How to think about revenue quality as an early stage founder
This post was originally published on September 12, 2022 for the Angular Ventures newsletter. Subscribe here to receive all new Angular blog posts, data reports, and newsletters directly to your inbox.
Ask any early stage investor what you need to raise a successful series A, and they’ll hem and haw, throw out some half-hearted benchmarks, and then say “well, really, it depends.”
As annoying as that answer is for founders who just want one iota of certainty in these uncertain times, they’re right. It does all depend. It’s about the team. It’s about the market. It’s about the product. And it’s about the revenue quality. That last one is what I’d like to talk about today.
Back in 2011, Bill Gurley wrote a fantastic post bemoaning the use of the revenue multiple as a technique for valuing companies because “all revenues are not created equal.”
I’d recommend giving it a read. It’s a classic. But I also recognize that it’s not particularly useful to the founders we work with. We’re first-check investors. The founders we speak with every day are signing their first design partners…they aren’t thinking about their gross margin or the incremental profitability of each marginal dollar of revenue (both variables that Gurley cites).
So, I thought I’d update Gurley’s piece for the early stage founders out there and explore what “revenue quality” looks like when you don’t have much revenue to begin with.
Let’s first build some intuition around what “revenue quality” even means. As Gurley explains in his piece, the only real way to value any financial asset, including a company, is to build a discounted cash flow (DCF) model, but that’s incredibly difficult to do for a fast-growing, early stage company.
As a result, investors rely on shortcuts, like revenue multiples, instead. However, when you look at revenue multiples of different companies, they range widely. The reason for this is because investors know which business qualities have a positive impact on a company’s long term cash flows, growth rate, operating margin, or position relative to their competitors (all critical assumptions in a DCF calculation.) Gurley cites ten of these characteristics (they include things like network effects, predictability, profitability and growth). The more of these characteristics a business has, the higher its revenue quality, and the higher its revenue multiple.
Said simply (and grossly simplifying Gurley’s excellent piece), for late stage companies, high quality revenue is revenue that is sticky, scalable and profitable.
For early stage companies, you get a bit more freedom. You’re selling a vision of a business you will build in the future. Your challenge is to construct a story that’s compelling enough that when investors squint they can imagine you as a late stage company with all those high quality revenue qualities.
The good news is that investors want to believe. The best are default optimists. So, in my experience, what’s critical is to avoid specific early stage revenue traps.
Some examples:
Relying on service-driven revenue. Let’s say you reach $2m ARR, but each dollar of ARR requires significant implementation service dollars to unlock. Using this sort of brute force approach to growing revenue may not have mattered in the heady days of 2021, but it does now. Investors look at service-driven revenue and discount it heavily for two reasons. First, it’s a long-term hit to your operating margin. Second, service dependence suggests you may have trouble scaling. Both of these characteristics negatively impact critical DCF assumptions.
If this sounds like your company, step back and think: can you invest in product solutions to reduce your reliance on implementation services? If there are no product solutions, can you focus on a different customer profile that needs less hand holding?
Taking revenue from the wrong customer profile. Imagine that you’re just about to close a Fortune 500 account (exciting!)…except you’re purportedly building a financial modeling tool for SMEs. You may be tempted to take the revenue. Don’t. Revenue from the wrong customer (especially if it’s a large customer like a Fortune 500 account) leads to wasted effort, erroneous product feedback and, eventually, churn.
Also, for investors who are trying to understand your market size and competitive set, or get a sense of your product’s stickiness, these customer stories are needlessly confusing (and potentially harmful).
Acquiring revenue via the wrong go-to-market motion. Top-down, bottoms-up, a combination of the two. It doesn’t matter. What matters is that you’ve found a go-to-market motion that fits your product and your target customer, and you’re starting to prove that it works. If you’re pitching a bottoms-up story, don’t waste your time closing $1M+ ARR from your network. Similarly, if you know building an enterprise sales motion will be critical to your business, sell into multiple high profile accounts top down, and then hire and train a sales rep to do the same. Investors are looking for predictability. Your goal is to show them that your business will be a money machine that can predictably turn $1 into something much greater.
Growing revenue too slowly. Imagine you’re an investor looking at two companies: company A and company B. Both have just reached $1.5M ARR. They both have solid net revenue retention. Unit economics looks good. But company A got to $1.5M ARR in 1 year and company B took 3 years. Who do you invest in?
It’s no surprise, but company A gets the term sheet every time.
To an early stage founder who has been toiling away for years, this may seem unfair. But, remember, nothing leads to a higher valuation than growth. The higher your growth, the larger future revenues will be, which has direct implications on the DCF calculation.
What I recommend to founders is to think about the early stage of your company as having two distinct phases: finding product-market fit and finding go-to-market fit. During the first phase, your goal is to build a sticky product that solves a real problem. Charge enough to learn what you need to learn (e.g. will people pay for your product), but don’t try to maximize your value capture. During the second phase, your goal is to iterate on your go-to-market motion and prove that you can grow. If you don’t distinguish between the two phases, investors may not give you credit for the growth you’ve been able to achieve.
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All of which is to say, for early stage companies, high quality revenue is revenue that proves a point. It derisks a central business challenge. It reinforces a core hypothesis.
The amount of revenue matters way less than the implications that revenue has on the future of your business. Sure, you will likely still need revenue (it’s the rare company that can raise without it), but I’ll take high quality revenue below whatever benchmark you’ve heard, over low quality revenue in excess, any day.
So if you’re thinking about what the story for your next round will be, my advice would be to put the revenue benchmarks out of your mind and focus on testing your company’s core hypotheses and proving to yourself the long term sustainability of your growth. If you do that well, high quality revenue will follow.