Starting in 2024, a stream of ‘holy shit’ progress metrics from VC-backed startups started to pop up on X [formerly Twitter]. In lower than three years, Midjourney’s ARR went from zero to $200 million. In 20 months, ElevenLabs, a voice AI startup, noticed its ARR soar from zero to close $100 million. In three months, vibe coding darling Lovable went from zero to $17 million in ARR, this summer time hitting $100 million in ARR. In its first six months, Decagon hit “seven figures” in ARR, the corporate reported. Essentially the most well-known instance: AI coding instrument Cursor went from nada to $100 million in ARR in a 12 months. However who wants a 12 months, anyway? Two VCs Fortune spoke to highlighted the declare made by Andreessen Horowitz-backed AI “cheat on everything” instrument Cluely, which claimed over the summer time to have doubled ARR to $7 million over a week.
“There is all this pressure from companies like Decagon, Cursor, and Cognition that are just crushing it,” stated one VC. “There’s so much pressure to be the company that went from zero to 100 million in X days.”
All of the examples have one factor in widespread: ARR, or “annual recurring revenue.” The metric got here to be a favourite of VCs and startups by means of the software-as-a-service (SaaS) wave beginning within the 2000s, when it was extensively accepted as a trusted proxy for a steady startup, with a dependable income and a fairly shored up future.
However as billions flowed throughout the enterprise capital ecosystem into AI startups, some mere months previous, the vaunted, trusted ARR metric has morphed into one thing a lot tougher to acknowledge. There’s now a large quantity of stress on AI-focused founders, at earlier phases than ever earlier than: In case you’re not producing income instantly, what are you even doing? Founders—in an effort to maintain up with the Joneses—are counting all kinds of issues as “long-term revenue” which are, to be blunt, nothing your Accounting 101 professor would acknowledge as reliable.
Exacerbating the stress is the truth that extra VCs than ever are attempting to funnel capital into attainable winners, at a time the place there’s no certainty about what evaluating success or traction even seems like. All through the 90s, VC as an trade grew to greater than 700 corporations managing about $143 billion. In the present day, there are greater than 3,000 VC corporations based on the Nationwide Enterprise Capital Affiliation, managing greater than $360 billion, with some projections suggesting enterprise will probably be a greater than $700 billion trade by 2029.
Artistic accounting, after all, has a protracted historical past of cropping up throughout a growth, a practice courting far again, to the Gilded Age when inflating property, understating liabilities, and bribery have been commonplace. Extra lately the dotcom growth and the leadup to the Nice Recession delivered to gentle such practices as “channel stuffing,” “roundtripping revenue,” and who can overlook “special purpose entities.” Now trade watchers are beginning to elevate pink flags about ARR. “The problem is that so much of this is essentially vibe revenue,” one VC stated. “It’s not Google signing a data center contract. That’s real shit. Some startup that’s using your product temporarily? That’s really not revenue.” Or slightly there’s income (the primary ‘R’) nevertheless it’s not recurring income (the second ‘R’).
One instance of what this seems like: A top-firm VC described an early-stage protection tech startup he was , the place the founder claimed $325,000 in ARR. “The first time he said it, he didn’t even make a big deal out of it,” the VC stated. “He was like: ‘Oh, by the way, we have a contract with this company and it’s worth this much.’ In the second meeting, I said, ‘Wait, let’s go back to that customer, that big contract. How did that deal happen?’ A very common question. He said: ‘Oh, it was super easy. It was a two-week pilot. And we have it on good authority that they’re going to keep paying us that much.’”
File scratch: “I was like: What does that mean?” the VC stated. “Hold the phone, man. The good authority I subscribe to is a signed piece of paper.”
How ARR turned the favored metric in AI
A quantity is sort of by no means only a quantity in tech. And it by no means has been.
Behind each income determine you’ve ever seen, particularly when speaking about privately-held tech startups, there’s a little little bit of science—and a variety of artwork. These corporations aren’t monitored the best way that public corporations are, reporting to the Securities and Trade Fee quarterly. Traders additionally don’t essentially audit the businesses they put money into, both. A monetary due diligence course of, earlier than a VC invests, might contain an off-the-cuff audit, however extra doubtless it’s a recreation performed with belief.
And within the SaaS period, technically beginning within the Nineties and gaining steam by means of the 2000s, belief in ARR got here comparatively straightforward. There was an agreed upon set of conventions. For instance, annual per-seat pricing was customary, the place one consumer pays for one 12 months after which accounts expanded by including a number of customers. And there was clear separation between ARR, CAR (signed contract worth earlier than activation) and acknowledged income (precise income booked). Usually 80 to 90% of CAR would convert to ARR, and you might predictably chart an organization’s growth, counting on low churn charges and regular prospects.
There have been, briefly, standardized strategies of calculating ARR.
“We did settle on these terms that everyone agreed on in the SaaS world,” stated Anna Barber, associate at VC agency M13. “It was a lot harder to fudge, because people had a general understanding of what things had to mean. Today, we don’t know what things have to mean in the same way. So, there’s a lot of confusion and, maybe, obfuscation.”
Now, right here’s the wrinkle: The SaaS period wasn’t a halcyon time of absolute income readability both. Because the cloud wave began to take form, ARR began to get somewhat funkier. Particularly for consumer-facing corporations (like restaurant software program firm Toast) there have been questions on whether or not subscription income was an excellent proxy for ARR. However it was the emergence of AI that created a complete new layer of uncertainty.
“Investors wanted to keep evaluating companies as SaaS-predictable, so they tried to shoehorn those elements into ‘recurring’ revenue,” stated Nnamdi Okike, managing associate and co-founder at 645 Ventures. “It doesn’t truly work, but it worked well enough for investors to keep doing it. Now AI has shown up with a whole new set of elements, and it would be better for investors to finally create new metrics to represent this new reality.”
ARR is in what might be described as an ungainly section, the place there are some AI startups which are making an attempt to make use of the metric with sincerity, however their enterprise dynamics are simply too totally different from conventional SaaS. Potential prospects are nonetheless in an experimentation section, making an attempt all kinds of merchandise on short-term pilots, creating excessive churn threat. And AI providers have unpredictable token utilization, which refers back to the quantity of textual content that AI processes to grasp language. (Extra tokens equals extra utilization, and extra sophisticated queries require extra token utilization, by extension.) So, a couple of “inference whales” like OpenAI and Anthropic have large pricing energy and might skew prices, making AI startups’ monetary constructions basically totally different from conventional SaaS companies.
“The classic SaaS model is dying as we speak,” stated Priya Saiprasad, basic associate at Touring Capital. “We shouldn’t be using classic SaaS terms to measure these companies, we shouldn’t be using the language of it. So we should all, collectively as an industry, evolve to a new set of metrics we feel comfortable measuring these companies by.”
The end result? Founders are counting pilots, one-time offers, or unactivated contracts as recurring income, six VCs advised Fortune. And there are many hairs to separate right here. For instance, some startups are claiming “booked ARR”—numbers primarily based on what prospects would possibly pay sooner or later slightly than what they really are paying now—though contracts continuously have provisions that permit prospects choose out at any time for any purpose.
“Companies are signing contracts with kill provisions, so they’re claiming booked ARR, but giving their customers an out,” stated one early-stage centered VC. “So it’s like, okay, so I’m claiming that I just booked this million-dollar-a-year contract. But by the way, it says in three months, you can cancel for no reason. Does that count?”
It’s essential to say: Whereas there’s a large quantity of variation throughout industries, there are additionally extensively accepted, optimum accounting ideas. Generally phrases, there are regular pink flags round income that accounting consultants look ahead to.
“If there’s speculation that revenue’s being inflated, that’s a primary concern among external auditors,” stated Jonathan Stanley, director of Auburn’s Harbert Faculty of Enterprise Faculty of Accountancy and KPMG endowed professor. “There are always many things you’re looking for, but a company potentially trying to manipulate the revenue numbers to achieve a goal that really contradicts objective reporting is always a red flag.”
And income itself, on a elementary degree, options each core truths—and discretionary realities.
“You book revenue when the service is provided and/or when the goods are delivered,” stated Bradley Bennett, accounting division chair and professor on the College of Massachusetts, Amherst’s Isenberg Faculty. “Depending on how the contracts are written, depending on how clear those stated objectives or benchmarks are noted, and/or just the industry in general, there’s some room for discretion and perhaps misreporting, intentional or not. Also, there are often incentives tied to revenue for management and members of the sales teams.”
Till confirmed in any other case, there’s nothing unlawful about taking the rosiest view of income, and lots of would even say it’s a time-honored custom. However that doesn’t imply it might probably’t trigger issues (or crises) down the road.
The round startup ecosystem
There are additionally broader sociological adjustments making the ARR shenanigans attainable. One VC says a part of the fault lies in well-established accelerators which have standardized “what to say” to boost cash, encouraging metric manipulation.
Y Combinator, this VC says, “standardized the approach to building companies to such a degree, mostly for the betterment of our industry, for the record,” stated one VC. “But they’ve also productized company-building to the extent that these people know exactly what to say. They’ve been in YC for ten weeks, so they think they know and they figure that annualizing whatever they’ve got in week nine feels like a reasonable thing to do.” (YC didn’t return a request for remark.)
And the truth that a lot of these startups in the end promote to different startups circuitously makes issues much more insular. “More than private equity, more than even banking, venture has an ‘in’ crowd,” stated NYU Professor Alison Taylor. “A certain sort of person gets funded with a certain sort of business model.”
The emphasis on ARR, in the end, is reflective of a wider reckoning in enterprise general. Not solely are there extra VCs (and extra capital) than ever, however priorities are in flux. “Generally, historically, there’s been an important tradeoff in the venture capital industry between profitability and growth,” stated Dr. Ilya Strebulaev, a professor on the Stanford Graduate Faculty of Enterprise and co-author of The Enterprise Mindset. However roiled by geopolitical tensions and macroeconomic uncertainty, “that pendulum has been changing over time. I think venture capitalists are now spending more effort on profitability today than in the past, and are spending more effort on revenue. But that doesn’t mean the tradeoff between profitability and growth has evaporated—absolutely not.”
In the long run, as College of Virginia economist Dr. Anton Korinek factors out, this isn’t about ARR in any respect, however one step in a a lot larger (and much more consequential) design. “The big picture question is, why are valuations so high?” stated Korinek. “This is one of the symptoms of that. The bet is AGI or bust…’If I want to give you even more money, because there’s so much liquidity sloshing around and we are really, really eager to invest in this, then please give me more ARR, and I’ll give you a higher valuation.’”
One VC says he looks like he’s going somewhat mad—however that’s the enterprise. “It’s like going to a carnival and saying ‘wait a second, this game where I’m supposed to throw a ring around the milk bottle—that’s not a real milk bottle, that’s not a real ring.”
The consensus amongst VCs appears to be that ARR gained’t in the end be the best way ahead in any respect: Good buyers will develop new methods to evaluate AI companies, specializing in retention, every day energetic utilization, and unit economics.
Till then, it might be the VCs and founders who’ve pumped up ARR that may really feel probably the most ache if a bubble bursts. That is an equity-driven growth, says Korinek, and “the main losers in equity-driven booms like the one right now are the ones who made the bets.”
