Revenue Quality, Not Just Quantity!

Revenue growth (or sometimes active user growth) is an obvious necessity for venture backed companies.  But life is never quite that straight forward.  Just as all site traffic is not created equal, there is good revenue and great revenue (there is no such thing as bad positive margin revenue).  Importantly, prospective revenue “quality” can dramatically alter the exit value you ultimately attain from a company.

There are two basic kinds of revenue – high margin and low margin.  For our purposes here, let’s assume decent gross margins and examine the two remaining components that determine revenue quality: friction, and recurrence.  By “friction” I mean cost and time required to acquire a customer.  If it costs $100,000 and takes 12 months, that is very high friction, while 10% and one month would be on the low side.  Investors love low friction/high margin revenue because these companies tend to be very capital efficient and grow really fast.

Here is a simple graphic in case you are a visual learner like me:

 Netflix is a good example of a company that grew without much friction, and has recurring revenue.  DropBox is another.  The lowest friction businesses use viral marketing or referral marketing to grow.  In the lower left, you have IT consulting, traditional enterprise software, companies that have expensive sales forces chasing high ticket, long sales cycle prospects.  Because cloud computing is reducing friction and increasing recurrence, Enterprise software is migrating to the upper right, which is causing investors to stampede towards that sector.  Network businesses start off with high friction and low margins, but eventually can reach a tipping point where friction falls to near zero and revenue is all recurring.

It is almost impossible to have high-margins while staying in the upper right quadrant.  As soon as you are visible competitors swarm in and down go prices/margins.  I look for businesses that could find themselves in the top row.  Where viral marketing is a real possibility, or where customer ROI is as short as a month.  I look for low friction sales, where the product addresses a top-of-mind issue for a customer at a price they find delightful.  Then I look for entrepreneurs that, when we all discover things are not as low friction as we thought, adjust quickly.  That is why I always spend time picking apart unit economics.

So, when you think about a new idea, place it on this chart, and build your pitch to investors around this concept.  Every investor I know writes checks in a hurry if they see a real chance to own part of a high margin business in the upper right quadrant.

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