Blog for The Entrepreneurial Hour
There is a saying in the real estate industry: the three most important things are location, location, and location. Similarly, for startups, the three most important things are revenue, revenue, and revenue. Although the location concept for real estate is the same, revenue for startups needs to be thought of as belonging to three categories. They are referenceable revenue, scalable revenue, and profitable revenue. At first glance, it might appear that focusing on revenue as a first step seems way out of place. Revenue is typically thought of as the result of effective marketing, sales, product development, and other operations. Instead, by objectively establishing revenue-related goals first, the optimum allocation of resources for marketing, sales, forecasting, and operations can be developed. It comes down to doing the right thing, at the right time, with the right level of resources.
Startups need to understand the differences between these three categories regarding their timing, characteristics, and impacts on the business. Quite often, the distinctions are not made, or they are pursued in an inappropriate order, resulting in serious consequences. Before discussing the differences, defining the term “revenue” is important as used in this context.
The term “revenue” can take on many different meanings or interpretations. Quite often, individuals can be discussing revenue with each person assuming a different definition. In general, it is defined as the income generated from the sale of goods or services. However, each term (“income,” “generated,” and “sale”) can mean different things to different people depending on their context. Startups are almost always cash-constrained, with virtually every decision impacting cash requirements. Although following Generally Accepted Accounting Practices (GAAP) standards is ideal, it must be remembered that “cash is king” and is the only thing that pays the bills. In this context, “revenue” is defined as the amount of cash received from a customer in exchange for the goods or services provided. Long-term contracts are great, but future payments won’t pay the bills today! SaaS business models are now the rage. Without a doubt, they help to predict the long-term value of a customer. However, if payments are received only on a monthly basis, cash to pay the bills may not be available. With so many restrictions on bank loans, many companies find themselves unable to secure loans to fund operations. Many of these companies go out of business even though they have actual orders or contractual commitments from customers because they do not have the funds to fulfill those orders.
Another common trap is to forecast revenue dollars. Again, this statement seems to be puzzling – forecasts, the heart of any financial model, need to be expressed in dollars. There is, however, a more basic element. It is sales events. A sales event can be defined as a binding commitment for goods or services from a customer. It can be a purchase order, a contract, a “shopping cart click” or, ideally, a pre-payment. The parameters associated with a sales event can be significantly different based on the revenue category. For example, the sales cycle for a new customer may be measured in weeks or months while a repeat sale to the same customer may take minimal effort and occur in days.
The three types of revenue are briefly summarized below.
Referenceable Revenue: What Others Do
Although you can assume you have designed a product or service that meets prospects’ requirements, you cannot be sure until customers have purchased and paid for your product. Ideally, customers will have repeatedly purchased it or provided positive recommendations to others who have also purchased it. It is not what you say or think that counts; it is what customers do – pay and be satisfied or delighted with their purchase. When you have several referenceable customers, you have significantly de-risked your business and are more likely to appeal to more customers and, perhaps, investors.
Most often, referenceable sales are made to “Rolodex” or personal contact list customers--people you know and trust you. At this stage, the goal is to receive some payment – even one dollar for your offering. The goal for this phase is to have others try your offering after they have made a financial commitment. Once they have tried it, the focus should be on receiving an additional order or commitment or their willingness to act as a public reference for you.
Scalable Revenue: Repeatedly Sold by Others
The entrepreneur or CEO often can make initial sales, perhaps with custom commitments, “hand-built” products, or manually configured services. These types of sales do not require any repeatable, volume processes and can be very misleading about the business's ultimate size. Being able to scale the sale, fulfillment, and support processes to support high volumes is critical to the long-term success of a business. The inability to scale sales and operations is probably the single most significant factor that causes new businesses to fail. As an example, the TV entertainment show, Shark Tank, often features entrepreneurs selling cookies or treats out of their kitchen. The business is said to be profitable. It might be, but what happens when demand dramatically increases, and the kitchen facilities are too small?
Scalable sales need to be made to “anonymous” customers; people that you do not know. These customers may have become aware of you through recommendations (Referenceable Customers) or through business partners or marketing activities.
The key to this phase is replicable processes. Quickly, an entrepreneur will determine what earlier activities can scale easily and which activities cannot. The best example is the transformation of the entrepreneur (the Chief Everything Officer) acting as the only sales rep to relying on others to find prospects, purpose, and close deals. A simple but effective method to identify scalable issues is to perform an “Add-a-Zero” analysis. It consists of examining each aspect of the business and assuming it will increase by a factor of ten. For example, instead of one sale per day, ten sales per day or moving from shipping two systems per week to shipping twenty per week. Of course, the ten-fold increase does not happen instantaneously. This exercise will allow you to plan for the future.
During this phase, per unit revenue can increase but the costs associated with building a scalable business will grow at a much faster rate. Cash to expand operations and cover inventory can quickly become unwelcomed surprises.
Profitable Revenue: More Than Margin
High gross margin (revenue minus product costs) is not enough. “Below the gross margin line” costs must also be carefully considered. The actual cost to place a product in a customer’s hands is often grossly underestimated, as is the long-term cost to support customers. Other overhead costs can also significantly overwhelm high individual product margins until higher volumes are achieved. Understanding the total cost of fulfilling a customer order is critical in determining its profitability.
A good example of the new “below the line” costs that will be incurred when sales volume increases is the need to “move out of the garage” to a commercial space. Rent, utilities, insurance, maintenance, and other costs associated with the at-home business now become line items on the business P/L. An axiom that every entrepreneur that has begun to scale their business is that “revenue always seems to be delayed but bills always arrive right on time!”
Measuring month-over-month revenue growth can be deceiving. Growing from one customer to two customers represents 100% growth. However, going from 100 to 110, 10% growth may be far more difficult. Another trap that can easily negatively impact the business is the delay between warranty and support costs and revenue. The costs incurred to support customers or resolve warranty issues usually lag behind sales, perhaps by weeks or months. So, as a percentage of new revenue, they may not seem to be out of line until the high revenue growth rate slows. Then, profitably can quickly erode as customer support's true cost as a percentage of revenue becomes obvious.
It only makes sense to examine a business's profitability after it has scaled and reached sustainable levels until that point it is easy to be misled.
From the above, the differences in the revenue categories should be obvious. Each will require different tactics, strategies, and emphasis at different points in time. Knowing what to do, when to do it, and understanding each category's metrics and goals will provide an orderly long-term plan to help the company meet its objectives.
Chapter 3.04 in the CxO-Atlas website, described below, has several articles that explore the concept of the three different types of revenue and their implications in more detail.
About The Entrepreneurial Hour
The Entrepreneurial Hour is a “pay it forward” organization focused on helping entrepreneurs and startups succeed. The Entrepreneurial Hour holds weekly meetings where one founder/startup presents to a group of seasoned business leaders who offer friendly but candid advice. Meetings are held from 8:00AM to 9:00AM EST every Wednesday. Visit the website: www.theentpreneurialhour.com to learn more.
About Tom Berger
Tom spent 22 years with public companies including 17 years at Motorola. He then founded or ran seven technology startups with exits over $260M. He now mentors entrepreneurs and startups. He has a free website www.CxO-Altas.com that contains almost 700 articles, presentations, and tools.
About www.CxO-Atlas.com Website
The website is a free repository for over 700 articles, presentations and tools. The contents is targeted toward entrepreneurs, startups, and senior managers. The 650 articles average about 850 words and each can be read in about three minutes. Volume 3 is specifically targeted toward entrepreneurs.