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The Run Rate Trap

 

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One of the best ways to think you are the only company not doing well is to go to a networking event and ask other founders about their “run rate.” You’ll hear that 6 month old companies are on a $50M run rate or that a three person startup is on a $100M run rate. Clearly there is a magic bean stalk that everyone else knows about except for you.

In finance, a run rate is an estimate for the full year value of a financial metric (e.g revenues) which is made by extrapolating from a shorter period of time (e.g. a few months). For example, you can use a run rate to estimate the annual revenues for a store by taking the first three months of the year and multiplying it by four to get the revenues for all twelve months. However, that assumes the rate of growth of store sales stays flat and if the business is growing, it’s better to assume the rate of growth, say 10% month to month, stays the same and estimating annual sales from that. It’s a quick way to understand the annual size of a business based on a snapshot of data.

Unfortunately, run rates are as error prone as they are simple. The faster your growth rate and the more volatile your finances, the less accurate a run rate estimate will be. When we extrapolated the annual revenues for a store from the first three months of the year we did not take into account the Christmas rush in December which can generate 50% of a store’s revenue.  If that was the case with this store we would have underestimated the annual revenue of the store by 50%.

If you take too small of a snapshot of data, or worse you cherry pick the data, your run rate estimate can be wildly inaccurate. Estimating the annual revenue for a store from only one day is impossible, and if that one day is Black Friday then your run rate estimate will be orders of magnitude higher than reality.

Which is exactly what your friends at the networking event were doing. The pressure to succeed is strong and it is tempting to bend the truth to make things sound good. Cherry picking a few good weeks or months of revenue and calculating your run rate from that is one way to bend the rules. Yes, it is technically possible that you will make $50M this year but that is hard to tell from the $3.5M you made in the first quarter even if you are growing 25% month over month. More than likely you will hit some bumps in the road and not quite get to $50M this year.

Not everyone uses their run rate to mislead you purposely, but in the world of fast growing companies the run rate is very often misleading anyway. Use it with care or at least with a dose of skepticism. So, the next time you hear someone’s run rate is an order of magnitude higher than yours don’t worry. They might just been telling you what they want you to hear.

This article was originally published at Sean on Startups, a blog about starting and growing companies.

Image credit: CC by George Thomas

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About the author: Sean Byrnes

Sean is the founder of Flurry, the leader in advertising and analytics services for mobile applications. He is currently an advisor, mentor and angel investor in the San Francisco bay area. You can read more of his advice and thoughts on building businesses on Sean On Startups and his personal website.

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