Revenue vs. margin optics trade-offs for investors

Michael Brill Technology startup exec focused on AI-driven products

July 24th, 2013

I'm trying to figure out how to pitch a revenue model to potential investors. The business model conceptually operates on an affiliate revenue basis (I get paid for referring traffic) but technically I take ownership of product for a short period.

So let's say that the model calls for $200 million in transactions at a 7% affiliate fee or $14 million in revenue at basically 100% gross margin. But I'm concerned about the optics of "only" a $14 million business to a tech investor. Alternatively, I can present $200 million with 93% COR or COGS - that shows a much more exciting top line and it's correct from an accounting perspective.

Also, since there is the potential to shunt some of the revenue to own-sourced products with much greater margins than affiliate products, I think it might be a more relevant number.

Thoughts?

Hoi Lam Senior Developer Advocate at Google

July 25th, 2013

I have worked as a technology analyst at two top ranked investment teams at Citigroup and Deutsche Bank. For me, I would regard $14m as the revenue and I would expect other professional investors too.

Some well-known companies such as Groupon has tried to account for the whole $200m and got into a lot of trouble for doing so. Accounting for the whole of the $200m is aggressive.

Also, pay attention to COGS, I know you said "basically" 100% gross margin, the reality is that you will need to account for the running cost / depreciating of your system as well as any traffic or content acquisition costs. Here's how Google define their COGS and they have a high 60s gross margin (excluding Motorola):

P.35 http://www.sec.gov/Archives/edgar/data/1288776/000119312513028362/d452134d10k.htm

"Cost of revenues consists primarily of traffic acquisition costs... Cost of revenues also includes the expenses associated with the operation of our data centers, including depreciation, labor, energy, and bandwidth costs, credit card and other transaction fees related to processing customer transactions, amortization of acquired intangible assets, as well as content acquisition costs."

Jeff Mills Global Vice President of Sales at iMerit Technology

July 24th, 2013

Hi Michael, Interesting... I've spent a bunch of time in VC meetings lately and they are ALL about margins. Ultimately the Gross Profit potential is all they are going to see anyway, so showing your GP is based on huge margins is a better story. That said, you can highlight other potential revenue models based on the "owned sourced" products piece... My 2 cents... Jeff

Jack Rose Founder at Colony

July 25th, 2013

My father drummed into me from an early age, "Revenue is vanity, profit is sanity."

My two cents would be to present your figures as transparently as possible, don't try to make it seem like a bigger opportunity than it is; it will only serve to undermine your credibility.

Jack Rose Founder at Colony

July 25th, 2013

It's a very interesting and challenging question. I understand you aren't trying to be misleading, otherwise you wouldn't have asked the question, but the conversation which has ensued evidently demonstrates there is scope for misunderstanding between yourself and investors which it would be preferable not to have to explain your way out of!

Bill Kelley

July 24th, 2013

Yes, the second alternative is accurate, since you "own" the revenue -- even if for a short time. That can open the door to short term arbitrage possibilities. Let them go for that bait. Sent from my iPhone 7S

Alan Peters VP Product and Technology at BusinessBlocks

July 24th, 2013

I've dealt with some similar PandLs. I would usually count the 200 million topline if your actually collecting and paying the transactions. 14 if its a separately collected fee. Essentially the books match how the money actually flows. In either case, is that the maximum possible upside? How much capital are you looking for?

Anonymous

July 25th, 2013

I think it's very important to make a distinction here between angel investors and institutional investors. Yes, calling $200M your top line revenue is problematic when you're either publicly traded or taking money from institutional investors, because it's actually the SALES number and not the revenue number. But when you're talking to early stage investors, they want to fall in love with your dream and your vision. They know that the actual nuts and bolts of the business as it matures have very little relation to what you talked about or expected in the early days. And most importantly, if you're raising a convertible round, you're not actually issuing a security upon receiving the financing.

John Wallace President at Apps Incorporated

July 25th, 2013

IMO the most important thing an entrepreneur can show investors is that they understand the financials of their business. I'd make sure the numbers reflect the real financial opportunity and gross margins, and account for competition. If you presented this to me as a $200M opportunity with 100% gross margins and no competition, I'd be pretty skeptical. If true, that's incredible! But is it true? Ultimately, if you do a deal you will be contractually bound to hit the numbers or you risk losing everything. (BTW, that doesn't mean that you shouldn't show that there is a vibrant $200M market, especially if there are market forces that will cause it to grow. Also, depending on competition there may be opportunities for greater margins, or other revenue streams. Also, as BIll pointed out, there may be many exciting arbitrage opportunities.)

Robert Clegg

July 25th, 2013

Sounds like you shouldn't be presenting this by yourself. The lack of an expert team member in this area will be what becomes apparent. I found Hoi's input extremely credible.

Michael Brill Technology startup exec focused on AI-driven products

July 25th, 2013

Thanks everyone. A few points:

1. I am not trying to be disingenuous in the least bit... but when it comes time to showing TAM and revenue plan, I gotta choose the bigger number or the smaller number. Think of it like Amazon Marketplace... except that the regulatory environment I'm working in requires taking possession of goods and that it is truly $200m revenue on a GAAP basis. However, imagine that over time certain products that are sold in the affiliate-type model are now sold directly by us (or an entity we control) and instead of the 7% margins, we operate at 20%. That's why I think the $200m number is relevant... in addition to my concern about optics.

2. Hoi, as per Cynthia's comment, I am not trying to represent revenue to the public markets (and even if I were, I'm not sure why the GAAP number would be incorrect). And I hear you on COGS number... was just trying not to clutter the issue... but point taken (having said that, it should be > 90% anyway). Thanks.

3. Robert, thanks for the thought... I'm curious as to where you read naivety into my question. I *feel* like I have a pretty good grasp on the issue (on a side note, I have a BS in finance, have built a financial modeling platform used by some of the world's largest banks and have raised > $100m in capital for 4 companies - including $15 as CEO for my last).

Thanks.

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