Evidence-based investing uses a rational method, instead of guesswork or secret formulas, to achieve investment objectives. Based on empiricism, evidence-based investing aims to filter through noise and emotion to identify reasoned investments for a given asset class.
It involves asking meaningful questions about investment decisions, applying answers accordingly and monitoring for effectiveness.
It wasn’t until the 20th century that the idea of randomised trial experiments, careful measurement and the application of statistics took place in medicine. The first academic paper on randomised controlled trials – the standard for ‘rational therapeutics’ in medicine – was published in 1948 after years of controversy.
When applied to listed equities, the meaningful questions seek to identify the characteristics of companies that have historically outperformed the market and consequently, to build portfolios overweight in companies with these characteristics.
It’s less about finding good companies and more about finding companies with the right factors.
Although potentially challenging, an evidence-based investing approach can be applied to venture capital. By studying the historical metrics of today’s highly successful technology businesses and contrasting them with their historical brethren, fledgling businesses can be examined and benchmarked.
Here are some ways to take a more disciplined and results-driven approach to evaluating early-stage technology businesses.
Operating metrics are key benchmarks
For a software-as-a-service (SaaS) business, customer churn – how many customers it loses each year – is a critical measure.
SaaS businesses must prove their ability to retain existing customers and acquire new ones. Xero, a listed SaaS accounting software provider, has monthly churn rates between 0.9 per cent and 1.8 per cent.
Top performing SaaS providers have annual customer renewal rates above 90 per cent.
Investors can benchmark prospective companies against top performers by scale, category and region.
Other key measures for SaaS businesses are committed monthly recurring revenue (CMRR) and customer lifetime value (LTV) to customer acquisition cost (CAC) ratio.
CMRR is the value of the recurring portion of subscription revenue.
For a business that charges $1,200 per year for access to its software, its CMRR for one customer would be $100.
For an early-stage business, CMRR growth demonstrates market demand for their product and sales effectiveness.
For seed or pre-series A SaaS businesses, month-on-month CMRR growth rates of 15 to 20 per cent are enviable, backing out at annualised revenue growth of 5.4 to 8.9 times earnings.
A business’ LTV is the amount of lifetime revenue generated from a customer. If a customer spends $1,200 per year for three years, its LTV is $3,600.
A business’ CAC is the amount of money spent on customer acquisition (such as sales and marketing) divided by the number of customers acquired.
For instance, if a business spent $10,000 to acquire 10 customers, its CAC is $1,000. A business’ LTV should exceed its CAC.
While it’s generally accepted LTV/CAC should exceed 3.0, top-performing companies have much higher numbers. In Australia for instance, Xero’s LTV/CAC is 7.6 and in New Zealand it’s 9.8.
For media businesses, engagement metrics are critical.
Daily active users (DAU) measures the number of unique visits to the site, app or game each day.
It’s a measure of stickiness and is often compared with monthly active users (MAU). In February 2017, Snapchat reported 158 million DAU (and 301m MAU) who generated 2.5 billion snaps per day.
The potential of early-stage businesses can be measured against the performance of businesses like Snapchat as they were growing three or four years ago.
Founders are critical too
Outperforming businesses are led by outperforming teams.
One way to identify outperforming founders is to work out the mathematical relationship between the traits of founders and the future returns of their businesses.
By understanding key characteristics of top-performing founders, correlations can be made with early-stage founders, adding additional data points to the investment decision process.
Over the last few years, we’ve been working with a psychology professor to refine a tool that measures entrepreneurial success.
Combining psychology’s big five personality traits plus other measures such as fluid intelligence, we’ve been tracking the longitudinal performance of founders and have found strong correlations between the performance of teams and their businesses.
For instance, founders with high levels of fluid intelligence and openness are more likely to have successful businesses than those with lower levels.
Similarly, a material difference in scores between founders of the same team will likely lead to interpersonal conflict and the departure of one or more co-founders.
Venture capital must adapt
Investing in venture capital shouldn’t be like the practice of medicine up until the 1950s. Instead, venture capitalists should adopt an evidence-based approach, applying rational and empirical techniques to separate noise from signal. This should result in higher and more sustained investor returns.
Article originally shared on Investor Daily.
