourself.