Benchmarking

What is benchmarking?

Benchmarking refers to the systematic comparison of a company's own metrics, processes or cost structures with reference values, in order to identify strengths, weaknesses and opportunities for improvement. The yardstick can be the company's own development over time, another unit of the company, a competitor, the industry average or the best known practice. Benchmarking does not determine a company value but shows where a company stands in comparison. In business administration (German: Betriebswirtschaftslehre, BWL), it is also called a performance or operational comparison (Leistungs- oder Betriebsvergleich); the reference yardstick itself is the benchmark.

Put simply, the heating cost statement of a rented flat illustrates the principle: only the comparison with flats of the same size in the same building reveals whether one's own consumption is high. Only the search for the cause clarifies whether windows, radiators or habits are behind it.

In controlling, benchmarking supplements the budget-vs-actual comparison with an external yardstick. The plan shows whether the company is reaching its own targets; the comparison shows whether those targets are appropriate in a market comparison. In funding rounds, benchmarking supplies arguments for the valuation. Benchmark valuation, that is, valuation using comparison values from funding rounds, uses it to justify a company's position within a valuation range.

Types of benchmarking

• Internal benchmarking: the company's own development over several periods or the comparison between locations and product lines. The data are uniformly defined, but the yardstick remains narrow.
• Competitive benchmarking: the comparison with competitors or the industry average. It shows the relative position in the market but often suffers from incomplete and inconsistently defined data.
• Functional benchmarking: Individual functions or processes, such as receivables management, are measured against companies that master them particularly well, including outside the industry (comparison with best practice).

By subject matter, a distinction can be made between metric, process and strategy benchmarking. In financing and company sales, the comparison of metrics is the main focus.

Approach: the benchmarking process in five steps

1. Define metrics: set out the formula, numerator, denominator and period in writing, for example whether customer churn is measured by number of customers or by revenue.
2. Select the comparison group: companies with a similar business model, similar size, growth phase and region.
3. Choose data sources: published annual financial statements, industry analyses by associations or bookkeeping service providers, published market reports, experience values from investors and advisers.
4. Normalise: adjust for one-off effects and balance out differences in accounting treatment. One example is development costs that under Section 248(2) of the German Commercial Code (Handelsgesetzbuch, HGB) may optionally be recognised as an asset on the balance sheet (capitalised) instead of being booked immediately as an expense. Another is a non-market salary of a shareholder-managing director.
5. Interpret and act: The actual benchmarking analysis looks for causes rather than rankings. Target values and responsible persons follow from it.

Typical metrics in benchmarking

• Gross margin: revenue less directly attributable costs in relation to revenue (gross margin). Comparable only if it is clear whether, for example, the costs of server operation (hosting) and customer support are included.
• Personnel cost ratio and revenue per employee: measures of productivity, distorted by freelancers whose costs are booked as external services.
• Customer acquisition in sales and marketing: sales and marketing costs per new customer (customer acquisition cost, CAC). Also their ratio to customer value, the gross profit of a customer over the entire contract term (LTV/CAC ratio), and the time until they are earned back (CAC payback period).
• Customer churn: the share of customers or revenue lost in a period (churn rate).
• Rule of 40: the sum of revenue growth and profit margin in percent, a widespread yardstick for software companies for growth and profitability at once (Rule of 40).
• Receivables days: average days until payment is received, a measure of receivables management.

Limits of benchmarking

Different definitions are the most common source of error; a churn rate by number of customers is not comparable with one by revenue. In addition come size and phase effects, because a company in build-up bears costs that come into proportion only at higher revenue.

Small comparison groups react strongly to individual outliers. Published comparison values come predominantly from companies that have held their own in the market, while failed ones disappear from the sample (survivorship bias). More robust than a single average is a range stating source, period and definition.

Benchmarking in a funding round and due diligence

Investors measure every company against similar companies from their experience. Growth, gross margin, customer churn and customer acquisition show them whether additional capital leads to disproportionate growth. Due diligence is the in-depth review before the contract is signed. It checks whether the metrics in the investor presentation (pitch deck) are calculated under the same rules as the comparison values the company relies on. Benchmarks thus feed into the valuation discussion but are not themselves a valuation method.

Worked example: benchmarking customer acquisition

Before a funding round, a software company checks its customer acquisition against the previous year and two widespread rules of thumb. Under these, customer value should be at least three times acquisition costs (3 to 1), and these costs should be paid back in less than twelve months.

• Acquisition costs per new customer: EUR 900,000 of sales and marketing costs divided by 60 new customers = EUR 15,000. In the previous year it was EUR 12,000, an increase of 25%.
• Gross profit per customer per month: EUR 1,500 monthly revenue × 80% gross margin = EUR 1,200.
• Payback: 15,000 divided by 1,200 = 12.5 months, just above the rule of thumb.
• Customer value: at 2% monthly churn, a customer stays on paper 1 divided by 0.02 = 50 months; 50 × EUR 1,200 = EUR 60,000.
• Ratio of customer value to acquisition costs: 60,000 divided by 15,000 = 4 to 1, better than the rule of thumb.
• Rule of 40: revenue growth of 45% plus EBITDA margin (earnings before interest, taxes, depreciation and amortisation in relation to revenue) of minus 15% = 30, below the threshold of 40.

The definition changes the picture. Without hosting and support costs, the gross margin rises to 88% and the gross profit per customer to 1,500 × 88% = EUR 1,320. Payback then falls to 15,000 divided by 1,320 = around 11.4 months. The rule of thumb would seemingly be met, solely through a different formula. An investor who calculates in full arrives again at 12.5 months. For the comparison, therefore, only the full calculation counts.

Distinctions: benchmarking and benchmark valuation

• Benchmark valuation: valuation using comparison values, above all using valuations that comparable companies have recently achieved in funding rounds. Benchmarking does not determine a value; it does show, however, whether a valuation at the upper or lower end of the comparison group can be justified.
• Precedent transactions: valuation based on the purchase prices paid in the acquisition of comparable companies. The subject is the price, not the company's performance.
• Financial health check: a comprehensive stocktake of the financial situation in which benchmarks are one building block among several.

Common mistakes

• Definitions not reconciled. Own values are compared with comparison values calculated under different rules. The result then says more about the formula than about the company.
• Unsuitable comparison group. Measuring a company with EUR 5 million in revenue against established market leaders leads to wrong target values.
• Point values instead of ranges. A single average suggests a precision that the data rarely provide.
• Benchmark replaces strategy. Targets derived solely from averages make mediocrity the goal.

Frequently asked questions

Where do reliable comparison values come from?

From published annual financial statements, industry analyses, published market reports and the experience of investors and advisers, in each case with a documented definition and comparison group.

Is benchmarking the same as a benchmark valuation?

No. Benchmarking compares metrics such as growth, gross margin or customer churn and does not determine a value. Benchmark valuation derives a value range from the valuations of comparable funding rounds and relies on benchmarking to justify the company's position within it.

May competitors exchange metrics with each other?

Only within narrow limits. The exchange of competitively sensitive information such as current prices, capacities or customer terms can breach the prohibition of cartels under Section 1 of the German Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen, GWB) and European competition law. Such comparisons are therefore usually run through neutral bodies with aggregated, anonymised and older data.

How can benchmarking be visualised?

A radar chart (spider chart) is usually suitable for visualisation, setting several of the company's metrics, each on its own axis, against the comparison value. For a single metric, a bar chart showing the range of the comparison group and the company's own position within it is enough. Strengths and weaknesses thus become visible without reading tables.

Which metrics do investors compare first for software companies?

Usually growth in recurring revenue, gross margin, customer churn, the ratio of customer value to acquisition costs and the monthly cash burn. The weight of the individual figures depends on the growth phase.

The Roemer Capital view

Before a funding round, we check our clients' metrics first for their definition and only then for their level. As rules of thumb, we use a few values around which investor discussions, in our experience, are oriented. These include a ratio of customer value to acquisition costs of at least 3 to 1 and a payback of acquisition costs of under twelve months. For the runway, that is, the reach of the liquid funds, our guideline at the start of a process is 12 to 18 months.

In Roemer Capital OS, the company's metrics are shown next to these guidelines, together with the financial check. If a value misses the rule of thumb, we work with the management on an explanation and an action plan before the first investor asks about it.