Should you focus on revenue or on raising money? (and the case for a VC-management consultant hybrid)

September 26th, 2009 by Greg Boutin

Varun Mathur, the Techvibes Community Manager, who I just learnt is based in Toronto (I look forward to meeting you, Varun), made an excellent point yesterday in his Techvibes post on What Separates 37signals And Twitter ?

For all the talk about “getting to revenue” as fast as possible, VCs are still valuing companies based on hype and unproven potential for exponential revenues. You can build valuations based on traffic, but if you can’t attach a realistic average $ amount to a visitor, and if you are going to hemorrhage your traffic as soon as you offer ads, then your valuation is built on shaky grounds – which in finance means you should likely be extremely conservative or discount it.

I don’t say there is never a case for giving high valuation to companies that have great brand awareness and usage even if they haven’t made a buck yet, but my thesis is that the risk of this revenue never materializing should lead to discounting valuations more heavily than they currently are. VCs should put their valuation through a simple risk-based, probabilistic tree analysis, contemplating the likelihood of 3 basic scenarios:

  1. will never get to revenue and can’t sell or IPO company
  2. can never get to revenue but can get company acquired
  3. can get to revenue (and then look at the different types of revenue to differentiate linear from exponential in particular)

The problem, which ultimately has to do with the probability and payoff you attribute to each scenario, is especially with number 2. Even in this market, founders and VCs can rely on overpriced acquisitions to unload a company to an unsuspecting acquirer (hello eBay).  And so, with the right connections, the probability of scenario 2 is still implicitly weighted higher than it should likely be in VC valuation models.

My theory is that the Silicon Valley is an echo chamber for tech venture hype (just like Wall Street for blue chips), and a lot of founders and investors are masters at amplifying and riding this wave – rather than focusing on actually creating a revenue engine. In other words, ladies and gentlemen, yes, there are a lot of respectable-looking scammers in that business, and very successful ones too.  VCs won’t tell you this but lots of them love embracing irrational exuberance, because bubbles is how they get rich quick.

Right now the real-time web is where this exuberance can be found. To Varun’s point questioning whether 37signals didn’t get Twitter-type valuation because of its Chicago location, I would add that perhaps the main reason why a valley-based Twitter will get a higher valuation than a Chicago-based or Canada-based twitter is that irrational exuberance dies off quickly when you have to take a 5h flight to close an acquisition -  reality-distortion fields don’t work well that far from the epicenter of the tech mecca. Locations that can turn perception into reality have a clear edge in businesses that rely on hypothesis for their valuation. So, yes, if 37signals want to reach astronomical values, it would do well to move to Mountain View or Palo Alto, drop any source of revenue, and change its name to reduce the likelihood their past revenue figures will constrain their future valuation.

However, that’s not all. In all fairness, one must point out that the potential for exponential revenues by 37signals as a platform developer targeting, well, application developers, is lower than a Twitter that can be used by potentially anyone. There is a lesson here for business models. Based on whether you target revenue or fundraising, your runway and product mix looks very different. In the first case (seeking revenues), you often need to diversify across a small range of products to test and create multiple sources of revenues – alpha, beta and subsequent market iterations are less dangerous because they don’t impact your long-term success as badly as a highly hyped flop from a VC-funded venture. You can fix things, there is less pressure to grow to $100M in 5 years, and quite often the decision to give you money is distributed across many potential users as opposed to concentrated on just a few VCs (who know and speak to each other).

In the second case (seeking capital), you often have only one chance to build buzz, and if it fails to support your story, it’s unlikely you’ll raise a round, and it’s likely you’ll die of capital thirst. So you want to bet the farm on one-single make-or-break application. It’s a different discipline. But still, the problem remains in the fundraising model, that it doesn’t encourage you to build your product with a revenue model in mind, until often too late in the game.

All in all, that’s a real problem for venture consultants like me as we generally encourage start-ups to get to revenue asap, and then a Twitter investment by VCs reactivates pipe dreams that all you need to do is a cool app and you’ll be a millionaire. If you are after VC money, it’s better not to make revenues if those are going to disprove the revenue potential of your model… Maybe that’s why new VCs need to emerge that don’t take a “winners take all” approach to investment, and instead focus on growing real revenues across their portfolio. Mmm, sounds like a hybrid of VC and management consultant… Did I just evolve my model? Thanks Varun!

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