Presented as part of venture capital content series in collaboration with Zayn Capital.
Venture capital (VC) has exploded in Pakistan in the last few years, with more startups popping up every month. It means more competition for you as a startup founder.
For this reason, it is more important than ever for you to be well-versed in the metrics VCs use to evaluate startups so that you can improve your odds of receiving venture capital. Additionally, the metrics VCs care about are important business metrics, so even if you’re not seeking venture capital, they can be helpful.
Investors and VCs use a variety of metrics to evaluate new startups. This includes market opportunity, traction, and financials.
1) Market Opportunity
A startup’s market opportunity is its potential customers or how much revenue it can generate if it capitalizes on its entire targeted consumer base. Identifying the market opportunity is vital for your startup and investors since it shows whether your business idea is viable. Additionally, it shows whether your startup’s target market has the appetite to support its business model.
Numerous metrics can be used to assess a startup’s market opportunity. Three of the most commonly used metrics are as follows:
Total Addressable Market (TAM):
TAM is the opportunity a startup would have if it were to capture 100% of the market share for its product or service.
When you know your startup’s TAM, you can gauge what marketing effort is needed to accelerate its growth. In addition, it helps identify which consumer segments and products will maximize revenue. Similarly, TAM shows investors what your startup can achieve in the future if it successfully expands its customer base and dominates the market.
While calculating TAM, you should not consider any constraints, such as competition, geographical boundaries, and language barriers.
Let’s use an e-commerce clothing store, Gul Ahmed, as an example and calculate its TAM.
Pakistan has a population of nearly 230 million people. Let’s assume that an average Pakistani man buys two shirts per year while an average Pakistani woman purchases 4 shirts per year.
Assuming that shirts are mostly worn by Pakistan’s urban population vs. shalwar kameez, which are more common among rural populations. 37% of Pakistan’s population lives in urban areas, which translates to 85 million potential customers for shirts. The male population in Pakistan is 51%; we can assume that 43 million are males (51% of 85 million) and 42 million are females (49% of 85 million).
Using our previous estimate that men buy two shirts per year and women buy four, we can calculate that men buy 86 million shirts annually (43×2) and women buy 168 million shirts yearly (42 x 4).
Based on these assumptions, the TAM for shirts in Pakistan is 254 million shirts per year.
Serviceable Addressable Market (SAM)
It is important to understand that the TAM metric assumes market opportunity without considering any constraints, such as geography or logistics.
Although your startup has a lot of potential customers, it’s difficult to serve them all. To address this limitation, VCs use SAM to determine what proportion of TAM your startup can reasonably cater to with its current business model.
Returning to our previous example, suppose Gul Ahmed is based in Lahore and does not currently have the funds to market and deliver its products to consumers throughout Pakistan. Furthermore, assuming Lahore has a population of 13 million, the total number of males in Lahore would be approximately 7 million (51% of the 13 million), and the total number of females would be approximately 6 million (49% of the 13 million).
Therefore, Gul Ahmed’s SAM would be 38 million shirts (a total of 2 for men and 4 for women in Lahore).
However, it is important to note that SAM for Gul Ahmed is calculated assuming that it is the only startup selling shirts in Lahore and thus has access to the entire target market in Lahore.
Serviceable Obtainable Market (SOM)
SOM is the proportion of SAM that a startup can realistically achieve, considering various factors such as its value proposition, the number of consumers it can reasonably reach through its marketing efforts, the level of competition, and its production capacity.
In other words, SOM helps you determine which consumers will most likely buy your products.
In our previous example, suppose Gul Ahmed only targets premium customers and has three competitors in the same market. Let’s also assume that all four e-commerce stores, including Gul Ahmed, can capture an equal market share and that only 20% of Lahore’s population is classified as premium customers.
Based on the assumptions above, Gul Ahmed’s SOM can be calculated as follows:
If 20% of Lahore’s population buys premium shirts, the total premium shirts market in Lahore would be 2.6 million (20% of 13 million). Moreover, the total number of male and female premium shirts consumers would be nearly 1.33 million (51% of 2.6 million) and 1.27 million (49% of 2.6 million), respectively.
Considering the above calculations, we can estimate the total market opportunity for shirts among premium consumers in Lahore is 7.74 million.
Based on our assumption that all four premium e-commerce stores will capture an equal market share, the SOM of Gul Ahmed would be approximately 1.94 million shirts (one-fourth of 7.74 million).
Traction is another important metric VCs use to understand how your startup is performing and may perform in the future. Traction describes a startup’s progress on different fronts, such as revenue growth and customer acquisition.
Traction is an important metric for VCs because merely having an innovative or promising idea is not enough to demonstrate that you have what it takes to build a successful startup.
Some popular methods for determining a startup’s traction are as follows:
Month-over-Month growth (MoM)
MoM growth of various factors, such as revenue and active users, is used by VCs to determine if your startup is progressing and on an upward trajectory.
In our example, if Gul Ahmed earned PKR 5 lacs last month and PKR 6 lacs this month, the month-over-month revenue growth would be 20% (the change in revenue as a percentage of last period’s revenue).
Number of Active Users
The number of unique users visiting a startup’s website during a specific period is called active users. The number of active users is also used to assess the popularity and growth of a startup.
However, there is no universally accepted method for calculating the number of active users. Different companies measure active users in different ways. For example, Meta (Facebook’s parent company) defines “active users” as accounts that have logged in on Facebook or Messenger within 30 days of a user’s last active date.
Website visitors, downloads, and subscribers
Consumers worldwide are increasingly inclined to shop and use services online due to affordable technology and increased internet access, particularly after the coronavirus pandemic.
By tracking factors such as website visitors, downloads, and subscribers, you can determine whether your startup is performing well and attracting potential customers.
The conversion rate tells investors how successful your startup is at convincing visitors to purchase.
This metric can be calculated by dividing actual paying customers by the total number of people who visited a startup’s store or website during a specific period of time.
Dropbox’s conversion rate, for example, is the percentage of users who switch from using only the free 2 GB storage to becoming paying customers for more storage space.
Your startup’s financial performance can be measured using various metrics, such as its revenue, net profit, and free cash flow positions.
Cash Flow Position
As a startup, managing cash flow is crucial because you are still in the early stages of the business cycle and cannot negotiate favorable terms with suppliers and debtors. The costs of running your startup must also be balanced with your expansion plans.
This is why startups with sufficient cash flows to comfortably meet their obligations, such as rent, salaries, and utility bills, are considered more attractive to VCs. It shows them that founders have a sustainable business model and have the ability to successfully help their businesses survive and thrive.
As the name suggests, unit economics is a metric to understand how profitable it is for your startup to sell one product or service.
There is a difference in metrics used by software-as-a-service (SaaS) and non-SaaS startups.
The most important metric to understand a non-SaaS startup’s unit economics is its contribution margin.
The contribution margin is the amount of money a startup makes per product sold to cover its fixed costs and eventually earn a profit.
It is calculated by deducting variable costs per unit from the unit price. Let’s take Food Panda as an example to better understand what a contribution margin is.
Food Panda is a well-known third-party platform that offers delivery services to Pakistani restaurants and stores. Let’s say a delivery costs PKR 100 on average, PKR 50 for fuel, PKR 50 for the rider’s salary, and the company’s average delivery charge is PKR 200. This means that on an average delivery, Food Panda incurs variable costs of PKR 100 while earning PKR 200 in revenue.
Based on the assumptions above, Food Panda’s contribution margin will be PKR 100 per delivery.
Let’s also assume that the company’s monthly fixed costs, such as office rent and software subscriptions, total PKR 1,000,000. Based on the previously stated assumptions, we can deduce that Food Panda will need to make 10,000 deliveries per month to break even (PKR 1,000,000 divided by PKR 1,000).
Therefore, Food Panda will be profitable only if its monthly deliveries exceed 10,000.
Based on Food Panda’s example, we can infer that the higher the contribution margin, the better. However, it is important to note that increasing your startup’s contribution margin should not come at the cost of lower demand for products, which would lead to lower profits.
If you run a SaaS startup, investors will focus on recurring revenue, customer acquisition cost (CAC), customer lifetime value (LTV), and churn rate.
As the name suggests, recurring revenue is the portion of a startup’s revenue that is expected to continue in the future.
The greater the percentage of recurring revenue as a percentage of total revenue, the better. This is because it communicates to investors that your startup can sustain itself and is less susceptible to external shocks. Different factors may contribute to recurring revenue, including long-term contracts, recurring subscription models, cross-selling, and a loyal customer base based on brand loyalty.
Recurring revenue can be calculated over different time periods, such as monthly or yearly, by excluding one-time revenue sources such as installation and hardware fees.
a. Customer acquisition cost
Customer Acquisition Cost (CAC) refers to how much a startup spends to attract new customers through its marketing efforts, such as the costs of running social media campaigns, installing billboards, and developing advertisements. The lower your startup’s CAC, the more efficient and appealing it is to investors.
CAC can be calculated by dividing a startup’s total marketing costs during a specific period by the total number of new customers gained over the same period.
For example, if Gul Ahmed spent PKR 100,000 on social media advertising in 2021 and attracted 10 new customers, its CAC would be PKR 10,000 per customer in 2021.
On the other hand, customer Lifetime Value (LTV) shows investors how much revenue a startup might make from a customer minus the costs expected to be incurred to retain the customer over the course of his or her shopping lifetime.
In the case of Gul Ahmed, if one shirt sells for PKR 1,000, then the total revenue generated from that customer would be PKR 2,000 per year (based on our previous assumptions). Furthermore, subtracting the costs of completing the sale, such as taxes and delivery costs, yields Gul Ahmed, an annual profit per male consumer.
Assuming that both taxes and delivery costs for a shirt are PKR 100 each, selling shirts to a male customer (purchasing two pairs per year) would be PKR 400. As a result, Gul Ahmed would profit PKR 1600 per male consumer annually.
Let’s now assume that the average male consumer buys shirts only from Gul Ahmed for 40 years in his lifetime. In this case, LTV for one male customer would be PKR 64,000 (PKR 1,600 profit per male consumer multiplied by 40 years).
b. Churn rate
The churn rate is financial metric investors use to evaluate a startup’s performance. This is the rate at which a startup loses customers.
The churn rate informs investors about the quality of your startup’s products and services and how it works to retain customers and increase recurring revenue. A high churn rate may indicate a feeble business model infected by lower-quality products and poor customer service. All of these factors would ultimately harm the startup’s profits and growth.
To calculate the churn rate, divide the number of customers lost by the number of customers gained during a given time period. Then multiply the result by 100 to get a percentage.
For example, if Gul Ahmed loses two customers per year and gains ten new ones, his annual churn rate would be 20%.
c. Conversion Ratio
The conversion rate tells investors how successful a startup is at convincing visitors to purchase or become paying subscribers.
It can be calculated by dividing actual paying customers by the total number of people who visited your startup’s store or website.
For example, Dropbox’s conversion rate is the percentage of users who switch from using only the free 2 GB of storage provided to all registered users to becoming paying customers to obtain more storage space.
3 Key Takeaways
- Founders should be familiar with the various metrics used by VCs to increase their chances of obtaining funding for product development and expansion purposes.
- The key metrics that founders should consider are the startup’s market opportunity, traction, and financial performance.
- It is important to note that companies in various industries and sectors may calculate metrics differently to accommodate their unique differences.
VCs use a variety of metrics to evaluate a startup’s performance and determine whether or not the startup is worthy of the VC’s capital. As a result, it is essential for you, as a founder, to understand the previously stated metrics so that they know which areas of your business require improvement.
Using this approach, you will be better positioned to successfully obtain startup funding.