Every time you spend a dollar in your business, you are making a bet. You are betting that the dollar will come back to you bringing friends. Return on Investment, or ROI, is the metric used to calculate how many friends that dollar brought back.
At its core, ROI is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. It answers a simple question. Was this expenditure worth it?
For a startup founder, this is not just about Wall Street portfolios. It applies to hiring a new developer, purchasing a SaaS subscription, or launching a marketing campaign. It is the ratio of net profit to cost.
The Basic Calculation
#The formula is deceptively simple. You take the current value of the investment, subtract the cost of the investment, and divide that result by the cost of the investment.
If you spend $1,000 on ads and generate $1,500 in sales, your net profit is $500. You divide $500 by the $1,000 cost to get 0.5, or a 50 percent ROI.
However, in a startup environment, the “cost” is rarely just the sticker price. If you buy a piece of software for $500, but it takes your lead engineer ten hours to integrate it, the actual cost includes those ten hours of salary. Failing to account for implementation time is a common mistake that inflates perceived ROI.
ROI vs. ROAS
#It is critical to distinguish ROI from a similar term you will hear often in marketing. That term is Return on Ad Spend (ROAS).
Marketing agencies and ad platforms love to report on ROAS. This metric only looks at the gross revenue generated from specific ad money. If you spend $1 on ads and get $4 in revenue, you have a 4:1 ROAS.
That looks great on a dashboard. But it ignores the cost of goods sold, shipping, payment processing fees, and the salary of the marketing manager.
ROI takes the broader view. It forces you to look at the bottom line profit after all expenses are accounted for. You can have a positive ROAS and a negative ROI simultaneously. Knowing the difference prevents you from scaling a campaign that is actually losing money.
The Trap of Intangibles
#ROI is easy to calculate when the inputs and outputs are dollars. It gets messy when the output is intangible. This is often called “Soft ROI.”
Examples include:
- investing in brand awareness
- improving employee culture
- attending networking conferences
You might spend $5,000 sending a team to a conference. If they do not close a deal immediately, the hard ROI is negative. However, the relationships built might yield fruit two years from now.
The Innovation Dilemma
#Strict adherence to ROI can sometimes kill innovation. New product development often has a terrible short-term ROI. You pour money into research and development with zero immediate return.
If you only approve projects with a guaranteed fast return, you will likely build a safe, stagnant business. The challenge for a founder is balancing high-ROI activities that keep the lights on with low-ROI (or unknown-ROI) bets that could change the trajectory of the company.
We have to ask ourselves: how long are we willing to wait for the return? Is the horizon three months or three years? The math changes depending on your runway.