Revenues or No Revenues? This Is The Question
During our mutual discovery process with Entrepreneurs at InReach Ventures, we engage in discussions of a strategic nature. This is mostly a function of the level of maturity of the startups in which we invest that often have limited metrics to fully support an investment decision. Therefore, strategic discussions are often the main topic to help us assess the investment opportunity.
During such discussions, one of the topics we cover is revenues and the nature of those revenues. Over many years of investing in different kinds of startups, we have learned that not all revenues are the same. Some types of revenues contribute more than others towards shareholder value.
When a business is bootstrapped or optimised for short term cash flow and dividends this concept makes no sense; revenues are always revenues.
On the contrary, when a business is built to scale up, to attract capital (i.e. venture capital) and potentially one day access the public markets, not all revenue types contribute equally and in the same way to the shareholder value creation process. The following are some examples of qualitative revenue composition that have different levels of shareholder value.
1 — Repeatable vs recurring revenues
In discussing with entrepreneurs, sometimes there is confusion in the distinction between recurring and repeatability of a specific revenue stream. Recurring vs non recurring is a function of the business model adopted by the entrepreneur. For example: SaaS businesses tend to have recurring revenue by definition. Repeatability is a concept related to productisation and sales & marketing execution. Non repeatable revenues tend to be a problem for entrepreneurs for multiple reasons:
- If in yr 1 the business has generated non repeatable revenues, it will be difficult to demonstrate growth for that specific revenue stream in yr 2. This is intrinsic in the concept itself of lack of repeatability.
- Non repeatable revenues usually imply one-off product development efforts and strategic and operational distractions (i.e. loss of focus). The opportunity costs related to such operational distraction can often outway the short term gain of non repeatable revenues.
In the initial days at Contentful (while at Balderton I led the Seed and A round of the company), the founders could have distracted themselves by pursuing specific customer requirements: for example large companies asking for in-house hosting solutions. For a small 5/7 person company, to say no to those very large (but short term) revenues was a difficult decision. I would make the argument that Contentful may not be the leading SaaS headless CMS company in the world if those tough decisions had not been taken at the start.
2 — Validate Ideal Customer Profile vs revenue driven customers
At InReach we typically invest pre-product market fit. However, at the time of the investment, the entrepreneur has some assumptions on product market-fit and a view on an Ideal Customer Profile (ICP). Sometimes the ICP assumption is right, but sometimes it is wrong and a new ICP must be defined: the key, in any case, is not to get distracted with tactical revenues that are outside of the ICP.
- Tactical revenues generated outside the ICP tend to distract the entrepreneur and the team and divert focus from the validation of the ICP. This might end up being a distraction of sales and marketing resources, but in the worst case also of product and engineering resources that respond to the wrong feature requests.
- Tactical revenues generated outside of the ICP tend to churn very fast, with all the negative implications associated with it.
In the first period of our investment at Soldo we had a lot of assumptions on the ICP that ended up being wrong. However, Carlo and his team did a kick ass job to twist the product and ICP until they found product-market fit. Being strategically focused in validating ICP has been the key to Soldo’s current success.
3 — Strategic growth vs tactical growth
At InReach we often engage in an unusual discussion with entrepreneurs about the strategic rationale that is motivating a specific revenue growth rate. We have been told many times by entrepreneurs that growth is pivotal to attract investors and that many investors get excited by top line revenue growth: revenue growth is always good.
There is a distinction between tactical growth (focused on short term nice looking trending charts and food on the table), and strategic growth (that supports the long term shareholder value creation process).
- Sustainable growth is more important than top line growth. Sometimes a 2x-3x annual growth rate can be better than a 5x-10x growth rate if this implies worsening/unsustainable unit economics and limited number of returning users.
- User growth in core strategic geographies is much more functional to the future shareholder value creation process than growth in random geographies based on customer acquisition cost optimisation. Secondary geographies usually imply lower average revenue per user (ARPU) and therefore inferior structural economics for the business.
For example, following our investment in Eneba, we spent a good amount of time engaging with Vytis in determining the characteristics and the right quality of growth to pursue. I would make the argument that this has also been one of the key ingredients of the success of Depop (while at Balderton I led the Seed and A round of the company).
4 — Right vs wrong product mix
As mentioned in this post, the same technology layer can take the form of multiple product packages. Strategically choosing which product package to validate is much more important than maximising short term tactical revenues across a multitude of product packages that fundamentally make it very difficult to prove product market fit. We refer to the practice of spreading validation too thin across too many product packages as spaghetti business.
For example Istvan at Shapr3D did not rush in expanding the product across multiple platforms until he had certainty of product market fit. Similarly, Balint at Craft has not yet released an Android version because although there are low hanging quick revenues to make, it will slow down the current feature discovery and product validation process too much.
At the early stages of the company building process, to validate the right product package is significantly more important than maximising short term revenues.
5 — Sales/Marketing channel validation
Sometimes entrepreneurs apply their ‘spaghetti business’ practice to their sales and marketing channels and are often motivated by the intrinsic “difficulty to say no to potential business” or “if I do not do it now, the competition will do it and I will lose the opportunity window”.
In reality, randomly executing at the same time across a multitude of sales and marketing channels chasing short term revenues does not help to validate which channel is worth investing in to scale up the business.
In the early stages for the company building process it is vital to distinguish between the maximisation of short term revenues at whatever cost and the use of revenues as a leading indicator to assess product market fit, channel fit and long term growth opportunities. Staying focused on generating the right type of revenues and in some cases even walking away from tactical revenues opportunities might be the right approach.