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

Last month, Scott Stevenson, co-founder and CEO of legal AI startup Spellbook, went to X in an effort to create what he called a “huge scamamong AI startups: inflation of the revenue figures they publicly announce.

“The reason many AI startups are shattering revenue records is because they use an unfair metric. The largest funds in the world support this and mislead journalists for PR reporting,” he wrote in his tweet.

Stevenson is not the first to claim that annual recurring revenue (ARR) – a metric historically used to summarize the annual revenue of active contracted customers – is being manipulated beyond recognition by some AI companies. Certain aspects of ARR shenanigans have been the subject of several other news reports And social media reports.

However, Stevenson’s tweet seemed to have struck a particular chord within the AI ​​startup community, with more than 200 replies and reactions from leading investorsa lot of foundersAnd a few headlines.

“Scott from Spellbook has done a great job of highlighting some of what you might describe as bad behavior from some companies,” Jack Newton, co-founder and CEO of legal startup Clio, told TechCrunch, adding that the post brought much-needed awareness to the topic, citing a explanatory post from Garry Tan of YC on the correct turnover statistics.

TechCrunch spoke to more than a dozen founders, investors, and startup finance professionals to assess whether ARR inflation is as widespread as Stevenson suggests.

Our sources, many of whom spoke on condition of anonymity, confirmed that false ARR in public statements is common among startups, and that in many cases investors are aware of the exaggerations.

No real income yet

The main obfuscation tactic is to replace “contracted ARR,” sometimes called “committed ARR” (CARR), and simply call it ARR.

“They are definitely reporting CARR” as ARR, one investor said. “If a startup does it in a category, it’s hard not to do it yourself, just to keep up.”

ARR is a metric established and trusted since the cloud era that represents total product sales measuring usage, and therefore payments, over time. Accountants do not formally audit or sign ARR, primarily because generally accepted accounting principles (GAAP) focus on historical, already collected revenue, rather than future revenue.

ARR was intended to represent the total value of signed and sealed sales, typically multi-year contracts. (Today, this concept tends to go by a different name: residual performance obligations.) Meanwhile, the term “revenue” is typically reserved for money that has already been collected.

CARR should be another way to track growth. But it is a much weaker metric than ARR because it measures revenue from signed customers who are not yet onboarded.

One VC told TechCrunch that he has seen companies where CARR is 70% higher than ARR, even though a significant portion of that contracted revenue will never actually be realized.

CARR “builds on the ARR concept by adding committed but not yet live contract values ​​to the total ARR”, Bessemer Venture Partners (BVP) wrote in a blog post But crucially, according to BVP, the startup must adjust CARR to take into account expected churn (how many customers leave) and downsell (those who decide to buy less).

The biggest problem with CARR is counting revenue before deploying a startup’s product. If the implementation takes a long time or goes wrong, customers can cancel during the trial period before all (or part of) the contractual revenue has been collected.

Several investors told TechCrunch that they are directly aware of at least one high-profile startup that reported ARR exceeding $100 million, with only a fraction of that revenue coming from currently paying customers. The rest came from contracts that had not yet been implemented and in some cases the technology can take a long time to implement.

A former employee at a startup that routinely reported CARR as ARR told TechCrunch that the company counted at least one substantial one-year free pilot as ARR. The company’s board, which includes a venture capital fund from a large fund, was aware that revenue from the final paying portion of the contract had been counted in ARR during the long-term pilot program, the person said. The board was also aware that the customer could cancel before paying the full contract amount.

The obvious problem with using CARR and calling it ARR is that it is much more sensitive to ‘gaming’ than traditional ARR. If a startup doesn’t realistically account for churn and downsell, CARR can become bloated. For example, a startup could offer deep discounts for the first two years of a three-year contract and count the entire three years as CARR (or ARR), even though customers in year three might not stick around to pay the higher prices.

“I think Scott [Stevenson] is right. I’ve also heard all kinds of anecdotes,” Ross McNairn, co-founder and CEO of legal AI startup Wordsmith, told TechCrunch about misrepresentations from ARR. “I talk to venture capital firms all the time. They say, ‘There are some choppy, choppy standards.’

Most cases are slightly less extreme. For example, an employee at another startup described a discrepancy where marketing materials claimed $50 million in ARR, when the actual amount was $42 million.

However, this person claimed that investors had access to the company’s books, which accurately reflected the lower amount. The source said some startups and their investors are comfortable playing fast and loose with their public metrics, in part because AI startups are growing so quickly that an $8 million gap is seen as a rounding error that they will quickly grow into.

The other, more problematic “ARR”

There’s another problem surrounding all those public ARR statements. Sometimes founders use a different measure 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 twelve months based on revenue for a specific period (for example, a quarter, month, week, or even a day).

Because many AI companies charge based on usage or results, this method of calculating annual run-rate ARR can be misleading because revenues are no longer locked into predictable contracts.

Most people interviewed for this story said that ARR exaggerations of all kinds are hardly a new phenomenon, but startups have become much more aggressive amid the AI ​​hype.

“Valuations have gotten higher, and so the incentives to do it are stronger,” Michael Marks, one of the founders and managing partners at Celesta Capital, told TechCrunch.

In the age of AI, startups are expected to grow much faster than ever before.

“Going from 1 to 3, from 9 to 27 is not interesting,” said Hemant Taneja, CEO and managing director of General Catalyst, at the 20VC podcast last September, referring to the millions in ARR that a startup traditionally expects to achieve each year. “You have to go from 1 to 20 to 100.”

The pressure to demonstrate rapid growth is prompting some VCs to back, or at least overlook, startups that present inflated ARR figures to the public.

“There are definitely VCs involved in this because they are incentivized to create a narrative that they have runaway winners. They are incentivized to get press attention for their companies,” Stevenson told TechCrunch.

Newton, whose AI legal startup Clio was rated $5 billion last fall also claims that VCs are often aware but silent about ARR misrepresentations. “We see some investors looking the other way when their own companies inflate the numbers because they look good from the outside,” he told TechCrunch.

What VCs really think

Other investors who spoke to TechCrunch say there is no reason for VCs to expose the exaggerations.

By turning a blind eye to public statements about inflated ARR, VCs effectively help crown the winners of their own portfolio companies. 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 pronounce it,” one venture capitalist told TechCrunch. “Everyone has a company that converts CARR as ARR.”

Still, anyone intimately familiar with the intricacies of the industry may find it hard to believe that some of these startups actually reached $100 million in ARR within a few years of launch.

“For everyone in it, it just feels fake,” said Alex Cohen, co-founder and CEO of health AI startup Hello Patient. “You read the headlines and you say, ‘I don’t believe it.'”

However, not all startups are comfortable with 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 based on ARR rather than CARR. These founders prioritize transparency.

Wordsmith’s McNairn, who remembers the struggle startups faced to justify high valuations after the 2022 market correction, said he doesn’t want to create an even higher hurdle by overstating his startup’s revenues.

“I think it’s shortsighted, and I think if you do that kind of thing for short-term gain, you overinflate the already insanely high multiples,” he said. “I think it’s super bad hygiene, and it’s going to come back and bite you.”