Why revenue quality matters
As a Series A and B investor, one of the most common questions I receive from founders is: “what metrics do I need to be a good candidate for Series A funding?”. I completely understand why founders ask that question. It’s a valuable input into their planning process and directly impacts how they run their business over the next 12–18 months. But I always wince a bit when I hear it. I wince because raising capital, like so much else in the world of building companies, is not a formulaic process — two companies could walk into a VC’s office with the exact same levels of traction and have different outcomes.
Much of this difference is driven by other elements of the business: the quality of the team, the dynamics of the market, the strength of the product, the value proposition, the business model, the competitive set, and other factors. But more specifically, even if you held those other drivers constant and focused solely on revenue as an important metric for Series A readiness, there would still be differences in outcomes.
All revenue isn’t equal — how you generate that revenue matters just as much as how much revenue you’ve generated.
Some of the largest underlying factors have been well covered by other writers:
- Clear product and customer focus
- Gross margins
- Sales efficiency and retention (LTV / CAC, magic number, quick ratio, etc.)
Leaving those aside, below are a few other aspects of revenue quality worth thinking about. Because the right metrics to focus on are business model dependent, I’ll focus on SaaS companies for the discussion below — but there is plenty of conceptual carry-over to other business models.
- Customer concentration. Take two companies with $1M in ARR. One has 10 paying customers (average ACV of $100K) and the other has 2 paying customers (avg. ACV of $500K). Though the larger contract sizes of the latter is attractive in its own right, the former likely both more robustly demonstrated product market fit. Convincing 10 customers to pay you isn’t easy), and at 10 customers, the first company has probably also shown the early signs of a sales process that might scale. Given VCs are looking for companies with $1B+ potential, which usually translates into $100M+ in ARR, the early proof points from a more sizable customer base provide more comfort. Two other notes worth mentioning: i) as the startup with larger ACVs adds a few customers, the contract size may begin to outweigh the concentration risk and ii) for an SMB focused SaaS business, concentration likely is not an issue at $1M in ARR — the longer term concern tends to be more around scaling customer acquisition and managing churn.
- Recurring vs. one-time revenue. Again taking two businesses with equal amounts of net revenue in a year, which would you be more confident about growing 3x the next year — business 1 with 90% recurring revenues, or business 2 with 30% recurring revenues? All other things being equal, business 1 — because they have a base of $900K of revenue going into the year (a little less after churn), whereas business 2 is starting from a base of $300K (also likely less after churn). This is also part of why the public markets tend to favor businesses with recurring revenue — their business prospects are often far more predictable than the typical software business.
- Founder driven vs. sales + marketing org driven. A strong, sales-oriented founder with a good network can get a company to $1M in net revenue. But that doesn’t scale — to build a large, enduring business that becomes a category leader, there likely needs to be a well-oiled sales and marketing approach. Even Atlassian and Slack, who have largely eschewed traditional enterprise sales, have a playbook for repeatably generating leads and winning new customers. While that approach can and must evolve from a company’s nascent system at the Series A round, having the early signs that the company can hire and ramp-up a sales team to demonstrate sales efficiency bodes well for the future. Note that some VCs might see founder-driven sales as an opportunity — if the founder (likely devoting <50% of her mindshare to sales) can get the business to $1M in net revenue, that may suggest lots of opportunity down the road. YMMV.
- Velocity. The venture model is predicated upon finding and working with high growth companies (see Paul Graham on this topic). How quickly you get to a given amount of traction is an indication of how well the product resonates with the target market, how clearly you’ve identified the right customer to go after, and how well your early sales approach is working. A business that reaches $1M in ARR 18 months after launch is far more compelling than one that takes 10 years to reach that point, all things being equal (which they rarely are). One important caveat to this: depending on the business, the right strategic choice for the business may be building some sort of strategic asset (e.g., proprietary data generation) vs. optimizing for revenue immediately.
This, of course, is an incomplete list — each business has nuances to their target customer, markets, etc. that require individualized thought and attention. This lack of context is part of the reason why the seemingly simple question of “what metrics do I need” is one that I struggle with. But understanding how investors think (or how at least one investor thinks) about revenue quality hopefully provides a data point for whether the venture model is one that makes sense for your business, and how best to craft your story to address some of these concerns.
Would love to hear your thoughts — either through comments or @ablordesays on Twitter.
