The venture capital industry has always had a complicated relationship with the truth, but the current AI boom has produced something new: a shared delusion dressed up as financial rigor. Across Sand Hill Road and its global outposts, investors and founders are using a version of "annual recurring revenue" so inflated it would make a carnival barker blush—and everyone involved seems perfectly content with the arrangement.
The traditional definition of ARR is straightforward: take your monthly recurring revenue from subscription customers and multiply by twelve. It's a forward-looking metric, yes, but one grounded in actual contracts and actual payments. The AI-era version bears little resemblance. Founders now routinely count pilot programs, one-time enterprise deals, and even "committed" revenue from verbal agreements as ARR. Some are annualizing a single strong month. Others include revenue from customers who signed up for a free trial and haven't cancelled yet.
The incentive structure is working as designed
The practice persists because it serves everyone at the table—except, perhaps, the limited partners whose capital is being deployed. Founders get higher valuations and larger raises. Venture capitalists get to mark up their portfolios and raise their next fund. The AI startups that would otherwise look like promising but early experiments get rebranded as the next Salesforce.
One investor, speaking on background, described the phenomenon with admirable candor: "We all know the numbers are soft. But if you're the one firm that insists on real ARR, you just lose the deal to someone who doesn't." The competitive dynamics of venture capital have turned metric inflation into a collective action problem. No single player can afford to defect.
The bill comes due eventually
History suggests this ends badly. The 2021 vintage of software startups, many of which raised at eye-watering multiples on similarly generous ARR definitions, has spent the past three years conducting painful down rounds and layoffs. The AI cohort is repeating the pattern at an accelerated pace, with even less underlying business durability. Many of today's celebrated AI companies have customer churn rates that would be alarming in any other sector.
The reckoning may be delayed by the genuine excitement around large language models and their applications. But excitement is not revenue, and revenue is not recurring revenue, no matter how creatively you define the term.
Our take
The ARR inflation game is a symptom of a deeper problem: the venture industry's willingness to suspend disbelief when a sector gets hot enough. AI is transformative technology, but transformative technology does not exempt startups from the basic requirement of building businesses that customers actually want to pay for, repeatedly, over time. The founders and investors who understand this will build durable companies. The rest are building press releases.
