How to talk about ARR for Consumption Based Businesses

This week we have the following CFOs answering your reader questions:

Today we’ll tackle:

Let’s get into it!

Dan from Mercury:

Do what'll be defensible as a public company from a GAAP perspective. There often is a lot of grey area for judgment where you should do the technical accounting work to support your conclusions on COGS vs. operating expense. GAAP at least provides a standard to help settle the debates, preferably with auditor sign-off. You don't want to restate financials for this when scrutinized by an auditor. And if there's valid rationale and support for classifying as an operating expenses, then great; just don't fool yourself on product economics.

For example, when calculating LTV, you should fully burden for variable costs regardless of whether COGS or operating expense. Also understand what's causing the debates — is it a pure academic argument? Concern about investor perception? Teams getting bonuses based on gross profit goals? Investors (who do their homework though not guaranteed) see through inflated gross margins.

Rama from Notion:

I would align on a strawman with your auditors and consistently report in this way. I wouldn’t be open to re-litigating when the number moves the “wrong” way. You can show an (internal only) pro forma for certain expenses if you really think that they are abnormally high one-time. But, the costs you mention above are typically ongoing variable costs…so you’re going to have to manage other opex with these in mind regardless of if folks like that answer!

Dan from Mercury:

I recommend keeping it simple and also being clear that the ARR is run-rate revenue, without getting into the nuances of what's truly recurring or not if your model is all usage-based. It's tempting to over-engineer the metric for all the nuances of your business model, but it often defeats the purpose by making it difficult for anyone to understand what the number truly is and doesn't necessarily change how you operate the business. That said, given this isn't a simple contracted value SaaS business, you should educate investors about the nuances of your business model — what drives seasonality, how does usage trend for cohorts/different segments, what are the different drivers of ARR growth, etc. Have that be part of your standard reporting to supplement an ARR figure. 

Rama from Notion:

Unless the usage based revenue is recurring (for example, an ongoing commitment each month or for full year), it may be tricky to call this ARR. I’d suggest naming it run-rate revenue and also sharing in-period revenue (monthly or quarterly). You may find it much easier to explain seasonality and growth accounting (new customers ramps, expansion, churn and contraction) this way, as well.

Dan from Mercury:

I'd start with doing a funnel analysis over time from the top of funnel all the way down to deal close to get an honest, holistic view of where the steps in the funnel have drifted. And then dig deeper into each.

Involve all of the GTM leads in this as a truth seeking exercise, not a blame attribution exercise. Where there has been drift, diagnose or if that's not possible, at least hypothesize. Viewing the sales funnel separate from the marketing funnel makes it easy for folks to operate and think in siloes versus thinking of GTM as one multi-funnel machine. The truth also is often complicated and isn't driven by a single step in the funnel.

Say you have a new aggressive competitor — that could lead to less efficient Cost Per Lead with a competitor aggressively competing for the same ICP in marketing channels and attention. It could also lengthen sales cycles as customers negotiate harder and also impact close rates. The more you get the various voices in the room, the easier it'll be to identify the meta themes that cut across multiple metrics. Sometimes it may be as simple as having a batch of new AEs who are still ramping and leading to lower sales productivity.

Rama from Notion:

To start, I’d build a full-funnel analysis that shows lead-to-win and conversion rates at each step over time. Along with conversion rates, I’d also build cost per conversion at each step.

For duration, I’d dig into the win rates. Is the lead-to-win ratio holding but taking longer? Or is it degrading (meaning closed lost is larger precent)? This requires a few quarters of data, but you may have enough to start to build this intuition.

Dan from Mercury:

Remind yourself what the purpose of the exec metrics dashboard is. A good dashboard should help execs quickly understand:

The FP&A view is helpful to start training your exec team on early, but start with the key things (e.g. revenue and gross profit vs. forecast, headcount growth, non-headcount expenses growth, burn-rate and cash runway).

The breadth and specific metrics really depend on your company's products/business model and stage. At an early-stage, focus more on growth and usage metrics with an eye on cash burn. A deck with 100 metrics is guaranteed to lose the impact of the metrics that really may matter and also overwhelm the exec team. There's no specific number that's right here — your goal isn't to cover every metric possible but the ones that help inform and drive action for the exec team.

After each review, ask for feedback and iterate and evaluate what people want to see more of and why. For pet metrics, consider whether they help the exec team operate better or if they make more sense at their respective team-level reports. And don't be afraid to ask that question and pushback.

Rama from Notion:

I would start relatively small (less than 10 metrics) and be sure you’re including both critical leading indicators (usage / adoption, etc) as well as output metrics (paid conversions, revenue etc). You can always add metrics — may be better to get everyone aligned on the KPIs that have the largest impact first & then add others that specific execs can focus on.

Dan from Mercury:

I'd recommend having a conversation with the new board member to understand what's driving these check-ins. It could be that he's new and really wants to dig in and understand the business — it could be overzealous but the intention may be coming from the right place. On the other hand, it could be that there's a breakdown in trust or visibility, leading him to stay closer to the business and feeling the need to micro-manage. Have an honest conversation and help him realize that that type of engagement could be distracting and/or cause thrash by over-reacting to short term fluctuations; but make sure you're addressing the underlying concern. Maybe it is a desire to get more granular reporting or status updates on momentum of your AI pivot. If product comes up in the board meeting, I would absolutely point to your VP of Product to answer the questions — true for directing questions to the subject matter expert outside of product as well. The board wants to see a strong, balanced executive team, not necessarily a CFO who knows everything across the company.

Rama from Notion:

It’s not unusual for investors to become more involved in downturns or moments of business uncertainty. Since this is an investor and Board Member, they likely have an expectation of access to management and data (and some corresponding rights).

I would recommend that you align with the VP of Product on the bi-weekly KPIs and metrics that they’re sharing! And, I would share them with the co-founders (also Board Members) as well. You should all have a shared understanding of what the metrics indicate and how you’re taking action on the findings. If an investor and Board member is consistently asking questions about specific KPIs and metrics, I would suggest including at least a summary in the quarterly Board materials & take-aways. If you want, you can suggest that the VP product speak to them in the meeting, but it’s very likely the investors and Board will also expect you to be aware of them and able to react.

Wishing you a CAC Payback period with clean and defined drivers,

CJ