Dear founder #4: not all revenues are created equal

Not_all_revenues_are_created_equal#2[A note from 5 Oct 2019: “gross margins” and “sustainable revenues” has become talk of tech town this past week, and a big-name Silicon Valley VC has made a similar point in “The great public market reckoning”

Indeed, “quality of revenues” is one of the first tools of the trade of a “public market” equity analyst.  And for the private sector VC, we should know that it’s not just about the numbers (the trend is not often completely clear yet), it’s about the business model, something we can actually influence and help founders bring (or steer) their revenue model onto a sustainable path.]

 

One thing that we talk about with founder-CEOs often is the “quality” of your revenues.  Apart from “top-line” revenue growth metrics, e.g. ARR (annualised revenue run rate), especially relevant for companies with a SaaS model, there are a few other things about the quality of your revenues:

  1. There is not too much customer concentration, e.g. 80% revenues come from 2 or 3 customers, while bearing in mind that most companies go through this stage and key is to quickly leverage on the early “wins” to grow beyond this.
  2. Much of your revenues is recurring, or your customers are “repeat” customers.
  3. The “share of wallet” or $ per customer is growing. (“Net negative churn” is a variation of this – more below).

Pricing does come into the picture (finding a viable pricing model is part of finding product-market fit): while some business models today involves the young company giving the customer a “rebate” of $1.5 in order to bring in each $ of revenues, the question for these companies is to have a clear path to turning this around and #2 and #3 above often play a key part.

It’s great to have growth which after all is the number 1 priority, but there are 2 things about pricing too low:

  • It is often very difficult to change or reverse later on: you need to explain what will make it possible for you to increase price later on.  More specifically, your “bargaining position” with the suppliers or the customers may improve with scale but how and to what extent and have you already set up the competitive game a certain way that makes it very difficult to change – i.e. what is your response if your competitors eat up part of your market share or your customers switch away if you raise your prices? (i.e. have you built any “barrier to exit” or “customer stickiness quotient”?).
  • A deeper question is whether the “product-market fit” is artificial and somewhat illusory. When something goes from “free” to “cost-reflective”, “market size” may shrink.

Churn is an important growth metric: the customer who brings in revenue of $1 after a “rebate” of $1.5 is paid to them may not return for a second time (hence the concept of “vanity metrics”.).  On the other hand, a business with many customers who stay and buy more may exhibit “negative churn” (find here an extended discussion of this in relation to peer-to-peer mobility company Uber – “people took more and more trips the longer they had the app installed …. negative churn exists when you’re driving more revenue from new & existing users than you’re losing through those deleting the app or using the app less” – and here in relation to the cloud-based software platform company New Relic): it means if the company were to cease spending money to acquire new customers, the business would still grow.  (Note: This does not mean or guarantee a sustainable business model or profitability, both of which require looking at costs as well as revenues).  

Illustration of net negative churn: Let’s say you have a business where the 95% customers who stay the next year increase their “spend” by 10% while 5% customers are “churned away”, and if this continues forever, the company would still grow by 4.5% each year (95% times 1.1 = 1.045) even if it does not add any single new customer (and by 14% if the growth in average spend is 20%).

These are not details.  This is about what is behind the headline numbers.

Put another way, your “growth metrics” should not just be the top-line numbers: they should include things like win rate, MRR growth, MRR churn, and variations on them.

Another question that drives much of this: are you acquiring the right customers?

 

 

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