5 Reasons Not All Traction Is Created Equal

Startup founders, does this sound familiar:

"Let’s talk again when you have a bit more traction"

But what does that actually mean? Even when it isn't the infamous VC "Soft No", it can be hard to get a straight answer from investor as to what constitutes "enough" traction.

The reason is that traction is a squishy concept.

Reason #1 – Velocity matters

What is more impressive: A 6 month old startup with $1M Annual Recurring Revenue or one that took 6 years to get there?

Let's move on....

Reason #2 – What did it take to get there?

What is more impressive: The startup that spent $500K to get to $1M ARR or one that needed $2M to get there?

But wait. This one isn't quite that simple. In some cases, the second startup burned $1.5M going after different customer segments or with a substantially different product before pivoting. Many investors would make the case that all of that is a sunk cost and that this startup basically hit its current milestones on the same $500K so (other than the extra dilution the founders took) both startups are equally attractive. Some investors, though, will see this as a potential indicator that the second startup wasn’t as cash efficient or was less attuned to the market and would still value the first startup higher.

Reason #3 – Not all revenue is created equal

Software-based recurring revenue is the gold standard. The marginal cost of growing revenue with SaaS is nearly zero. And if the contracts auto-renew (or are multi-year terms), so much the better.

But pure SaaS revenue is rare. Many enterprise software companies charge one time set up fees and increasingly startups are have upfront hardware (e.g., sensors) sales. Those kinds of revenue don't scale as well because they require manual labor and/or physical material. Investors generally discount these revenues, in some case even writing them off entirely.

Transactional revenue is also tricky. If a customer has to remember to go back to a website or app to actively purchase the item again, the revenue is less predictable and, as such, less valuable. If the product or service being sold is one that most customers purchase repeatedly and relatively frequently on a consistent timeframe, you could make a case that repeat transactional revenue like this is pretty close to recurring revenue. On the other hand, revenue from infrequently purchased items that are replenished on unpredictable timeframes is considerably less valuable, at least until the startup has enough scale that the randomness starts to cancel out and broad, more or less consistent averages start to emerge.

The least valuable revenue is service based. Consider consulting. If a consulting firm sells more business, it needs to hire more people to staff up those projects. They are in effect selling bodies so they have lower margins and cannot scale as quickly as software companies. As a general rule, service revenue is worthless. The main exception is if you are purposefully doing something manually behind the scenes that you could easily automate as quick and simple way to validate the market demand before putting a lot of resources into coding the actual solution (a.k.a. the “wizard of oz” prototype). To get 'credit' for this kind of revenue, it is critically important that the customer experience is the same both before and after the shift from behind-the-scenes manual effort to automation .

Which brings us to the last element of revenue composition: discontinued revenue. If you made $1M last year but you are pivoting to a new a product or service, that's counts for zero in investors' eyes. Even if your product stays the same but you are changing who you sell to (e.g., shifting from B2C to B2B) and/or how you charge for the product (e.g., one time fee to subscription), your past revenue may not count for much. Remember: your current revenue only matters in that it tells an investor where you are headed. If you are not traveling in that direction anymore, your current traction is no longer a leading indicator.

Reason #4 – Customer mix

What tells you more about product market fit, a startup with four mid-sized enterprise clients or a startup with one big customer? More clients equals more data points.

Investors are also looking at the founder's skill at sales. With just one or two large clients, it is impossible that these leads were not arms-length, that the person who championed them and ultimately approved the purchase was an old friend, a former employer or colleague, a close relative, etc. More clients says more about the founder's ability to prospect for leads and to close deals.

That said, large, well-known customers do count for more than small and mid-sized ones. It is harder to find and get to the right decision makers at large corporations, to appropriately engage all stakeholders, to safely sidestep corporate politics, and to efficiently navigate through the order process.

So net-net, would I prefer a startup with one or two large customers versus five or six mid sized customers? That's a tough one.

Reason #5 – Quality of the Go To Market plan

When startups say, “We got here with zero marketing spend,” what I hear is, "We have no idea how to scale revenue."

Often, the initial sales come through the founders' personal networks. What happens when they have tapped out that extended network and they have to generate new leads? How do they 10x growth? ...100x growth?

As strange as it sounds to some startups, investors would rather see that a startup has spent a few thousand dollars on Google or Facebook ads, knows exactly what the Cost of Customer Acquisition is (and that Lifetime Customer Value is at least 4x higher), and that there is enough keyword inventory to scale that search engine or social media advertising spend up 100X. That's a startup that has proven it can scale.

In other words, it is nice that you made it halfway across the desert on a single tank of gas but if you don't know where the next gas station is, that is a big problem.

Conclusion

So the next time a VC tells you, "Let’s talk again when you have a bit more traction," you can respond with, "Great. Can we talk about the milestones you would like to see before you invest?" and take that discussion beyond just revenue.

Good luck!