Most often we think of traction as related to revenue and revenue growth rate of an enterprise. That was certainly the focus of my initial commentary of “traction” as the second most important component of the 5-Ts concept.The hundreds of deals I’ve seen over the years has considerably expanded my thinking about what actually constitutes “traction.”
Now I propose the following more encompassing definition of traction as it pertains to any company Blu Ventures might consider an investment in: Traction is the measure of sustainable momentum in growing enterprise value. While growing revenues can certainly be an important component of this “sustainable momentum” equation, other factors besides revenues are equally, and sometimes more important when we think of traction.
Traction Directly Related to Revenues:
Absolute numbers and rate of change: Let’s begin with revenue-generating companies as the most common example of traction. We want to know how much revenue a company generates, but that absolute number is only a part of the picture. Equally important is the rate of change of these revenues. Are revenues (hopefully) increasing, flat or (worse case) decreasing over time? If revenues are increasing, is the rate of increase nominal (<5%) substantial (>25%) or somewhere in between? All else being equal, we are going to value more highly a company that is growing revenues 100% year over year compared to another that’s growing at a quarter of that rate.
Margins and profitability: But our analysis of revenues does not end with the magnitude and direction of revenues over time. It is important to understand if such revenues generate high gross profits or not and if such margins are increasing with increasing revenue scale. We might actually prefer a company growing revenues at a somewhat more modest rate profitably to a company growing revenues faster, but unprofitably. A quick “rule of 40” analysis will help to answer this question.
Recurring versus non-recurring revenues: Are revenues recurring (common in SaaS businesses) or non-recurring, or, as is often the case, some mix of the two? Many enterprise software businesses will charge a low margin implementation fee, followed by a much higher margin recurring revenue subscription fee. And for those companies with recurring revenue models, a more detailed analysis of SaaS metrics is warranted to assess churn, net revenue retention, customer acquisition costs, and many other metrics that all go into our overall judgment regarding traction. While many companies that generate a large majority of their income as recurring revenues are valued more highly than those that generate income as non-recurring revenues, that is not always the case, especially in the case of a non-recurring revenue company that can demonstrate consistently fast growth coupled with strong and increasing margins.
Customer concentration: Our assessment of traction also depends on customer concentration risk, regardless of whether the business generates recurring versus non-recurring revenues. This is a key factor that is too often overlooked, especially with early startups that may only have a handful of customers. Clearly there is a much lower risk profile with a company whose largest customer represents no more than 2% of revenues compared to another company with a single customer accounting for 30% or more of their revenues.
Customer contracts: With recurring revenue (i.e. SaaS) companies, we should delve into the actual customer contracts to understand the total contract value and durability of such revenues, learning the length of the contracts, the payment terms and the conditions under which the customer can cancel the contract. All of these factors help us to better predict the likelihood of achieving sustained revenue growth and eventual positive cash flow.
Pilot projects: Many B2B companies will find customers that require some initial pilot (limited in scope and/or duration) engagement before committing to a larger-scale contract. Such pilots are either paid or unpaid, and obviously paid pilots are a far better indicator of early traction than unpaid pilots. We must pay close attention to the length of time it takes to convert pilot customers to regular (larger-scale) contracts, as well as the percentage of pilots that end up successfully converted. A large and growing number of pilot projects is often a good indicator of larger contractual revenues in the future.
Traction Indirectly Related to Revenue:
We must also assess those initiatives and efforts that directly or indirectly drive revenues and revenue growth. Let’s break these down into three major categories:
Sales process and pipeline: How do we consider traction in the case of a pre-revenue company, or of pre-revenue “indicators” for a post-revenue company? A good place to start is to evaluate the sales process and pipeline as part of our overall assessment of traction. Simply, a good sales process and a growing pipeline are strong predictors of future revenues. Too often, we encounter companies where the CEO is also the chief salesperson, often without a formal sales process. While this may suffice in the early stages, long-term success requires a professional sales team and a robust sales process, including pipeline management.
When considering the sales pipeline we want to know how many potential customers are in each stage of the pipeline and the potential value of each customer, as well as the sum total of the weighted pipeline. A well-constructed and managed sales pipeline is a critically important indicator of future revenues, and if accurately (i.e. not over-optimistically) implemented, the pipeline will provide a strong indicator of future revenue traction.
Marketing and brand-building: Much investment and effort is taken by many companies to market their products or services and build brand awareness and reputation. Such initiatives, when well executed, grease the wheels for the sales team by providing inbound leads and strengthening the sales pipeline. Every day most of us are hit with such advertising and messaging on a TV, radio, billboard, Google search, Facebook ad and other channels, as companies vie to get themselves “top of mind” among potential customers. This applies broadly, whether a company is selling cheeseburgers or enterprise CRM solutions.
Strategic partners and channels: When a company establishes productive relationships with strategic and channel partners, this is also included as a measure of traction, as such relationships can and do impact revenue growth when well executed. While many companies will sell through both direct and indirect channels, such go-to-market strategies vary widely depending on the type of company we’re evaluating. Consider a B2C beverage manufacturer versus a seller of cybertech management solutions for enterprise. We don’t only want to know that such relationships have been established, but also how much revenue each channel/partner produces (or is expected to produce), the margins of each and the contractual nature (e.g. revenue sharing versus re-sale; exclusive versus non-exclusive) of each.
What is not Traction:
As a part of this discussion it is just as important to clarify what is not traction, as this term is too often applied to many aspects of an enterprise that are not appropriate. For example, if a key individual is added to the executive team, the Board or as an advisor, that adds to the strength of their “team”, but this is not traction. If a new patent is issued, or a pre-revenue drug company has a successful outcome in a preclinical or clinical study, these are attributes of the company’s “technology” or their product. When a new federal or state regulation opens up new customer opportunities in previously untapped markets, this affects “TAM”.
A Final Thought on Traction:
There are many variables (as described above) that contribute to our assessment of traction, and no single equation can describe their relative value or interrelationship. Some are far more relevant for certain companies than others, and it is for us to make this assessment in the course of our diligence process. We should not apply the same “traction checklist” to every company we see. For example, while churn is critically important to a B2B SaaS company, it is not relevant for most producers of durable medical equipment.
Furthermore, the judgment of investors regarding the relative importance of each of these traction indicators will change over time. For example, in the earliest stage of a startup we may be mostly focused on building the sales pipeline, then onboarding and retaining initial customers. At a later stage we will focus on reducing customer concentration, establishing strategic partners and driving higher profit margins. For a more mature company, brand-building and marketing emerge as priorities. In the final analysis, we must rely on our experience and judgment as both operator and investors to apply the best measures of “traction” to every deal we encounter.
Comments