Profit 101 #9: Not All Revenue is Created Equal
Sep 21, 2023
Using Gross Margin as a metric instead
Flying across the LinkedIn wire you'll see the breathless posts: How we got to 10M ARR in 18 months! I got to 20M ARR with three different startups! Hey, and I'm guilty too, since I recently posted on LinkedIn that Fraction made it to 3M ARR. But how do you compare these revenue numbers across industries, and is this grandstanding in some cases, but not in others?
News Flash: Not all revenue is created equal!
You can try to tease out the quality of revenue a couple of different ways:
How much of the revenue is recurring?
How much of the revenue does the company keep? We'll explore this concept (Gross Margin) more later.
How profitable is the revenue? This gets more complex in a hurry, as there are literally dozens of financial metrics you could calculate. [1]
SaaS companies with long term recurring contracts may have great visibility into their future revenue base, while at the other extreme sellers of durable goods in e-commerce (the online mattress players for instance) have to earn new revenue with new customers every day. When it comes to profitability, SaaS gets the nod as well, because each new sale theoretically requires almost no marginal cost. Our (underappreciated) mattress company has substantial product cost with every mattress, not to mention shipping costs! Services businesses (like technology or management consulting) fall in-between, as they often have repeat business with customers, but their costs are high since every new project requires more consultants.
These business differences lead to different revenue multiples by sector:
SaaS revenue multiples hit 19x at the 2021 highs, and have stabilized in the 7x range currently. Many founders use 10x as a convenient mental target for a SaaS revenue multiple, but the reality is that it's highly market dependent.
At the opposite extreme, small businesses oftentimes command revenue multiples below 1, and the 0.5-1 range is common!
DTC e-commerce businesses are more typically valued on EBITDA multiples, but when we do look at revenue multiples, companies like AllBirds, Stitch Fix, and Chewy are all trading below 1x revenue, while a more highly valued company like Warby Parker is still only at 2x revenue!
Technology services businesses are in-between: the largest of them all, Accenture, sports a revenue multiple of 3 today, but hit 5 at the market highs.
With this wide variation in revenue multiples and valuation based on industry, there's got to be a better way to gut check your startup's progress, right? Let's talk about an easy one that normalizes and cuts away a lot of the noise for comparison: Gross Margin.
Gross Margin is a Better Metric than Revenue
There's a way to compare this wide range of businesses more equally: look at gross margin instead of revenue. Gross margin is what's left after subtracting the cost of goods (or services) sold. This normalizes between a SaaS play like Asana, a DTC mattress play like Casper, a real estate play like Industrious, and a tech services marketplace play like Fraction.
Since many SaaS companies have gross margins above 90%, their revenue and gross margin are very similar. A DTC e-commerce player might have a gross margin of 20%, so that 5 dollars of their revenue is worth one dollar of SaaS revenue. When I compare my last two businesses, one dollar of HiddenLevers (SaaS) revenue is worth almost 3 dollars in Fraction revenue - so crossing 3M in ARR is a nice step, but in reality it's more like crossing 1M for a pure SaaS company.
But with all of these examples, once you strip out cost of goods sold, and get down to gross margins, what's left are pretty similar core business operations. Every company will have some sales and marketing and internal operations expenses. Even research + development costs accrue in all but the most mundane of industries. Once you've boiled down to gross margins, then growth rate is the remaining factor influencing valuation [2].
How to Use Gross Margin
Here's how to use gross margin when running your business:
1. If you're running a SaaS business, your gross margin should be greater than 90%, and ideally over 95%. Credit card fees will be 3% of that 5%, leaving you just 2% in variable expenses for hosting and all your OpenAI calls! This is not to say you should spend all your time in the early days cost-optimizing, but it will pay dividends to do this after you've got product-market fit.
2. If you're running a physical goods or services business, a great target is a 50% gross margin. That may not be realistic in all industries, but it's worth aiming high - Tesla has substantially raised the bar on what's possible in the auto manufacturing industry, for instance.
3. Get comfortable looking at your business from a gross margin perspective - it's your real "revenue", what your business keeps, as opposed to the glossy (inflated) top line number. When you look at the valuations of businesses with similar gross margins and similar growth rates - you'll find similar valuations. Even if you don't do the math, potential acquirers and investors will!
[1] Finance 101 teaches us that any business is valued by taking the present value of its future profits. This is called discounted cashflow based valuation. You can't value a business (particularly a startup business) based on just present results, because so much of the value is in future growth! Now, because many (most) startups aren't profitable, it has become common to value them based on a multiple of revenue. But this still ties back to assumptions around future profitability, and particularly end state profit margins. EBITDA margin is often used, in part because that enables financial engineering by excluding interest, taxes, depreciation, and amortization, all tools that PE shops love to play games with!
[2] If your investor/acquirer is strategic, they might assign a valuation in part based on "future synergies" - but financial buyers/investors will use a valuation that really just depends on two things: end-state profit margins, and long-term revenue growth rate. If you maximize your gross margin, then optimizing your internal expenses to produce high end-state profit margins becomes easier. From there all that matters is topline growth - the higher the better.
More Posts from the Profit 101 Series
Business Principles
Startup Costs Video Series
Pursuit of Profits