How VCs and founders exaggerate ARR to elevate AI startups
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Exposing Revenue Inflation in AI Startups
Last month, Scott Stevenson, the co-founder and CEO of legal AI startup Spellbook, made waves on social media by labeling the revenue declarations of many AI startups as a “huge scam.” His claim centers on the inflation of revenue figures through misleading metrics. He tweeted, “The reason many AI startups are crushing revenue records is that they are using a dishonest metric. The biggest funds in the world are supporting this and misleading journalists for PR coverage.”
The Manipulation of Revenue Metrics
Stevenson’s assertion isn’t unprecedented; the manipulation of Annual Recurring Revenue (ARR) figures has been a contentious issue in the startup ecosystem, particularly among AI companies. ARR, a metric traditionally used to calculate annual revenue from active customer contracts, faces scrutiny as companies purportedly stretch its definition. Reports and social media chatter have discussed these practices, but Stevenson’s comments resonated deeply, garnering over 200 reshares and comments, along with acknowledgment from notable investors and founders.
Jack Newton, co-founder and CEO of Clio, remarked, “Scott at Spellbook did a great job of highlighting some bad behavior on the part of some companies.” He stressed that awareness of this issue is crucial, referencing a thorough explanation from Garry Tan of Y Combinator regarding accurate revenue metrics.
Confirmation of Concerns in the Community
To further understand the extent of ARR inflation, TechCrunch consulted more than a dozen founders, investors, and financial experts. Many of these individuals, who preferred anonymity, corroborated Stevenson’s claims, acknowledging that inflated/publicly declared ARR figures are not only common but sometimes known by investors.
The Tactics Behind ARR Manipulation
The primary tactic employed by some startups is to replace “contracted ARR,” often labeled “committed ARR” (CARR), calling it straight-up ARR. An investor noted, “For sure they are reporting CARR as ARR. When one startup does it in a category, it is hard not to do it yourself just to keep up.”
ARR measures the total value of contracts signed, typically covering multi-year agreements. However, it’s crucial to highlight that Generally Accepted Accounting Principles (GAAP) focus on realized revenue—not future projections—meaning that traditional audits often skip over ARR metrics.
While ARR was crafted to represent confirmed revenue from signed contracts, CARR is a more nebulous metric as it factors in customer agreements that are not yet active. One venture capitalists (VC) remarked on companies reporting CARR figures where the disparity with ARR reached as much as 70%. Unfortunately, a portion of these contracts is unlikely to produce any actual revenue.
Bessemer Venture Partners emphasized in a 2021 blog post that CARR should be adjusted to acknowledge expected customer churn and “downsell” situations, wherein customers purchase fewer services than initially signed. The challenge lies in recognizing revenue from clients before a startup’s product is fully deployed; if implementation drags on or encounters issues, clients may opt out, leaving the contracted revenue unrealized.
Red Flags in Reporting Revenue Figures
Reports have surfaced regarding a high-profile startup claiming over $100 million in ARR, with a substantial portion stemming from pending contracts rather than active customers. A former employee recounted a scenario where a company included a year-long free pilot in its ARR calculations. Even the board of directors, including a VC representative from a leading fund, was aware that this arrangement misrepresented the true revenue situation.
Using CARR and branding it as ARR presents a vulnerability ripe for manipulation. If clients are offered significant discounts over several years, there’s a risk that projected revenue may not hold firm. For example, should a company promote three years of revenue but only enough customers remain to pay the discounted price in the first two years, the inflated claims may not materialize.
Acknowledgment from Within the Industry
Ross McNairn, co-founder and CEO of Wordsmith, expressed that he resonates with Stevenson’s perspective. He noted, “I speak to VCs all the time. They’re like, ‘There are some choppy, choppy standards out.’” Many instances of slight distortions exist, such as a startup marketing a $50 million ARR when the actual figure was merely $42 million. Yet, investors had access to the accurate financials and seemed willing to overlook the discrepancies, viewing minor gaps as inconsequential.
The Other Controversial ARR
A further complication in the public discussion around ARR arises from the different interpretations of the acronym. Annualized Run-Rate Revenue—another version of ARR—projects current revenue over the next year based on recent performance. This calculation can be particularly misleading for AI companies whose revenue models often depend on usage or performance, as it lacks the consistency found in more predictable agreements.
Despite the prominence of ARR overstatements, many experts noted that aggressive practices have notably intensified amid the AI boom. Michael Marks, a founding managing partner at Celesta Capital, emphasized that increased valuations have incentivized misleading claims.
The Speed of Growth Expectations
The expectation for AI startups to demonstrate unprecedented growth is greater than ever. Hemant Taneja, CEO and managing director of General Catalyst, highlighted the drastic acceleration in projections: “You got to go like 1 to 20 to 100,” moving beyond traditional linear growth metrics.
This pressure challenges some VCs to either support or remain complicit in the misleading portrayals of inflated ARR figures. Stevenson argued that VCs have incentives to craft narratives for their portfolio companies and investigate inflated figures.
The Consequences of Inflation
Investors aware of inflated revenue might hesitate to flag these issues since high public revenue figures can attract top talent and customers, crafting a facade of success. TechCrunch spoke to various insiders who expressed disbelief in claims of rapid ARR growth, citing an element of “fakeness” in public perceptions.
However, not all startups are comfortable representing their growth via CARR in lieu of ARR. Many prefer full transparency, as markets primarily evaluate software companies based on ARR metrics. McNairn voiced concern that exaggeration can generate short-term gains but ultimately leads to bad practices. “I think it’s super bad hygiene, and it’s going to come back and bite you,” he warned.
Conclusion
Scott Stevenson’s revelations reveal a worrying trend in the AI startup scene—where revenue figures can be manipulated, creating a fog of uncertainty for investors and the market. It urges stakeholders to consider the integrity of revenue reporting and the long-term consequences of inflating figures. Transparency and honesty in financial reporting will not only uphold trust but also foster sustainable growth in the fast-evolving landscape of AI startups.
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