Original article by Wout Bobbink & Goort de Bruijn
Quick question: how often do you as the founder of your own startup check your numbers? If your answer is ‘not too often’ you should definitely continue reading this blog post!
When you are not steering your company using several critical success factors (or KPIs: key performance indicators), then you are navigating your startup without a compass. How do you determine what path to follow when you do not know how you are spending your money, which sales and marketing strategies are working well and what products or services are successful? Stay in control and grow your firm by adopting the ten KPI’s explained below!
What is a key performance indicator?
Before we deep dive into several KPIs often adopted by startups it is good to briefly discuss their background: key performance indicators are measurable values (and hence objective values) that function as a measure of performance for your firm. They help you determine whether crucial goals are being achieved. KPIs are vital metrics that help you distinguish successful activities from less successful ones.
Not every firm uses the same KPIs, there exist numerous and which ones are appropriate to use depends on your type of industry, company and even department/activities. It is not difficult to imagine that an online SaaS (Software as a Service) startup wants to measure different things compared to the HR department of a large corporate firm.
The SaaS startup will likely be more interested in things like the number of active users per month, the churn (amount of unsubscribes), and the burn rate (total negative cash outflow). In contrast, the HR department of the large firm will likely keep an eye on the cost per new hire or the headcount (number of employees within a company or department).
This is important to realize as the ten KPI’s that we will discuss today will not be appropriate for each and every firm for the reasons described above. However, are you planning on tracking your numbers more consistently, so you are better able of steering your company and informing yourself, potential investors or shareholders? Then the list below will provide you with more than enough inspiration, irrespective of your company’s nature or business.
1. Active users
The number of active users is very interesting for online services and apps. Think about online software, social media platforms, online games and mobile apps. Active users represent the amount of unique individuals/visitors (not to be confused with the number of sessions) that perform activities on an app or webpage, e.g. per month.
When you have insight in the number of active users you can better predict the demand for a product and the user growth rate. Moreover, it will provide you with information regarding potential for revenue generation.
2. Gross margin
The gross margin (displayed as a percentage of revenues) shows you the difference between the total production costs of your product or service and the total revenues of the related sales. Long story short: total revenues minus total costs. You calculate this insightful figure as follows:
Gross margin = (Total revenues – total costs of production) / total revenues * 100%.
A high gross margin means that you generate relatively low costs related to the production of your products or delivery of services. Hence, it is intuitive that the gross margin of a SaaS firm is much higher than that of a 3D printer production firm as the production of printers is (likely) more costly compared to the delivery of online software.
In order to arrive at your firm’s operating profit (EBIT) you deduct operational expenses such as sales, marketing, R&D, etc. from the gross margin. A high gross margin therefore automatically means that you have more margin to cover such operational expenses. Moreover, you could use your gross margin to compare your performance to similar firms to see how competitive you are in terms of buying (raw) materials and sales price.
3. Burn rate
Cash is king! When you are a startup founder and have never heard about the burn rate, you should scratch your head. The burn rate is vital for determining the runway (see point ten below) and helps you establish at what point in time your firm will be out of money based on your current cash flows. The burn rate is defined as the net outgoing cash flow (e.g. per month), or in the form of a formula:
Burn rate = total cash inflow in month X – total cash outflow in month X à when outflow > inflow.
Having a positive burn rate means you have spent more money in a given period than that you have earned. Say that you own €50,000 in cash at the beginning of the month and are left with €40,000 at the end of that month. That would mean that in this specific month you have spent €10,000 more than you have earned and hence your burn rate is equal to €10,000.
When you have more money flowing in than out of your company, your burn rate is negative. This might seem counter intuitive, but is in fact a good thing!
4. Conversion rate
The conversion rate is the number of people that performs a certain action on the basis of a ‘call to action’ represented as a percentage of the total amount of people that have been exposed to the call to action.
For instance, let’s say you curate a blog page that includes a sign up form for a weekly newsletter in which new blogs are shared. If a thousand people would visit this blog page and one hundred of them subscribe themselves for the blog’s newsletter (the call to action) then the conversion rate is 10%.
Conversions occur on various levels: from lead to client, from website visitor to newsletter follower, from Facebook visitor to webinar subscriber, etc. By measuring conversion rates and experimenting with different calls to action or webpage lay-outs you can try to improve your conversion rates and sequentially create more leads or customers.
The eventual conversion to a final customer provides validates both the ability of a firm to sell a product/service and the demand of the market for that product/service.
5. Customer Acquisition Costs
Customer acquisition costs (CAC) show the average expenses required to acquire a new customer. These typically include sales and marketing expenses. You calculate CAC as follows:
CAC = Total expenses of acquiring new clients / total new acquired clients
The CAC informs you about the effectiveness of your sales & marketing strategy and helps you with optimizing the return on investment (ROI) of these tactics. It is therefore important to monitor your CAC for your different sales & marketing activities so you can learn which acquisition channels are more effective than others.
Are you acquiring many new clients via Google Adwords and via Facebook advertising, but is your CAC lower for Facebook advertisements? Then save costs and increase your profits by shifting investments to Facebook advertisements!
6. Customer Lifetime Value
The customer lifetime value (CLTV or LTV) is a prognosis of the total revenues that one client will generate on average during the full period that he/she is buying or using your services or products. There are various ways to calculate the LTV (ranging from Childs’ play to very complex versions) and this infographic by Kissmetrics describes three methods based on a Starbucks case study.
The most simple way of calculating Starbucks’ LTV as described by Kissmetrics is to multiply the number of average visits of a customer to Starbucks per year by the average sales to a customer per visit and then sequentially multiplying that by the number of years that this individual is a client (number of visits * sales per visit * lifetime of the customer). For the LTV of software applications you can also check out this article.
Now why is the LTV so useful? That is because it provides you with extremely important insights when used in combination with the aforementioned CAC. The LTV shows you what you earn per client during his/her lifetime as your customer; the CAC shows you the costs of acquiring a new customer. Hence, when your CAC exceeds your LTV you are in trouble! Apparently the costs of acquiring new customers is higher than the revenue they generate.
7. New leads and clients
KPI #7 is plain and easy: the number of new leads and new customers acquired in a given period. Each and every firm has (or should have!) targets related to acquiring new customers. On the basis of the conversion rate (see number four above) from lead to client you can calculate the number of leads you need to achieve your target of new clients. If you seek to acquire 100 new clients per month and your conversion rate of lead to client is 10%, you will need to generate 1000 leads per month!
For firms that are working with subscriptions it is recommended to also have a look at the churn rate (or turnover rate). This rate is calculated as follows (for a period of one month):
Churn rate = (number of customers at the start of the month – number of customers at the end of the month) / number of customers at the start of the month * 100%.
The churn rate is crucial for firms with a business model that include recurring revenues and shows the amount of customers that cancel their subscription during a given period. A low churn is a good indication as it means that few customers are leaving. And trust us; keeping your customers is much easier (and cheaper!) than acquiring new ones!
8. Revenue (growth)
Almost as simple as the previous one: revenue (growth)! The existence of revenue validates that there is demand for your products or services and revenue growth indicates that you have adopted an effective sales and marketing strategy.
Revenue growth expressed per week or month is not always insightful as it can fluctuate significantly during such short periods of time; especially if you have just established your startup. More informative is revenue growth for semiannual or annual periods, e.g. by adopting the Compound Annual Growth Rate. Investopedia has created a tool so you can perform this calculation easily yourself. The formula looks like this:
CAGR = ((Revenue start period/revenue end period) ^ (1 / (end period – start period)) – 1) * 100% à where a period often is a specific year of interest.
9. Operational costs as a percentage of revenues
Why don’t you try to allocate your operational expenses in a given period over a number of categories? Why? Well, not because it is just so much fun, but because it can help you in managing your business!
You could use the following categories: Sales & Marketing, Research & Development and General & Administrative. Personnel could be a fourth category but you could also include personnel costs over the three categories mentioned above.
The next step is to represent all costs for each category as a percentage of your revenues (by dividing the costs of each category by your total revenues and multiplying the result with 100%). Below an example of how your results could look like:
- Sales & Marketing costs: 25% of revenues;
- Research & Development costs: 15% of revenues;
- General & Administrative costs: 5% of revenues.
So then, how does this help you in managing your startup? Well, first of all these costs are so-called indirect costs, meaning that they do not directly depend on the number of products you create or services you deliver. This means that they are generally easier to reduce temporarily when this is required (when you need to cut costs for instance).
Moreover, if you ever need to create a financial forecast, for instance when applying for funding, then this exercise will also help you in testing the assumptions behind your financial plan. You could for example compare your forecasted revenues with your Sales & Marketing expenses expressed as a % of total revenues in all the years of your financial plan.
When your revenues spike but your Sales & Marketing as percentage of revenues stay the same or decrease you should (re)evaluate whether you are planning to invest enough to achieve your expected revenue growth.
Vital for every startup: the runway. The runway shows you the time your startup has left until there is no money left anymore, usually expressed in a number of months. The runway is hence closely related to the burn rate (revisit point three above) and is calculated as follows:
Runway = current cash position / monthly burn rate.
This means that you are literally looking at your bank statement of today and that you calculate on the basis of your burn rate how many months you can still survive with the cash at hand. This is crucial for startups as such firms often want to grow faster than they could organically, often resulting in more costs than revenues.
By measuring the burn rate and runway you know exactly how much money is burned every month and when you will need additional funding. When your runway is short it is time to start looking for new financing as soon as possible (unless you manage to bootstrap your firm).
Only for startups?
Whether you are a founder of a tech startup or not, make sure that you take some time to learn which figures are most important for the performance and growth of your firm and start measuring! This does not only show you the performance of your firm, but also the performance of the people you work with.
Assign responsibilities of specific targets to your team members on the basis of their expertise and periodically check whether they are meeting their targets. You might not have expected it, but in this way key performance indicators can propel growth of your firm!