Picking the right revenue model is an important aspect to running a successful startup, but is a complex and often misunderstood process. In this blog post, we walk you through the most important terms and concepts you need to know about revenue to ensure that your company has everything it needs to make money and to monitor its progress.
1. Active Users (MAU, WAU, DAU, HAU)
The definition for "active users" varies for each company, as it depends on their offering and target audience. For instance, Facebook defines “active” as a registered user who has logged in and visited the site via any device, or as a user who took an action to share content or activity with Facebook friends via 3rd-party sites integrated with Facebook.
The important things to remember when measuring your active users are to: (1) clearly define it; (2) make sure it’s a true representation of “activity” on your platform; and (3) be consistent in applying that definition.
Here are a few other examples for different types of companies:
Social Platforms: common metrics of measure for activity are MAUs (monthly active users), WAUs (weekly active users), DAUs (daily active users), and HAUs (hourly active users).
Content Sites: a common measure of active users and activity on all kinds of content-based sites has been “uniques” (monthly unique visitors) and visits (page views or sometimes “sessions” if defined at a minimum period of complete activity).
E-Commerce Businesses: these businesses have a much more telling metric — revenue (and gross margin).
2. Average Revenue Per User (ARPU)
ARPU is defined as your total revenue divided by the number of users for a specific time period, typically over a month, a quarter, or a year. This is a meaningful metric as it demonstrates the value of users on your platform, regardless of whether those users buy subscriptions or click on ads as they consume content.
For pre-revenue companies, investors will often compare the prospects of a company against the known ARPU for established companies. For example, Facebook generated $9.30 ARPU in FY2015Q2 from its U.S. and Canada users.
3. Balance Sheet
A balance sheet is a document that details a company’s assets, revenue, and expenses. Balance sheets are typically calculated at a specific point in time, like at the end of a month, a quarter, or a year.
Below is an example of a balance sheet, from the article “How Do I Prepare a Balance Sheet for Business Startup?”:
Liabilities and Owner's Equity
Current Liabilities $1,000
Loans and Long-term Liabilities $50,000
Prepaid Insurance $2,500
Furniture & Fixtures $18,000
Owner's Equity $12,500
Total Assets $63,500
Total Liabilities and Owner's Equity $63,500
4. Burn Rate
Burn rate is the rate at which a company’s funds decrease. It’s especially important for early stage startups to know and monitor burn rate as companies fail when they are running out of cash and don’t have enough time left to raise funds or reduce expenses. Here’s a simple calculation:
Monthly cash burn = cash balance at the beginning of the year minus cash balance end of the year / 12
It’s also essential to continuously monitor company’s net burn vs. its gross burn:
Net burn [revenues (including all incoming cash you have a high probability of receiving) – gross burn] is the true measure of amount of cash your company is burning every month.
Gross burn on the other hand only looks at your monthly expenses + any other cash outlays.
Investors tend to focus on net burn to understand how long the money you have left in the bank will last for you to run the company (referred to as your "runway", which is typically measured in months). They will also take into account the rate at which your revenues and expenses grow as monthly burn may not be a constant number.
There’s all kinds of churn — dollar churn, customer churn, net dollar churn — and there are varying definitions for how churn is measured. For example, some companies measure it on a revenue basis annually, which blends upsells with churn.
Investors look at it the following way:
Monthly unit churn = lost customers/prior month total
Retention by cohort:
It is also important to differentiate between gross churn and net revenue churn:
Gross churn: MRR lost in a given month/MRR at the beginning of the month.
Net churn: (MRR lost minus MRR from upsells) in a given month/MRR at the beginning of the month.
The difference between the gross churn and net churn is significant. Gross churn estimates the actual loss to the business, while net revenue churn understates the losses (as it blends upsells with absolute churn).
6. Customer Lifetime Value (LTV)
Customer lifetime value refers to the present value of the future net profit from the customer over the duration of the relationship. It helps determine the long-term value of the customer and how much net value your company generates per customer after accounting for customer acquisition costs (CAC).
A common mistake is to estimate the LTV as a present value of revenue or even gross margin of the customer instead of calculating it as net profit of the customer over the life of the relationship.
Below is a way to calculate LTV:
Revenue per customer (per month) = average order value multiplied by the number of orders.
Contribution margin per customer (per month) = revenue from customer minus variable costs associated with a customer. Variable costs include selling, administrative and any operational costs associated with serving the customer.
Avg. life span of customer (in months) = 1 / by your monthly churn.
LTV = Contribution margin from customer multiplied by the average lifespan of customer.
Note: If you have only a few months of data, the safe way to measure LTV is to look at historical value to date. Rather than predicting the average life span and estimating how the retention curves might look, we prefer to measure 12 month and 24 month LTV.
7. Cohort Analysis
Cohort analysis breaks down the activities and behavior of groups of users (“cohorts”) over a specific period of time that makes sense for your business - for example, everyone who signed up for your service in the first week of January - and then follows this group of users longer term - who’s still using your product after 1 month, 3 months, 6 months, and so on?
A good cohort analysis helps reveal how users engage with your product over time. Startup investors especially appreciate this because it helps them to gauge how much people really love your product, since many startups are pre-revenue, and many of their users may not have voted with their wallets just yet.
Here are the steps for a cohort analysis:
Pick the right set of metrics rather than a vanity metric (like app downloads)
Pick the right period for a cohort - this will be typically be a day, a week, or a month depending on the business (shorter time periods typically make sense for younger businesses, and longer ones for more mature businesses)
Period 1 (day, week, or month): 100% of install base takes some action that is a leading indicator for revenue, such as buying a product, listing a product, sharing a photo, etc.
Period 2: calculate the percentage of install base that is still engaging in that action a week or month later
Repeat the analysis for every subsequent cohort to see how behavior has evolved over the lifetime of each cohort
The two trends investors like to see in cohort analyses are:
Stabilization of retention in each cohort after a period such as 6 or 12 months. This means you are retaining your users and that your business is building a progressively larger base of recurring usage.
Newer cohorts performing progressively better than older cohorts. This typically implies that you are improving your product and its value proposition over time.
8. Gross Margin
Gross margin is expressed as a percentage and represents the percent of total sales revenue that a company keeps after subtracting the cost of producing its goods or services. The higher the percentage, the more the company keeps on each dollar of sales (that will eventually go toward paying its other costs and obligations). In simple terms, if a company’s gross margins are 25 percent, for every dollar of revenue that is generated, the company will retain $0.25 before paying its overhead, which includes salaries, rent, and more.
9. Gross Profit
While top-line bookings growth is incredibly important, investors want to understand how profitable that revenue stream is, which is referred to as “gross profit”.
What’s included in gross profit may vary by company, but in general it consists of all costs associated with the manufacturing, delivery, and support of a product/service.
10. Month-over-Month (MoM) Growth
Month-over-month growth refers to the changes in user, revenue, expense, or profit levels compared to the previous month. MoM numbers tend to be more unpredictable as they are more affected by one-time events (e.g. stock market crash, natural disasters, months with many working days, months with many people on vacation, etc.).
Here’s a way to calculate MoM growth, according to the article, “MoM, QoQ and YoY comparisons”:
Month X – Month Y numbers
________________________ x 100 = Percentage Growth
11. Profit and Loss Statement (P&L)
Profit and loss is a financial statement that summarizes a company’s revenue, expenses, and profit during a particular period with the intention of indicating a company’s performance, and is also often referred to as "statement of profit and loss", "income statement," "statement of operations," "statement of financial results," and "income and expense statement”.
Here is an example of a P&L statement, featured in the Factor Finders article, "How to Make a Profit and Loss Statement for a Small Business".
12. Revenue (Annual Recurring Revenue, Monthly Recurring Revenue)
Revenue is the amount of money that can be recognized according to accounting policy.
Even if it is paid for upfront, usually subscription revenue ("recurring revenue") can only be recognized ratably over time as the service is delivered. If more money has been paid than can be recognized, the difference goes into a balance sheet item called "deferred revenue".
Revenue is often calculated in the following ways:
ARR (annual recurring revenue): ARR is a measure of revenue components that are recurring in nature. It should exclude one-time (non-recurring) fees and professional service fees.
MRR (monthly recurring revenue): Often, people will multiply one month’s all-in bookings by 12 to get to ARR. Common mistakes with this method include: (1) counting non-recurring fees such as hardware, setup, installation, professional services/ consulting agreements; (2) counting bookings (see #1).
13. Registered Users
Registered users refers to the number of users who have registered for your service. In most cases, the preferred user metric is active users, which is more indicative of actual product use - and often translates directly to revenue potential over the long term.
14. Run Rate (Annualized Run Rate or ARR)
Annualized Run Rate is the annual run rate of recurring revenue from the current installed base. This is annually recurring revenue for the coming twelve months if you don’t add or churn anything, and is calculated in the following manner:
ARR is the measure of recurring revenue on an annual basis. It should exclude one-time fees, professional service fees, and any variable usage fees. This is important to keep in mind, because in a given month you may recognize more revenue as a result of invoicing one-time services or support, and multiplying that number by 12 could significantly overstate your true ARR potential.
15. Unit Economics
Unit economics are the direct revenues and costs associated with a particular business model expressed on a per unit basis.
For instance: in a consumer internet company, the unit is a user. The fundamental unit economics in this case are:
To the extent that LTV exceeds CAC, you have a business. One of the major jobs of an entrepreneur is to understand the levers that impact those unit economics, and figure out ways to create structural advantages that shift them in your favor.
In this example, LTV and CAC are the primary metrics, but they are really the outputs of many other secondary metrics, which are the things you can most easily measure and influence. You can improve LTV by finding ways to increase the amount of money each user spends, or by determining how to improve user retention. CAC can be tweaked by optimizing your virality or improving the effectiveness of your online advertising.
Unit Economics are extremely important for startups, because they show (1) that you have a fundamentally sound business, and (2) that your business can scale.