Leveraging portfolio analysis to improve your fund’s IRR, a CFO’s perspective
BELLE: Thank you so much to everyone who gave some time today to join our conversation. We’re gonna be talking about leveraging portfolio analysis to improve your funds. To kick things off. My name is Belle and I’m leading growth for our investor product. Kristian is the founder and CEO at FinStrat. FinStrat Management was founded in 2017. They provide accounting finance reporting services to B2B SasS, investor-backed companies, Angels’ family offices, and venture funds. They’ve helped raise over 100 million dollars in debt and equity financing for their startup clients.
KRISTIAN: I founded the company back in 2017. Initially, when we started, the focus was on providing CFO-led accounting and finance services to founders. Since then, the company has evolved. We operate at the intersection of the shared interests of founders and investors, both Angels and VCs. With a whole scope of services, we’re in this unique position where we not only understand founders and what they’re interested in, in terms of monetization but similar with investors, both Angels and VCs.
BELLE: Excellent. And yes, you’ve been a Chartered Financial Analyst(R) (CFA) since 2004. So good context to add just like the in-depth understanding from the financial perspective, which we wanted to bring in today.
KRISTIAN: That’s right. Next year will mark two decades as a CFA charter holder. For those who may not be as familiar with the designation international license, it is significant in the scope of investment analysis. I am very fortunate to hold a handful of accounting investment roles over my career and Finstrat Management was just a great way to help share my expertise and experience with the rest of the market.
BELLE: We’ll just quickly talk about Visible. Visible investor platform is all about post investments, monitoring, and reporting. Visible was founded in 2015. We’ve been profitable since 2017. We’re supporting customers in over 47 countries and have over 350 venture funds on our platform, thousands of founders, and users on six continents.
First I will dive into the importance of having an in-depth understanding of financial performance data, where to find benchmark data and how to use it, which metrics are most important, and what they tell you. And then Kristian will share a dashboard example of how you can evaluate company performance. Then we’ll end with tips for moving from analysis to action.
Kristian, I would love for you to discuss the why behind portfolio insights. Investors spend a lot of time doing diligence on companies before they invest. Why is it essential to continue to understand the financial performance of your companies after investment?
KRISTIAN: Whenever we attempt anything, we’ll ask the question, what’s the objective? And we find that beginning with the end in mind puts us on the right path. In the world of investors, most people would agree that you’re looking for a return. That return can be in the form of a future sale, but it can also be in the form of dividends. Understanding that is the objective of many investors to see a return on their money. A question becomes, are there any steps that can be taken to either increase the probability of hitting an investment threshold or simply increase the net return? In our experience, the answer is yes. Any improvement begins with measurement. This is a quality improvement or improvement in general. And the concept holds in the entire industries, manufacturing, healthcare … or investment analysis. The starting point is if I know I want to measure a return, I know I need to understand how that company is performing. I may need to get a third-party valuation. But in any regard, it starts with the data.
How often should I measure? The answer comes down to what are you gonna do with the information. If an investor had their finger on the pulse and was getting daily updates, my position would be, that’s great, but what are you gonna do with it? I find most institutional investors are in a position where they have the underlying infrastructure to assess and potentially take action on information every quarter. It varies. We work with some VCs who do it more frequently … monthly. Others twice annually. Maybe even some instances annually. One of the themes you’ll see coming up today is the concept of risk stratification. What’s the profile of the investment? Are they pre-revenue or getting ready for a Series F? Two different types of companies. In any event, those are the macro themes that I find are a great starting point for answering the question: Why? And then how frequently?
BELLE: What advice would you give non-financial people to upskill in data analysis to create meaningful insights for their team?
KRISTIAN: I don’t know that I paid much attention in elementary school, but one thing that stuck with me was I remember the teacher saying GIGO, but the concept was garbage in garbage out. Any analysis will only be as good as the integrity of the data set you’re using. There are other considerations – the size of the data set would be another- a lot of what we will look at today is only possible because financials are prepared on a gap-compliant basis. Cruel versus cash. I’d argue that it’s not the best use of their time and is better spent on product development sales and marketing. If there’s consensus that that’s the case, then the question is, do you employ a full-time team? Are you looking for a partner? The short of it is, regardless of the path anyone takes, just knowing that you have a clean set in the U.S. gap-compliant financials is a must.
BELLE: Why is understanding portfolio insight more critical now in this market than in the past four years in VC?
KRISTIAN: Cash is the lifeblood of any company. Companies go out of business for one reason, they run out of cash. If you consider the profile of investments that institutions like VCS are targeting, they’re generally early stage i.e., they’re not yet profitable. It was plentiful before the Federal Reserve started raising rates in March last year. But also the risk profile for limited partners was different, it was more acceptable to take early-stage risk because of the lack of options out there and that’s changed.
We’ve had the longest string of interest rates by the U.S. Central Bank since the early 1980s, which has a downstream effect on lending practices. The question then just becomes, what happens in the early stage investing space? From where I sit, I sense that the landscape is changing for better and worse. I see limited partners now have more options and the consequence is that for a VC to raise additional funds, it becomes more challenging. For a VC to respond to a portfolio company’s request to do a bridge round or participate in a round becomes harder. The potential for a down round increases, which has the potential to create tension between a portfolio company and a VC depending on the scope of the relationship and has the potential to create tension with the VC and the LPs. The upside is that it asks founders and investors some problematic questions. One of the things that I see now is a bigger appreciation of profitability. That landscape is changing. The short of it is that because money is more expensive and investors have more options, a significant amount of emphasis will be placed on performance.
BELLE: Bridge rounds and following rounds becoming more common to help companies bridge the gap between their next price round, but investors use their performance data to make those decisions so if they only have a certain amount of capital that they can allocate to follow on rounds, who in their portfolio are they going to choose? Will they need to understand those performance metrics in depth? From our perspective, that’s how we’re seeing investors use that as well.
What is the value of benchmarks in medians and where can people find some of this data or how is FinStrat coming up with the benchmarks they’re using when they’re supporting companies?
KRISTIAN: If we’re gonna answer a performance question, you, we have to answer relative to what in the simplest terms? And so are we measuring performance relative to the past for an individual company? Are we measuring performance relative to other portfolio companies within a fund, a segment, or the nation? And so we need a yardstick before doing any amount of this investment analysis. And in our experience, you know, there’s a couple ways to approach this.
There are medians, it’s just taking your existing portfolio and measuring the median individually. The benchmark’s spirit is intended to be perhaps a bit more objective because it includes values outside of your fund. And so the question becomes, ok, well, what are some great sources? We have to talk about whether we like it or not our old statistics class and the sample size. It has to be statistically valid. I don’t know that there’s a hard and fast rule; in my experience, at a minimum, you need 30.
I will oversimplify it and say the more the better. But you know, if your data set includes hundreds of data points, the better because we start eliminating noise. Where to find benchmarks? You’ve got two great sources up here for everybody’s benefit: survey-based benchmarks, which I’ve been growing. If you go to their websites, I think you can find their most recent reports if you share your email address.
Alternatively, FinStrat is in a unique position because of our client base, we also have access to benchmarks that we can use.
And then last but not least another source. It does a little more work that’s been involved, albeit public, not private. But in the past, we’ve used SEC filings for public SAAS companies. You must do some math by teasing the information out of their 10 Ks.
But I think there’s an even more important subject here and that is that, you know, I can look at growth rate. The growth rate is – should I use the same yardstick for every company? Our position is no. We want to start creating a profile for the investment. So a straightforward example would be the company’s ARR. Our position would be if you’re under a millionaire or probably don’t want to compare you to if you’re a billionaire and I can extrapolate that same concept to a whole host of metrics. At least, you know, open views and benchmark, it’s a credit if you take a look at their benchmarks, they publish, they stratify their respondents. To give you a solid sense to better hone in on a good answer based on an individual company.
BELLE: Definitely. Now we’ll do a deep dive into some essential performance metrics. And again, pulling in that CFO lens and talking about why these are important and how they could be applied to your fund when you’re also looking at portfolio company performance. So Kristian, what are growth rates? Why are they important?
KRISTIAN: Most investors looking at early-stage businesses use revenue growth as the holy grail regarding the company’s prospects, i.e., I’m not interested in profitability. If you’re profitable, why don’t you reinvest that money into product development, sales, and marketing? And so, in our experience, we use a monthly MRR growth rate and all of its sub-components. If you look at NET MRR, it consists of new sales, expansion sales, additional sales from existing clients, and gross churn. Revenue loss, either because an existing client purchased less in a given month or you lost that client altogether.
Using growth rate as a yardstick depends on the size of the company. It’s not fair to say that, on average, a business doing a billion in ARR should have the exact growth expectations that a company doing a million in ARR. I can also make a case that early-stage businesses that may not yet have a solid handle on their growth strategy are at five or fewer percent. This is just one metric of many before I would ever pass an assessment on an individual company.
BELLE: 30% was the average from the 2022 financial year. And then just looking at the differences across the board again, based on the company’s size and how much that can differ. When evaluating company performance within your portfolios, you can keep that 30% as the average. But then again, think about the importance of segmenting your portfolio companies. A small plug for Visible is our benchmarking solution built into our platform that allows you to segment your companies pretty quickly, making them easier to identify across the board.
BELLE: What is the rule of 40? If people haven’t heard of it before, why is it important? What does it tell an investor or someone evaluating company performance?
KRISTIAN: The rule of 40 builds on growth by factoring in profitability. It’s the combination of revenue growth rate and net income margin. The industry has set up a threshold of 40% and if you’re not profitable, your growth rate better makes up for your lack of profitability by getting you over 40. On the flip side, if your growth rate was anemic, there’s an expectation that you’re profitable and profitable to the point that your net margins more than make up for your lack of growth in terms of profitability. However, given the higher interest rate environment, one of the things that we see is that this metric in particular has taken on new meaning because of the emphasis on profitability that I mentioned earlier; my money is more difficult to come by.
There’s an expectation now that if you’re not growing, we want to see you not need additional cash in the future because you’re profitable or close to profitability. Again this is an individual metric. Not to say it’s the end all, be all. However, given the higher interest rate environment, this metric has taken on new meaning because of the emphasis on profitability I mentioned earlier. Money is more challenging to come by, so there is an expectation that if you’re not growing, we want to see you not need additional cash in the future because you’re profitable or close to profitable.
BELLE: And I think you, you kind of just answered this. There’s a spike here in 2021 that we saw 42% across the board. Why would you think or hypothesize that it was much higher in ‘21 than ‘22?
KRISTIAN: I don’t know how much credit I will give to the year’s first half. If we could look at this every quarter, I’d be willing to bet a nice dinner that a lot of this took place in the second half of the year when the writing on the wall was clear. The fed was raising rates, and money would be more expensive.
Now, on that note, for the benefit of your readers, I don’t know if everyone’s familiar with Tomasz Tunguz. He does sharp weekly posts. In March, he published a piece on how markets value software companies in 2023. It was very enlightening. So there’s been a standard narrative right now that the big emphasis for early-stage business is profitability when using public SAAS companies as a litmus test that it’s not the case. There is a percentile of businesses that are still receiving funding because of their growth rate and who are not profitable.
BELLE: Excellent. And then someone asked if you can repeat the name of the person you mentioned, I’ll probably butcher it, so I’ll have you say his name again.
KRISTIAN: Yes, it’s Tomasz. It’s spelled T-O-M-A-S-Z. Then the last name is spelled T-U-N-G-U-Z.
BELLE: The next one we’ll dive into is the payback period. So what is this and why is this important?
KRISTIAN: This particular metric answers the question: How long does it take for a company to recoup the money it spends to acquire a new client? Let’s say it took a month. That’s great. But let’s then compare that to say, I’m gonna exaggerate to make my point, 10 years, right? So you spend $10,000 to pick up a client but don’t earn that money back until a decade later. You better be making wine. It’s not a sustainable business because the amount of cash you’ll need to support that model will be excessive. And so this starts to answer the question and there’s a lot of – probably a separate webinar as well – but a lot of metrics is just algebra, right? So if you think about the customer acquisition cost payback period, it answers whether I am charging enough. So it’s looking at average revenue per account. Am I selling to the right people? Because if you’re selling to small deals or enterprise deals, that’ll impact ARP, average revenue per account. So also, how much am I spending to acquire customers? So, customer acquisition costs all oversimplify, but it’s just effectively taking your entire sales and marketing bucket from operating expenses and saying this is the money I’m spending to acquire customers.
I know there are opportunities to do trailing six months. The idea is that the money spent in one month doesn’t necessarily correlate to any clients picked in that month because sale cycles could be more significant than 30 days. But the spirit of it is answering: how long does it take me to recoup this and the smaller the number, the better? But again, if it was one month, you can argue that you should be spending a lot more on sales and marketing to pick up more customers, but that just gets into a broader sales and marketing strategy. Regarding benchmarks, we have historically used 12 months within FinStrat. The idea is as you go longer in the tooth, i.e., more significant than a year, we wanna understand why because especially in this environment where cash is harder to come by, you know, it means that your growth better be commensurate with the more extended amount of time it takes for you to recruit the money you had to outlay to pick up that client.
BELLE: Definitely. Yeah, just from the benchmark average that they’re seeing is 17 months, but again, it’s just an exciting stratification down here. As you’re evaluating a company’s payback period, remember the size of the contracts they’re closing if you’re having that in-depth conversation with portfolio companies.
KRISTIAN: I would add that if it’s intuitive that the larger the company, the odds are you start to shift to maintain your revenue growth, you shift away from consumers or small businesses to enterprise. If you think about the sale cycles and the costs associated with closing an enterprise deal, it’s materially larger than for a small business. So this goes back to stratifying your population within your fund. I want to know, am I looking at a pre-revenue early stage, you know, series ABCD? And then what’s the underlying product that’s being sold?
BELLE: The final metric we’ll talk about here before we transition into actually looking at some data in a dashboard is Net Revenue Retention. So Kristian, can you walk us through Why this is an important metric?
KRISTIAN: This metric as compared to Gross Revenue Retention, which will never be greater than 100 – can’t be greater than 100 or less than 100. In simplest terms, that’s asking the question if I just take my existing clients, i.e., exclude new sales, is that cohort growing month-over-month? So we’re taking existing reoccurring revenue, in the case of software, we’re adding any expansion revenue, but then we’re subtracting churn whether it’s because the client purchased less or because you lost the client. All things equal, the greater the number, the better. That means that you have successfully closed someone, they’re sticking around, and they’re buying more.
There’s also a concept of negative net churn. Still, in simplest terms, if you, as I mentioned earlier, start to break down the components of revenue net expansion churn, you could make a case that, in the absence of new sales – because you operate in a mature space – that’s acceptable if you can land and expand, and if we’re perhaps at first mover advantage and have a large enough client base. In any event, this proxy helps answer questions: are you selling to the right people? Is your product sticky? Do they like what you’re selling them? Because if the answer to those questions is yes, you’ll see, you’ll see a higher number.
BELLE: Excellent. We will transition to having Kristian share a dashboard where he has mocked up some of this data and we’ll talk about it in greater depth.
BELLE: If you have questions, please follow up with us via email. Kristian, where is a great place to learn more about FinStrat or contact your team?
KRISTIAN: The company’s website is FinStrat, so F-I-N-S-T-R-A-T and M-G-M-T, short for management, dot com. (www.finstratmgmt.com). You’re welcome to use the Contact Us form if you’d like to email me. It’s my first initial K, and my last name Marquaz so K-M-A-R-Q-U-A-Z at the same domain at FinStrat Mgmt dot com.