Factors For Picking Winning Companies: Traction

Traction means different things to different companies, but can be generally defined as the progress of a start-up company and the momentum it gains as the business grows. This will look different for each company.

There is no one right way to measure traction –  but by analyzing the right metrics, investors can learn a lot about the company’s trajectory and potential.

When evaluating traction, investors are mainly looking for growth. Investors want to back a company that has momentum, and that has the potential to provide very large returns in a relatively short amount of time. While there are many ways to measure growth, the following are two common startup metrics that relate to growth.

Paul Graham, founding partner at Y Combinator, has been know to tell companies that they should identify the most important metric for them and focus on growing that metric 10% week over week. While there are exceptions to this rule – for example, companies that focus on building unparalleled technology will require significant up-front amount of R&D – in many cases this kind of growth is a strong positive indicator.

 

Common Startup Growth Metrics

Recurring Revenue

While few early-stage companies will not significant revenue, once a company has started accepting any amount of revenue for their product, this becomes a good indicator of whether customers value the service.

While one-time revenue can be a good indicator that customers are willing to pay for a product, investors are often most interested in recurring revenue. This is the portion of a company's revenue that is highly likely to continue in the future.

This revenue is predictable, stable and can be counted on in the future with a high degree of certainty. Because recurring revenue is relatively predictable, it helps de-risk a business’s sales, and build long term value — value that will be very appealing to acquiring companies down the line.

 

Active Users

When a company gives their number of users, they are giving you the number of people that have ever signed up for or bought their product. But active users are not the same as all users.

Total users is a number that will never go down. But when a company gives you the number of active users they are giving you insight into the engagement level on their product.  Active users however, can go down, and a company showing steady growth in their number of active users is a very positive signal.

Active users are counted by measuring the number of unique users during a specific measurement period.  

For example, monthly active users  will be measured by looking at the number of users engaging with a product in the previous 30 days. Daily active users will be measured by looking at the number of users engaging with a product in the previous day.

A company with strong recurring revenue growth should also have strong active user growth. If they don’t, this could be signal that the company has a very strong sales team, but a product no one actually uses.

 

Churn Rate

For companies relying on a subscription business model or recurring revenue, an important number to understand is its churn rate.

Customer churn refers to the percentage of subscribers to a service that discontinue their subscription to that service in a given time period. Revenue churn refers to the percentage of revenue that is lost or discontinued during a given period.

In order for a company to expand, its growth rate must exceed its churn rate.

 

“Vanity Metrics”

While evaluating companies, keep your eyes out for vanity metrics used as part of a pitch. These are metrics that might look good at first glance but have no bearing on the actual viability of a business.

While these stats might have real bearing on some businesses, for most companies they are nothing but noise. At best, they provide little useful information. At worst, they are meant to distract investors from the underlying issues with the business’s more important metrics.

Common vanity metrics are sign-ups, visits, time on site, or number of social media followers.

Another form of “vanity metric” is the use of cumulative metrics, rather than than breaking out metrics month by month or week by week. When you show growth using a cumulative graph, it will always look like a company is growing. This is at best confusing, and at worst misleading.

Why Metrics Matter

Companies that can show growth, month by month, are the companies that are actually growing.  Most early stage companies should show some traction. For some investors, signs of traction will be the main factor they consider before choosing to invest.

Companies, where the most attractive quality is traction, are companies that have been so rapidly embraced by customers, that the company's metrics are almost unbelievable.

Curious about metrics, and how to separate the signal from the noise? Check out Lean Analytics or the Instigator Blog archives.