What’s in the Business Model??
While looking to invest in an early or growth stage the important question that investors like to know is “HOW DO YOU MAKE MONEY?” this might sound too capitalist but if a company is unable to monetize its user base or product it tends to go out of business. Large companies like FB and SnapChat eventually had to learn to generate revenue once they had millions of users using the platform for free. A social networking platform has some leeway in the realm of revenue growth as the belief is that the more users they have eventually a monetization strategy will turn up. All the other companies, however, do not have this luxury. SaaS-based platforms tend to experiment with a freemium model where they provide users with a taste of the platform and then hope to convert them into a monthly subscriber to enjoy premium benefits. Although this is a great strategy the only way a company succeeds with this Business Model (BM) is by having a product that is really addressing a gap or problem in the market. Netflix, for example, was able to hook millions of users to its SaaS-based platform for 8–10$ per month because people needed a source to watch television content without signing up with Comcast. There are several SaaS-based companies out there that spend years trying to find a great product market fit but fail to do so. It is not the business model that is flawed but the lack of product demand to create a sustainable business. On the other side of SaaS business are enterprise platforms that charge anywhere from 100K to 5M per year per user. These companies are able to address problems faced by large companies and by targeting Fortune 1000 companies they are able to have a smaller customer base but much higher revenue.
While evaluating a business from a VC perspective it is important to understand where the company sits on its business model and how does it plan to expand or monetize its customer base as it scales up. In the tech space, the common BM is SaaS based where one company sells its service to another company or end user for a monthly or annual fee. So focusing on just these types of companies it is important to understand how to good the company is and some of the key points and questions that need to be asked are:
1) Who is the end user?
a. If it is a social network company like SnapChat, revenue is not one of the first things to look at but rather the number of daily or monthly active users, since the end users are you and me one should expect that number to ramp up quickly due to the network effect.
b. If the company is providing a service through its online platform the end-user could be either SMB (Small Medium Business) or Enterprise (large Fortune 1000 companies) customers and depend on where the company sits it’s average contract value (ACV)would vary
2) What’s the ACV?
a. The Average Contract Value is the amount of revenue the company charges each or its customer
b. This value could be a multiple of the service provided based on the size of the company and the amount of assistance or service it would require
c. The length of the contract, long term 3–5 year contracts have a lower annual fee but generate predictable revenue from that customer over the period of the contract
d. However with the rapid advancement in technology, it is difficult to get customers to sign up for such length periods of time
3) What is the CAC to ACV ratio?
a. The CAC or Customer Acq Cost is a number of dollars it would cost in sales and marketing and COGS to bring on a customer
b. If the CAC is lower than the ACV and the expected contract length then the BM has a positive effect on the bottom line and each additional dollar above the CAC is a profit for the company
For example, let’s take a two private companies that have different business models:
SnapChat and DOMO
SnapChat:
As everyone should know, SnapChat is a $16B social media platform that allows users to share personal messages in the form of pictures that disappear within seconds. Since the Company started they did not have a set monetization strategy it focused on growing its MAU (Monthly Active Users) from less than 100K within the first year to over 160M this past year. Now that they have reached the average MAU base similar to Twitter, Pinterest and FB at the time of IPO the company is revisiting its revenue strategy. They could have either just charged users a $0.99 download fee like WhatsApp did post acquisition or figure out a way to make more than 160M a year just through downloads. The Company followed FB’s footsteps and like every other social media company focused on ad and marketing revenue. They are now partnering up with several enterprise clients to push ads through their story’s. Since the clients are no longer people like you and me but rather large corporations that want to increase brand awareness the company can go ahead and charge over 100K per month.
DOMO
Is a business analytics company based out in Salt Lake City, UT and its last round valued the company upwards to $2B. This company has a great platform that allows people to visualize their data and it is leveraging this wave of “Big Data” to allow companies to better digest their information. For a company like this, the ACV starts at around $40K for small business all the way to $400K for a large company. Although both the companies get access to the same platform, the additional cost is mainly geared to the whole “concierge” service that the large companies receive along with a lot of customization instead of the out of the box version.
Both these companies have different end users but are able to generate about the same in ACV every year however the key difference as an investor to note is which one has the potential to have a better return. SC did not receive a high valuation in its earlier rounds as it barely had any users. Domo, on the other hand, was able to demand a higher valuation once the platform was ready and it was signing on large enterprise clients. Depending on the strategy of the VC both are great opportunities but come with their own risks:
SC for example:
1) Is heavily dependent on its user base that can be highly fickle and could be a passing fad like Orkut or High5
2) Its rapid growth has led to a high valuation in the private markets but after turning down FB twice is there another potential acquirer or would an IPO result in a lower valuation?
3) Can companies see quantitative proof about their ad money being converted into revenue
DOMO
1) This is a pure tech company that is led by a seasoned entrepreneur (Josh James sold his last company Omniture for over a billion dollars)
2) However the big data space is experiencing a lot of disruption and there are 10 other companies out there that provide exactly the same business
3) Since there is not much proprietary tech involved is it more of a first mover advantage situation
So I feel getting a better sense of what the Business Model is really important if you want to be a VC and over the past 3 years I have had the chance to see so many different models some work other go bust. But this is one of the main aspects of a business one should understand before investing . To help with that analysis there are several metrics and ratios that one can use and I will include that information in my next post.