Last month, Scott Stevenson, co-founder and CEO of legal AI startup Spellbook, took to X in an effort to uncover what he called “huge scamamong AI startups: inflation of publicly reported revenue figures.
“The reason many AI startups are breaking revenue records is because they use a dishonest metric. The biggest funds in the world support it and mislead journalists for PR coverage,” he tweeted.
Stevenson is not the first to claim that annual recurring revenue (ARR) — a metric historically used to sum up the annual revenue of active customers under contract — is being manipulated by some AI companies beyond recognition. Certain aspects of ARR abuses have been the subject of multiple other news exhibitions and social media posts.
However, Stevenson’s tweet seemed to strike a particular nerve in the AI startup community, drawing over 200 retweets and comments from high profile investorsa lot foundersand a few headlines.
“Scott at Spellbook did a great job of highlighting some of what you might describe as bad behavior on the part of some companies,” Jack Newton, co-founder and CEO of legal startup Clio, told TechCrunch, adding that the post brought much-needed awareness to the issue, referring to explanatory post from YC’s Garry Tan on the right revenue metrics.
TechCrunch spoke with over a dozen founders, investors and financial startup professionals to assess whether ARR inflation is as pervasive as Stevenson suggests.
Indeed, our sources, many of whom spoke on condition of anonymity, confirmed that misleading ARR in public statements is common among startups and how, in many cases, investors are aware of the exaggerations.
No actual revenue, yet
The main obfuscation tactic is to replace “contracted ARR”, sometimes referred to as “committed ARR” (CARR), and we simply call it ARR.
“They’re definitely reporting CARR” as ARR, one investor said. “When a startup does it in a category, it’s hard not to do it yourself to keep up.”
ARR is an established and trusted metric since the cloud era to indicate overall product sales where usage, and therefore payments, are measured over time. Accountants do not formally audit or sign off on ARR primarily because generally accepted accounting principles (GAAP) focus on historical, already earned revenue rather than future revenue.
ARR was meant to show the total value of signed and sealed sales, usually multi-year contracts. (Today, this concept tends to go by another name: residual performance obligations.) Meanwhile, the term “revenue” is usually reserved for money that has already been collected.
CARR is supposed to be another way of tracking growth. But it’s a much more accurate metric than ARR because it measures revenue from signed-up customers who haven’t signed up yet.
One VC told TechCrunch that he has seen companies where CARR is 70% higher than ARR, even though a significant portion of that contractual revenue will never actually be realized.
CARR “builds on the concept of ARR by adding committed but not yet contract values to overall ARR,” Bessemer Venture Partners (BVP) he wrote in a blog post 2021. Crucially, however, BVP says, the startup is supposed to adjust CARR to account for expected customer churn (how many customers leave) and downsell (those who decide to buy less).
The main problem with CARR is counting revenue before a startup’s product is implemented. If the implementation is time-consuming or goes wrong, customers may cancel during the trial before all—or any—of the contract revenue is collected.
Several investors told TechCrunch that they are directly aware of at least one high-profile business startup that reported exceeding $100 million in ARR when only a fraction of that revenue came from paying customers today. The rest came from contracts that were not yet developed and in some cases the technology could take a long time to implement.
A former employee at a startup that routinely reported CARR as ARR told TechCrunch that the company counted at least one major, year-long free pilot as ARR. The company’s board, including a VC from a major fund, knew that revenue from the final payment of part of the contract had been calculated into ARR during the long-running pilot, the person said. The board was also aware that the customer could cancel before paying the full amount of the contract.
The obvious problem with using CARR and calling it ARR is that it is much more prone to being “gamed” than traditional ARR. If a startup doesn’t realistically account for churn and sales decline, CARR could be inflated. For example, a startup could offer deep discounts for the first two years of a three-year contract and count the full three years as CARR (or ARR), even though customers might not pay the higher prices in the third year.
“I think Scott [Stevenson] it is correct. I’ve also heard all sorts of anecdotes,” Ross McNairn, co-founder and CEO of legal AI startup Wordsmith, told TechCrunch about ARR’s misleading statements. “I talk to VCs all the time. They say, “There are some shaky, shaky standards out there.”
Most cases are slightly less extreme. For example, an employee at another startup described a discrepancy where marketing materials claimed $50 million in ARR, when the actual figure was $42 million.
However, that person claimed investors had access to the company’s books, which accurately reflected the lower amount. The source said some startups and their investors are comfortable playing fast and loose with their public metrics, in part because AI startups are growing so fast that an $8 million gap is seen as a rounding error in which to grow quickly.
The other, more problematic “ARR”
There is another issue with all these ARR public statements. Sometimes founders use another metric with the same acronym “ARR” and a similar name: annual revenue from execution rate.
This ARR is also controversial because it extrapolates current revenue over the next 12 months based on the recall of a given period (eg a quarter, month, week or even a day).
Since many AI companies charge based on usage or results, this method of calculating annual ARR can be misleading because revenue is no longer locked into predictable contracts.
Most people interviewed for this story said that ARR overstatements of all kinds are hardly a new phenomenon, but startups have become much more aggressive amid the AI hype.
“Valuations have gotten higher, so the incentives are stronger to do it,” Michael Marks, founding partner of Celesta Capital, told TechCrunch.
In the age of artificial intelligence, startups are expected to grow much faster than ever before.
“Going from 1 to 3 to 9 to 27 is not interesting,” said Hemant Taneja, Managing Director and CEO of General Catalyst. podcast 20 VC last September, referring to the millions in ARR that a startup is traditionally predicted to hit each year. “You have to go from 1 to 20 to 100.”
The pressure to demonstrate rapid growth prompts some VCs to back, or at least overlook, startups that present inflated ARR figures to the public.
“There are definitely VCs in it because they’re motivated to create a narrative that they have runaway winners. They’re motivated to get press coverage for their companies,” Stevenson told TechCrunch.
Newton, whose legal AI startup Clio was valued 5 billion dollars last fall, also alleges that VCs often know but remain silent about misleading ARR statements. “We see some investors looking back when their companies inflate their numbers because it makes them look good from the outside in,” he told TechCrunch.
What VCs really think
Other investors who spoke to TechCrunch say there’s no reason for VCs to expose overvaluations.
By turning a blind eye to public announcements of inflated ARRs, VCs are essentially helping to crown their own portfolio companies winners. When a startup publicly reports high revenue, it is more likely to attract top talent and customers who believe the company is the undisputed king in its category.
“Investors can’t disclose it,” one VC told TechCrunch. “Everyone has a company that monetizes CARR as ARR.”
However, anyone well versed in the intricacies of the industry finds it hard to believe that some of these startups actually reached $100 million in ARR within a few years of launching.
“For everyone inside, it just feels fake,” said Alex Cohen, co-founder and CEO of health AI startup Hello Patient. “You read the headlines and say, ‘I don’t believe it.’
However, not all startups feel they represent growth by reporting CARR instead of ARR. They prefer to be clean and clear about their numbers in part because they understand that the public markets measure software companies by ARR instead of CARR. These founders prioritize transparency.
Wordsmith’s McNairn, who remembers the struggle startups faced justifying high valuations after the market corrected in 2022, said he didn’t want to create an even bigger hurdle by exaggerating his startup’s revenue.
“I think it’s short-sighted, and I think when you do things like that for short-term gain, you’re already overinflating crazy high multiples,” he said. “I think it’s very poor hygiene and it will come back to bite you.”
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