ROI Alone is a Dangerous Metric for Investors

Nearly every term sheet includes some kind of Return on Investment (ROI). Although this is an important factor, it’s not a complete picture of a venture’s viability. There’s at least one more metric that needs to be assessed, and it’s one that often times isn’t tracked; especially with smaller ventures. This metric is called Return on Reinvested Profit (RORP).

A startup offering attractive ROI terms is fine, however, what happens if the company is doing a lousy job of maximizing financial growth with their earnings? Startups that demonstrate an ability to reinvest profits (not necessarily all of their profits) for growth indicate a mature business acumen.

We’ve seen countless ventures that pour all their profits into things that don’t advance the company’s economic position at all. This includes office furniture, owner’s draws from equity for personal expenditures (Vegas anyone?), and product feature obsessions.

Nothing is riskier than this, because a company that fails to reinvest wisely runs a very high probability of going broke. Many investors gravitate towards ventures with high RORP without even realizing it, because all they know is the company is thriving.

This is also a reason why many companies go public, claiming they need public financing to achieve the kind of scale that they desire. Yet if most of the venture leaders were asked about their RORP’s, they wouldn’t be able to easily provide specific data around their RORP figures – and if they did, the results would likely be dismal.

For investors, the ROI is nothing more than an indicator of what the payoff could be if things go as planned. But as this may come as a surprise to some, we all know that actions aren’t always consistent with words.

Although RORP is a lagging indicator as well, it has a much more valuable utility in assessing a venture’s prospects, because at a minimum it reflects management behavior.

Here are some example questions that can be used to illicit helpful data about a particular venture’s viability using RORP, along with an explanation of how the data can be used in vetting.

What is the average RORP %? (Metric 1)

If a startup has this data readily available along with verifiable evidence to support it, that’s a very good sign. Why? Because it indicates that self-funding is a priority for the organization, which could be interpreted in any number of positive lights.

We’ve noticed that many ventures where this metric isn’t being tracked have leadership that are sucking all the profit out of the venture, thus reducing it’s overall ability to execute. This is what generally leads to venture leaders having to seek outside funding, and we like to avoid investments that are poor at managing profits.

This metric also shows management’s ability to reinvest wisely (or not) into their organization’s growth. So in other words, the higher the figure, the better, in general terms.

And finally, this metric is a good indicator of whether or not the organization will be able to honor their ROI commitments.

What is the average % of profit reinvestment? (Metric 2)

Our first question identifies the startup leader’s effectiveness with reinvestment, while this question uncovers the leader’s commitment to reinvestment.

Metric 1 doesn’t give us the complete picture, because if an organization has a 60% profit margin, and they only reinvest 5% of that, then where in blue blazes is all the rest going?

That’s exactly why Metric 2 is helpful, because it reveals how much profit has been reinvested.

Imagine a company generating high RORP’s on 90% of profit reinvested? One could argue this company may never need external financing.

These two metrics indicate a patient and savvy mentality of the leaders, as opposed to the occasional Shark Tank participant who comes onto the show to raise money so they can pay themselves a healthy salary.

We could go on for days demonstrating the various benefits to the investor using RORP, but the truth is, these two aspects alone are sufficient. In fact, even investors who struggle to fully understand the RORP would still benefit from it greatly just by using it to (a) weed-out deal flow, (b) identify viable prospects and (c) keep a leading pulse on their current portfolio’s performance.

One more final note, tracking a trend in a ratio between top line revenue growth (%) and RORP (%) is a great way to quickly monitor a venture’s viability. So for example, if a venture spinning off 20% top line growth has 80% RORP, that yields a Growth-to-RORP ratio of .66. This indicates the venture is not only good at sales, but reinvestment as well.

Now imagine an organization with a 1,000% top line revenue growth with only a 5% RORP, that leaves a ratio of 200. Investors may think there’s nothing wrong with this because the growth is stellar – and they would be right in the short-term. However, a long-term investor in the venture should see this as a red flag, because there’s a mismanagement of profit. Also, even for short-term investors, not all ventures explode like this right away, which is why the organization needs investment in the first place. So the measure is still useful in assessing the team’s effectiveness until that point.

Blessings.