The Fallacy of Benchmarking
Relative Analysis Has Many Shortcomings
A big pet peeve of mine is investors and management teams drawing conclusions based on benchmarking. It happens everyday from private company board meetings to public company investment decisions.
This blog post is not to say that benchmarking is not useful. But that the emphasis that investors place on benchmarking is misplaced if not taking into account the full context.
A great example of benchmarking is provided by Public Comps, an excellent resource for any SaaS investor or management team to start looking for ideas from a purely financial screening perspective.
In many board meetings, a benchmarking analysis like this would lead to the following conclusion. “Your peers have a 51% average of Revenue Growth + Free Cash Flow % and you are only showing 30%. I would work to improve those numbers so you can come in line. Let’s discuss how to work on that improvement.”
Sounds reasonable right?
Except who the F cares?!!!!
Every stage and state of a business is different. Yes it is important to understand how other comparable companies are performing and what best in class metrics look like. However, one business can have the same scale of revenue and even be in the same category like CRM software but could have drastically different TAM and market share trajectories at the same level of metrics. So for example Salesforce vs Veeva are completely different. If they both had $300M ARR, Salesforce at that time would be targeting a much broader market with more competitors while Veeva’s TAM would be smaller but likely they have more market share captured in the life sciences vertical.
So Salesforce at the same scale of revenue should likely be showing lower Rule of 40 metrics as they have more to invest in to capture market share against increased competition at that point in time. This is a super simplistic analysis but for brevity hopefully you get the point.
The most common example of Benchmarking Fallacy I run across is in growth stage board meetings. Companies with $20M ARR+, everyone starts to focus on gross margins and net revenue retention. The common refrain well be “we ran benchmarks across your stage and your gross margins are coming out 10% lower. We need to work to improve that asap as your gross margins should be higher. How can we work on improving them.”
You see the problem with the above questions? The assumption is that because the benchmarks are higher for similar scale companies, then something must be wrong with the current business. So the conclusion is to say, let’s improve these and then all the discussions focus on cost optimization, efficiencies, etc.
What if the best thing for the business is actually to take gross margins even lower? Let’s say adding more customer support and professional services now on a lower revenue base will onboard customers better and retain them for longer in the future. This will generate more Free Cash Flow in the long term even if the short term margins look worse. But for the health of the business, this may actually be the right tradeoff, assuming no near term funding needs.
In the current hype of rounds being raised every year at 100x ARR and growth being prioritized above all else, we seem to have gone benchmarking blind! It’s ok if your comparable set of companies at same stage has higher growth, higher gross margins, higher net retention.
[Sidenote on the risks to Prioritizing the Long Term for Startups
The main risk you need to be aware of when prioritizing for the long term is not pushing your metrics too far from the pack if you don’t have the capital available to manage the business for 2-3 years. Otherwise, exposing yourself to funding risk is not optimal for the long term health of the business even if you think what you’re doing is correct.]
What management teams and investors need to focus on more is the stage of the business, state of the market, customer base, and what is right for the business at that point in time that will eventually lead to enabling the business to have best in class metrics according to the benchmarks in the future.
I will have more posts continuing this rant :) in a different vein in upcoming blog posts.