Note: A version of this post appeared in my semi-regular column on AlleyWatch.
“Let’s talk again when you have a bit more traction”
I don’t think there is a founder on earth who hasn’t heard that from an investor. Is it legit or is it the infamous VC “soft no”?
The savvy founders know to follow up with some variation of, “I completely understand. So that I know what milestones I should be aiming for, can you tell me what metrics you would want to see before I’m in your strike zone?”
The savvy founders also know that, if the investor squirms a lot and is reluctant to offer up a specific number, it’s probably a soft no.
But then why do many investors who are genuinely interested and who confidently answer with hard numbers also seem a bit uncomfortable with this question?
The answer is that traction is a squishy concept.
Squishiness #1 – What’s the slope of the line?
Which startup impresses you more: the startup that got to $1M Annual Recurring Revenue in 6 months or the one that took 6 years to get there?
Squishiness #2 – With what inputs?
All other things equal, a startup that gets to $1M ARR on $500K investment is more impressive than another that needed $2M to hit that same mark.
But this one isn’t that open and shut. What if the second startup spent the first $1.5M on a different type of product or attacking a different customer and then pivoted. In this case, version 2.0 of the startup used the same $500K to get to the same milestone. So how do we view the first $1.5M they spent? Is it all truly a sunk cost, with no bearing on the future of the business, whose only impact is that the founders of the second company are more diluted than the first? Or do we view it as a potential indicator that they aren’t as attuned to the market or perhaps not as cash efficient as the first startup?
Squishiness #3 – What type of revenue is it?
It’s no secret that recurring software-based revenue is the gold standard. When you are selling electrons, the marginal cost of rapidly growing your revenue is near nothing. Add to that long term / auto-renewing contracts and it just doesn’t get any better than that.
But what if some of your revenue comes from one time set up fees or hardware sales? Those revenue streams come with hard costs in labor and/or material so investors generally discount these revenues. Many investors even mentally write them down to zero.
Then there is transactional revenue. How do you value revenue when the Customer has to go back to a website or app and actively purchase the item again? If the revenue is consistently growing and the vast majority of the customers reorder repeatedly on a well-understood timeframe, that kind of repeat transactional revenue is pretty close to recurring revenue. But if sales vary dramatically from month to month and there is little data to support the claim that customers will frequently and repeatedly purchase the product or service, the startup will get considerably less credit for that revenue.
Service revenue is the least valuable. To increase sales you have to throw more bodies into the mix. That means you have lower margins and you can’t scale as quickly. Most VCs will completely ignore your service revenue unless you can somehow convince them that it will soon convert into a different kind of revenue. For example, let’s say you built a “wizard of oz” prototype – your service looks automated to the customer but you are processing their requests manually for now because you want to prove that you have product-market fit before building the automation. If you can convince me that everything that goes on behind the scenes can and will be automated as soon as practical, I’d likely credit this revenue as if it were repeated transactional or recurring revenue.
Lastly, most investors will completely ignore revenue that was generated under a business model or product or service that you’ve discontinued. For example, if you sold $500K of your product to large enterprises but have decided to switch to selling direct-to-consumer, the $500K from B2B sales tells me nothing about how you’ll do B2C. Remember: where you are is a proxy for where you can go. If you don’t do it that way anymore, your current traction is useless as a predictor.
Squishiness #4 – What kinds of customers?
I would rather see a B2B startup with 4 mid-sized customers than 1 big customer. The former tells me a lot more about product-market fit and the startup’s ability to sell. When a startup has just 1 or 2 big customers, they might be the founders’ former employer or they might have a close relative at that company championing them.
On the other hand, big “name brand” customers count for more than mom & pop customers. It’s harder to get to the right decision makers and navigate through the order process at larger companies, especially for a startup.
So how does a startup with 2 big, name brand, customers stack up against one with 4 mid-sized, less known customers?
Uhh, let me get back to you on that one…
Squishiness #5 – Is the Go To Market scalable?
Startups like to brag, “…and we did it all with zero marketing spend!”
They have no idea how nervous that makes investors.
What it says to me is that they don’t know how to acquire customers at scale. A startup can often get its first few customers or first couple of thousand users simply by reaching out to their extended network. But when they’ve exhausted that avenue, where do they get the next 10x growth? On the other hand, a startup that can, for instance, point to Google or Facebook ads spend as driving the revenue growth and show that their cost of customer acquisition is many multiples lower than the lifetime value of the customer, that’s a startup that can scale. As long as the inventory of keywords that are effective for them is large, they can multiply their advertising spend by 10x or even 100x and grow their revenue correspondingly.
If a startup cannot show that what got them to where they currently are will continue to get them where they need to go, their traction is less impressive than it otherwise might be.