Last month, Scott Stevenson, co-founder and CEO of AI law startup Spellbook, took to
“The reason so many AI startups break revenue records is because they use a dishonest metric. The world’s largest funds support this and mislead journalists for PR coverage,” he tweeted.
Stevenson isn’t the first to claim that annual recurring revenue (ARR) – a metric historically used to summarize annual revenue for customers active under a contract – is being manipulated by some AI companies beyond recognition. Certain aspects of the ARR scams have been the subject of numerous other news reports and social media posts.
However, Stevenson’s tweet appears to have struck a chord within the AI startup community, attracting more than 200 shares and comments from prominent investors, several founders and some headlines.
“Scott at Spellbook has done a great job of highlighting some of what could be described as bad behavior on the part of some companies,” Jack Newton, co-founder and CEO of law startup Clio, told TechCrunch, adding that the post brought much-needed awareness to the topic, referring to an explanatory post from YC’s Garry Tan on proper revenue metrics.
TechCrunch spoke with more than a dozen founders, investors, and startup finance professionals to assess whether ARR inflation is as widespread as Stevenson suggests.
In fact, our sources, many of whom spoke on the condition of anonymity, confirmed that fabricated ARRs in public statements are common among startups, and how investors, in many cases, are aware of these exaggerations.
Not really revenue, yet
A key confusion tactic is to replace the phrase “contracted ARR,” sometimes referred to as “committed ARR” (CARR), and simply call it ARR.
“They definitely report CARR” as ARR, one investor said. “When a startup is doing it in a category, it’s hard not to do it yourself just to keep up.”
ARR is a metric that has been established and trusted since the cloud era to indicate total product sales where usage, and therefore payments, are measured over time. Accountants do not audit or formally sign off on the ARR in the first place because Generally Accepted Accounting Principles (GAAP) focus on historical revenues already collected, rather than future revenues.
The purpose of the ARR was 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 actually raised.
The CARR ratio is supposed to be another way to track growth. But it’s a smoother metric than ARR because it counts revenue from registered customers who haven’t joined yet.
One venture capitalist told TechCrunch that he’s seen companies where the CARR is 70% higher than the ARR, even though a significant portion of that contracted revenue will never actually materialize.
“CARR builds on the concept of ARR by adding the values of committed but not yet live contracts to the total ARR,” Bessemer Venture Partners (BVP) wrote in a blog post in 2021. However, crucially, BVP says, the startup is supposed to adjust its CARR to take into account expected customer churn (the number of customers who leave) and “downsells” (those who decide to buy less).
The main problem in CARR is calculating revenue before implementing a startup’s product. If implementation takes too long or goes wrong, customers may cancel during the trial period before collecting all – or any – of the contracted revenue.
Several investors told TechCrunch that they know firsthand of at least one high-profile startup that reported to have surpassed $100 million in ARR, while only a portion of that revenue came from currently paying customers. The remainder were contracts that had not yet been published and in some cases it may take a long time to implement the technology.
One former employee at a startup that routinely reported CARR as ARR told TechCrunch that the company counted at least one major free pilot for a year as ARR. The company’s board, including venture capital from a large fund, was aware that revenue from the final reimbursement portion of the contract had been counted toward the ARR during the lengthy pilot program, this person said. The Board was also aware that the customer could cancel before paying the full contract amount.
The obvious problem with using CARR and calling it ARR is that it is more susceptible to manipulation than traditional ARR. If a startup does not realistically account for declines and sales, the CARR may inflate. For example, a startup could offer deep discounts on the first two years of a three-year contract and count the entire three years as CARR (or ARR), even though customers may not continue to pay the higher prices in the third year.
“I think Scott [Stevenson] This is correct. “I’ve heard all kinds of anecdotes, too,” Ross McNairn, co-founder and CEO of AI legal startup Wordsmith, told TechCrunch about ARR’s misrepresentations. “I talk to venture capitalists all the time. They say, ‘There are some standards that are fickle and fickle.’
Most cases are a little less extreme. For example, an employee at another startup described a discrepancy where marketing materials claimed $50 million in ARR, when the actual number was $42 million.
However, this person claimed that investors had access to the company’s books, which accurately reflected the lower amount. Some startups and their investors are comfortable playing fast with their overall metrics in part because AI startups are growing so quickly that the $8 million gap is seen as a rounding error over which they will grow quickly, the source said.
The other more problematic “ARR”
There is another problem surrounding all public ARR announcements. Sometimes founders use another measurement with the same abbreviation “ARR” and a similar name: annual run rate revenue.
The annual rate of return (ARR) is also controversial because it extrapolates current revenues over the next 12 months based on the length of a given period (for example, a quarter, a month, a week, or even a day).
Since many AI companies charge fees based on usage or results, the ARR calculation method can be misleading because revenues are no longer tied to predictable contracts.
Most people interviewed for this story said ARR overvaluations of all kinds are not a new phenomenon, but startups are becoming more aggressive amid the hype around AI.
“Valuations have gone up, so the incentives to do this are stronger,” Michael Marks, founding managing partner at 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 very interesting,” Hemant Taneja, CEO and managing director of General Catalyst, said on the 20VC podcast last September, referring to the millions of ARR that startups are traditionally expected to generate each year. “You have to go from 1 to 20 to 100.”
The pressure to show rapid growth leads some venture capital firms to back, or at least overlook, startups that present inflated APR numbers to the public.
“There are definitely VCs involved in this because they are incentivized to create a narrative that they have runaway winners. They are incentivized to get press coverage for their companies,” Stevenson told TechCrunch.
Newton, whose legal AI startup Clio was valued at $5 billion last fall, also claims that venture capitalists are often aware of ARR misrepresentations but are silent. “We see some investors looking the other way when their companies inflate numbers because it makes them look good from the outside in,” he told TechCrunch.
What are venture capitalists really thinking?
Other investors who spoke with TechCrunch say there is no reason for venture capital firms to disclose exaggerations.
By turning a blind eye to public statements about the inflated return rate, venture capital firms are effectively helping shape their own portfolio companies. When a startup publicly advertises high revenues, it is more likely to attract top talent and customers who believe the company is the undisputed winner in its category.
“Investors can’t rule it out,” one venture capitalist told TechCrunch. “Everyone has a company that invests CARR in the name of ARR.”
However, anyone familiar with the intricacies of the industry finds it hard to believe that some of these startups have already reached $100 million in ARR within a few years of launch.
“For everyone on the inside, it looks fake,” said Alex Cohen, co-founder and CEO of AI startup Hello Patient. “You read the headlines and say to yourself, ‘I don’t believe it.’”
However, not all startups feel comfortable representing growth by reporting the CARR rate instead of the ARR rate. They prefer to be clean and clear about their numbers in part because they realize that the public markets measure software companies based on ARR rather than CARR. These founders prioritize transparency.
Wordsmith’s McNairn, who remembers the struggle startups have had to justify high valuations after the market correction in 2022, said he didn’t want to create a bigger hurdle by overstating his startup’s revenues.
“I think that’s short-sighted, and I think when you do things like that for short-term gains, you’re over-inflating already crazy high multiples,” he said. “I think hygiene is so bad, it will come back and bite you.”
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