Scott Stevenson, co-founder and CEO of the legal AI startup Spellbook, recently brought attention to what he termed a “major scam” within the realm of AI startups: the inflation of revenue figures in public disclosures.
He noted, “Many AI startups are reporting record revenues by using misleading metrics. This practice, supported by leading funds, misleads journalists and distorts public perception,” he wrote in his post.
This isn’t the first assertion regarding the manipulation of annual recurring revenue (ARR), a key metric traditionally used to reflect the total annual revenue from active, contracted customers. Reports and social media discussions have previously highlighted similar concerns related to this metric’s integrity.
However, Stevenson’s comments appeared to resonate particularly strongly with the AI startup community, leading to over 200 shares and reactions from notable investors, various founders, and media outlets.
“Scott at Spellbook did an excellent job of shedding light on some questionable practices among certain companies,” stated Jack Newton, CEO of legal startup Clio. He emphasized that the tweet increased awareness on this critical topic, referencing an explanatory post from Garry Tan of Y Combinator about accurate revenue metrics.
To gauge the extent of the ARR inflation as suggested by Stevenson, ToolsMixAi reached out to a dozen founders, investors, and startup finance specialists.
Many industry insiders, who preferred to remain anonymous, confirmed that overstating ARR in public statements is not uncommon, and in many instances, investors are aware of these discrepancies.
Misleading metrics in play
A prevalent tactic involves interchanging “contracted ARR” or “committed ARR” (CARR) and simply presenting it as ARR.
“Absolutely, they are reporting CARR as ARR,” noted one investor. “When a startup engages in this practice, it’s tempting for others to follow suit to maintain competitiveness.”
Traditionally, ARR serves as a reliable metric developed in the cloud era to quantify the total sales from products where usage and payments occur over time. Accountants generally don’t audit ARR, as established accounting practices prioritize already collected revenue, rather than future projections.
ARR aims to reflect the complete value of formally signed multi-year sales contracts, while “revenue” typically refers to money that has already been received.
CARR aims to provide another model for growth tracking, but it is less reliable since it includes revenue from future contracts that have yet to be initiated.
One venture capitalist relayed to ToolsMixAi that he had encountered companies where CARR was 70% higher than ARR, even though a substantial portion of that contracted revenue was unlikely to materialize.
CARR “augments the ARR concept by incorporating revenue from contracts that are not yet active,” remarked Bessemer Venture Partners (BVP) in a blog entry from 2021. However, BVP cautioned that startups should adjust CARR figures to reflect expected customer churn and “downsell”—situations where customers purchase less than initially anticipated.
The central issue with CARR lies in prematurely counting revenue before the product is implemented. If the implementation phase is extended or problematic, clients may cancel during trials, resulting in the loss of potential revenue.
Several investors informed ToolsMixAi of a prominent enterprise startup that claimed to exceed $100 million in ARR, despite just a small portion of that revenue stemming from active customers. A significant amount was from contracts not yet in operation, some of which may require considerable time to be fully deployed.
One ex-employee from a startup that commonly reported CARR as ARR shared with ToolsMixAi that the company tallied a substantial year-long free pilot as ARR. Leadership, including a venture capitalist on the board, were aware that revenue from the paying component was counted during the lengthy pilot but did not have assurance that the client would pay the complete contract sum later.
Using CARR and labeling it ARR poses a greater opportunity for manipulation compared to traditional ARR. Without a realistic assessment of churn and downsell, CARR figures might be artificially inflated. For example, a startup could offer significant discounts for the first two years of a three-year contract while counting the entire contract value as CARR (or ARR), despite potential customer avoidance of higher prices in the final year.
“I believe Scott [Stevenson] is correct. I’ve heard numerous anecdotes on this matter,” stated Ross McNairn, CEO of Wordsmith. “In conversations with VCs, it’s clear there are inconsistent standards prevalent.”
In many situations, discrepancies are less extreme. An employee from another startup recounted a scenario where marketing materials claimed $50 million in ARR, while the verified figure was $42 million. Yet, investors knew the true number as they had access to the company’s financials. The source indicated that some startups and their investors are comfortable bending their public metrics, viewing an $8 million discrepancy as an easily achievable target given the rapid growth of AI startups.
A second, troubling definition of “ARR”
Another issue surrounding public ARR statements is the use of a different “ARR” definition: annualized run-rate revenue. This version also draws scrutiny as it projects current revenue over the next 12 months based on short-term performance (like quarterly or monthly metrics).
Given that many AI companies charge by usage or outcomes, this method can create misleading projections because revenue is no longer locked into fixed contracts.
Most sources consulted for this article emphasized that inflation of the ARR figure is not new, but startups are reportedly becoming more brazen due to the current AI boom.
“With rising valuations, the incentive to inflate figures has grown stronger,” remarked Michael Marks, founding managing partner at Celesta Capital.
In an era dominated by AI, expectations for rapid growth are the new norm.
“Transitioning from 1 to 3 to 9 to 27 isn’t impressive,” remarked Hemant Taneja, CEO of General Catalyst, during a recent 20VC podcast. “You need to accelerate to 1 to 20 to 100.”
This pressure compels some venture capitalists to overlook or support startups with inflated ARR declarations.
“There are definitely VCs who are complicit, driven to build a narrative around their portfolio companies,” Stevenson observed. “They too benefit from favorable press coverage.”
Newton, whose legal AI company Clio achieved a valuation of $5 billion last autumn, suggested that VCs often choose silence regarding ARR inaccuracies. “It’s common to see investors ignore discrepancies in numbers because it reflects well on them,” he added.
VCs’ perspectives on the matter
Other investors who communicated with ToolsMixAi believe there’s little reason for VCs to challenge inflated revenue claims.
By overlooking these inflated ARR announcements, VCs essentially support their own portfolio companies in maintaining a favorable public image. Publicized high revenue often helps attract top talent and discerning customers who may regard the company as a leader in its field.
“Investors find it hard to call out these overstatements,” remarked a VC. “Almost everyone seems to monetize CARR as ARR.”
However, industry insiders often struggle to reconcile claims that some startups genuinely achieved $100 million in ARR shortly after launching.
“To those inside the industry, it simply seems implausible,” remarked Alex Cohen, co-founder of health AI firm Hello Patient. “You see these headlines and think, ‘I find that hard to believe.’”
Not all startups opt to inflate their growth by using CARR instead of ARR. Some prioritize clear and honest reporting, recognizing that public markets predominantly evaluate software companies based on ARR metrics. These founders emphasize transparency.
McNairn from Wordsmith recalls the challenges startups faced justifying high valuations post-2022 market adjustments and aims to avoid creating additional barriers by inflating revenue figures. “It’s short-sighted; such tactics inflate already lofty multiples,” he stated. “It’s ultimately detrimental and will come back to haunt you.”
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