In previous articles, we analyzed why it's important for each startup to look at different metrics, depending on their business model. This time, we'll address ROI, a key metric that you should keep track of.
What is ROI and how is it calculated?
To talk about ROI is to talk about return on investment. ROI is, therefore, a financial ratio that compares the benefit or profit obtained in relation to a certain investment made. It is a metric that allows us to analyze the company's financial performance. To calculate ROI, divide profits or losses by the total invested and multiply the result by 100. Where, we will obtain the profits or losses by calculating the difference between the income earned and the total invested. We must bear in mind that the result obtained will be expressed as a percentage.
There are those who sin to limit the concept of ROI only to the financial department of startups. The reality is that the concept is much broader, and can be used with all those investments, from which certain profits are expected to be obtained. The ROI can, therefore, be calculated both by the startup's own entrepreneurs and by their investors (current or future) and can even be useful for anyone with leadership positions in the different departments of a company.
What is ROI used for?
ROI is a metric for analyze the return that an investment has in the company, from a financial point of view. Knowing its value allows us to make decisions based on data. But... Can we delegate all resource allocation based on which project or activity is generating greater or lower ROI in companies? The answer is simple: NO. We must bear in mind that ROI doesn't take into account other important factors, such as risk and time. Therefore, to make decisions that are as efficient as possible, based on ROI, we must take into account the value of other critical metrics for the company.
Why is ROI important in startups?
Assuming that a company had unlimited funding (understood as resources in the ROI formula), one could afford to spend time and, consequently, money, to experimenting or carrying out activities with a low or even negative return on investment. Of course, this is not the case of startups, who tend to have limited budgets and where giving priority to certain activities or projects means leaving aside others, due to the lack of sufficient capacity to carry them out in parallel. With limited resources, the need to make decisions that allow us to be as efficient as possible in order to maximize long-term benefits is of paramount importance. In a startup, each investment must be carefully considered as it can have a significant impact on the success or failure of the company. ROI is a way of evaluating the return on an investment relative to its cost and helps startup founders make informed decisions about how to allocate resources and capital.
But, as we've already mentioned, ROI isn't just a useful metric for company founders or managers. By calculating and monitoring the ROI, the founders of the startup can demonstrate to investors that they are making responsible investment decisions and that they are working to maximize the value of the company. And, on the other hand, startup investors can use the same metric when they want to calculate how attractive it may or may not be to participate in existing funding rounds in the entrepreneurial ecosystem, and the benefits they are getting from each of their invested startups. As we said, ROI is not only for the founders of a startup, or for their own investors, ROI can be applied to any investment that is made or must be made in the organization. For example, the marketing department can use ROI as a metric to measure the effectiveness of marketing and advertising campaigns. Is it profitable to continue paying for online ads? Is it more worthwhile to allocate more resources to traditional media campaigns? The ROI will allow you to identify which campaigns are most effective and adjust your strategy accordingly. Another example? The human resources department of a company, although it may seem to be one of the most remote when it comes to purely financial metrics, can use the ROI formula to calculate the return on investments made in, for example, staff training and skill development activities and programs, employee retention initiatives, etc. And in the same way, the operations department, the R&D department, and any other department that must assign specific resources to certain specific resources can be done. activities. In short, the ROI is used in various departments of a company to evaluate investment returns and make informed decisions about how to allocate resources and capital.
What mistakes should we avoid?
The ROI calculation allows us to calculate the return on investments and act accordingly. But there are things that we must take into account in order not to have a partial view of the company's situation, and to act biased.
- The ROI Ignore the opportunity cost, when measuring only the return of an investment compared to its cost, it does not take into account the opportunity cost of not investing that same money in another profitable opportunity for the company.
- The ROI does not take into account the risk associated with an investment.
- The ROI does not take into account time: An investment with a high long-term ROI may be less attractive than an investment with a lower short-term ROI.
- The ROI does not take into account indirect costs: It only measures the direct costs and benefits of an investment, but it does not take into account indirect costs, nor does it take into account indirect benefits (How much notoriety has the marketing campaign carried out generated?).
Alternative metrics to evaluate the return on an investment
- NPV (Net Present Value): Calculate the present value of the expected future cash flows of an investment, discounting the initial cost of the investment. The NPV helps determine if an investment is profitable or not, and it also takes into account time and opportunity cost.
- IRR (Internal Rate of Return): It measures the expected rate of return on an investment. The IRR is used to determine the return on an investment and is compared to the rate of return required to make an informed investment decision.
- Recovery period: Indicates the amount of time it takes for an investment to recover its initial cost. The payback period is used to determine the time needed to recover the investment and is compared to other projects and investment options.
- Rating multiples: These are ratios used to compare similar companies in the same industry. These multiples can include the price/benefit ratio, the price/sales ratio, the price/earnings ratio before interest, taxes, depreciation and amortization (EBITDA), and others.
Choosing the right metric will depend on the nature of the investment and the investor's objectives.
What values can ROI have?
The ROI can take any value, from zero to infinity. If the ROI is equal to zero, it means that the investment has not generated profits or losses, that is, the return on investment is equal to its initial cost. If the ROI is greater than zero, it means that the investment has generated profits and that the return on investment is greater than the initial cost. The higher the ROI, the more profitable the investment, in monetary terms. If the ROI is less than zero, it means that the investment has generated losses and that the return on investment is lower than the initial cost. In this case, the investment is not profitable and it may be necessary to review the investment strategy or make other decisions. As we have already said, it is important to note that the value of the ROI alone does not provide complete information about the return of an investment. You need to evaluate ROI in conjunction with other financial metrics and consider the context and objectives of the investment to make an informed decision.
What are the expected ROI values in startups?
The ROI values that an investor expects when investing in startups can vary widely and depend on several factors, such as the startup's sector, the business model, the company's stage of development, and others. In general, startups have high growth potential, but they also present a greater risk compared to other investments. Therefore, investors in startups tend to seek a higher ROI than in other, more stable and secure investments.
Some studies suggest that a successful ROI for an investment in startups is usually at least 3 times the capital invested over a period of 3 to 5 years. However, some investors may be looking for an even higher ROI, up to 10 times the capital invested or more.
It is important to keep in mind that, in many cases, startups do not generate profits during the first years of operation and, therefore, ROI cannot be calculated right away. However, in some cases, a low ROI can be considered successful if it meets specific investment objectives, such as generating stable and sustainable cash flow instead of a large return on investment in the short term.
