How VCs and founders use inflated ‘ARR’ to crown AI startups

Scott Stevenson, co-founder of legal AI startup Spellbook, exposed what he called a "huge scam" among AI startups involving the inflation of revenue figures. He claimed that many AI startups are crushing revenue records by using a dishonest metric, with the world's largest funds supporting this and misleading journalists for PR coverage. Stevenson's tweet struck a nerve within the AI startup community, drawing over 200 reshares and comments from high-profile investors and founders. TechCrunch spoke with over a dozen founders, investors, and startup finance professionals to assess the prevalence of this practice. The main obfuscation tactic is substituting "contracted ARR" (CARR) and simply calling it ARR. ARR is a metric established since the cloud era to indicate total sales of products where usage and payments are metered out over time. CARR is supposed to track growth by adding committed but not yet live contract values to total ARR, but it is a much squishier metric because it counts revenue from signed customers that aren't onboarded yet. One VC told TechCrunch that he has seen companies where CARR is 70% higher than ARR, even though a significant chunk of that contracted revenue will never actually materialize. The main problem with CARR is counting revenue before a startup's product is implemented. If implementation is lengthy or goes awry, clients might cancel during the trial before all or any of the contracted revenue has been collected. Several investors told TechCrunch that they directly know of at least one high-profile enterprise startup that reported it surpassed $100 million in ARR, when only a fraction of that revenue came from currently paying customers. The rest was from contracts that hadn't been deployed yet and in some cases may take a long time to implement the technology. The obvious problem with using CARR and calling it ARR is that it is far more susceptible to being "gamed" than traditional ARR. If a startup doesn't account realistically for churn and downsell, CARR could be inflated. There's another issue surrounding all those public ARR declarations. Sometimes founders use another measurement with the same "ARR" acronym and a similar name: annualized run-rate revenue. This ARR is also controversial because it extrapolates current revenue over the next 12 months based on a given period's haul. Since many AI companies charge based on usage or outcomes, that method of calculating annualized run-rate ARR can be misleading because revenue is no longer locked into predictable contracts. Most people interviewed for this story said that ARR overstatements of all kinds are hardly a novel phenomenon, but startups have become far more aggressive amid the AI hype. The valuations have gotten higher, and so the incentives are stronger to do it. In the age of AI, startups are expected to grow much faster than ever before. The pressure to show rapid growth is prompting some VCs to support, or at least overlook, startups presenting inflated ARR figures to the public. There are definitely VCs in on this because they're incentivized to create a narrative that they have runaway winners. They're incentivized to get press coverage for their companies. Other investors who spoke with TechCrunch say there is no reason for VCs to expose the overstatements. By turning a blind eye to public pronouncements of inflated ARR, VCs are effectively helping to crown their own portfolio companies winners. When a startup publicly reports high revenue, it is more likely to attract the best talent and customers who believe the company is the undisputed king in its category. Investors can't call it out because everyone has a company monetizing CARR as ARR. However, not all startups feel comfortable representing growth by reporting CARR instead of ARR. They prefer to be clean and clear about their numbers in part because they understand that public markets measure software companies on ARR rather than CARR. These founders prioritize transparency. Wordsmith's McNairn, who remembers the struggle startups faced justifying high valuations after the 2022 market correction, said he doesn't want to create an even higher hurdle by exaggerating his startup's revenue. He thinks it is short-sighted and that when you do things like that for a short-term gain, you're overinflating already crazy high multiples. He thinks it's super bad hygiene, and it's going to come back and bite you.

(Source：Tech Crunch)