The $1m ARR fallacy

Series A Benchmarks for startups are tricky...or are they?

Ask any seed stage founder what milestone they need to achieve prior to raising their future series A round. “$1m in ARR” will likely get blurted out before you have the chance to finish the question. On the surface of it, this seems logical. For a series A round, investors want to see quantitative evidence that customers are engaged with the product, that the go to market strategy has legs and that the team has the ability to execute. And as we all, especially VCs, love round numbers, $1m seems to be a good target.

What’s interesting then, is that when I look at our portfolio at TLV Partners, the $1m ARR benchmark is rarely, if ever, reached prior to raising an A round. Now before you accuse our portfolio companies of raising underwhelming rounds, let’s take a look at the numbers.

Over the past two years, seven portfolio companies of ours have raised series A rounds. These were all rounds that were led by a new firm, at an at least 2.5x valuation increase and, as you can see from the round sizes, were significant rounds. What’s fascinating is that not only did the $1m ARR benchmark not seem to apply, our companies had more than 5x less ARR than that number on average.

I could end this post here and simply say that you do not need $1m in ARR to raise a series A. And if you take one thing from this post I hope it is indeed that. But let’s go a bit deeper.

The simplest explanation for this discrepancy is that we VCs are annoying. Sometimes when we pass on investment opportunities, an easy cop-out answer is simply to tell founders that they need to come back with $1m in ARR. This kills two birds with one stone, as it enables funds to pass on companies without giving too detailed a reason why, as well as keeps them in mind for the next financing round should the company actually reach that milestone (at which point, maybe it’s worthwhile to take another look). Have I used this tactic* myself before? Yes. Do I try to avoid it? Yes.

(*As an aside, this tactic is very different from the “it’s too early for us” tactic, which in my eyes is much more legitimate. Maybe I’ll dive into this in a later post.)

A more nuanced explanation however is that series A rounds, for the most part, are glorified seed rounds. What I mean by this is that series A rounds are raised primarily based on vision, not traction.

As I’ve demonstrated in the illustration above, seed and series A are incredibly close together, in fact almost on top of one another, on the vision-traction scale. Obviously in order to raise subsequent rounds you need to progress along the traction side of the scale, but not in the way you may have thought.

In general I believe that revenue is a lagging indicator for early stage technology startups. So much hard work and effort goes into the first 12-18 months of building a company. You’ve hired a core team, built a product that design partners love and set up your initial go to market. Sophisticated investors look at these achievements, together with falling in love with the vision you have for your company, and decide whether or not to invest. So while commercial progress does indeed need to be made between the seed and A rounds, revenue is not, and indeed shouldn’t be, the way to measure said progress.

Caveats

While the overarching theme of this post - you don’t need anywhere close to $1m in annual revenue to raise a successful series A round - holds true for all startups, there are some important caveats to make.

1) The examples from the TLVP portfolio I included are all enterprise software companies.

2) There is a difference between “deep-tech” companies and non deep-tech companies when it comes to proving series A readiness. For an innovative cyber security startup, an infrastructure play, a computational biology company or a new application of ML, series A readiness is defined as I described above. Whereas a company innovating on the business model side of things would most likely need to progress more from a revenue perspective.

3) ARR and annual revenue are not the same thing. The second “R”, recurring, is a pretty big deal. In some cases $200,000 of annualized recurring revenue is more impressive than $1m in non recurring annual revenue.

4) As a rule of thumb, revenue growth rate, is more important than total revenue. A company growing at a rapid monthly/quarterly pace is always more impressive than a company growing more slowly with more total revenue.

In the next post, I’ll dive into some of the macro trends that have created this phenomenon, and whether or not they still hold true in a Covid/post-Covid environment.