US start-ups compete in a large single domestic market of 326 million people. In such a large market, start-ups need a high degree of market penetration to gain a competitive size advantage over potential imitators. Growth and traction are therefore often viewed as the main success factors by both US investors and start-up founders.
Many US start-ups launch with a boom, creating massive media coverage, getting thousands of users within the first weeks and continuing their growth marathon. They continue to do this as long as they can in the hope that the momentum generated will be sufficient to reach critical mass.
In contrast, European start-ups are typically expected to start producing revenue earlier than US start-ups. This is partly due to lower levels of available funding, which forces companies to prove their business model sooner in order to attract further funding. As a rule of thumb, European investors want to see revenue, and ideally profits, earlier than US investors. This in turn makes it harder for European start-ups to get a big leg-up at the beginning and can lead to a vicious circle emerging.
A maxim in the tech world is that if you have lots of users, you already have a big advantage. But what is really key to success is a company’s ability to transform users into long-term paying users. A revenue-generating proof of concept is therefore the key criteria we look for in our investments. Revenues, and translating revenues into profits, are the underlying bedrock to any valuation. To avoid this question is to walk the path to failure.
It is fair to say that the challenges of monetising users have historically been somewhat overlooked by some investors. As a result, in the last couple of years, a growing number of investors have been going back to basics and placing more emphasis on a company’s ability to generate revenue and profits, whether currently or in their business projections.
Predicting growth in user numbers is extremely hard. Any investment predicated on assuming a start-up will gain a large target number of users is inherently a riskier proposition than investing in a company that is focussed on growing a paying customer base (and therefore revenue). In a users-first start-up, if the company does not hit its growth stride (and raise successive funding rounds) it won’t be able to pay its bills indefinitely and eventually it will be forced to close down. In contrast, a revenue-first start-up should have enough runway to keep experimenting until it hits its own growth formula or at the very least be less critically dependent on successive funding rounds.
Our preferred investment stage at TMT Investments is when companies are already generating revenue (minimum $50K a month) but before they raise their first institutional equity round, the so-called “Series A” round in which larger VC firms typically participate. This is our investment “sweet spot” at which the company is already a viable business with proven revenues and a successful business model. At this stage the company has the potential to significantly increase revenues and profits and offers very significant revaluation potential. A good example of this is Pipedrive, where we were among the first external investors in 2012. Pipedrive went on to raise over $30m from a range of larger VCs including Atomico and Bessemer, at significantly higher valuation levels, allowing us to revalue our holding by 9.6 times from $775,000 to $7.4 million. We are not in the game of funding unproven concepts that only burn money and produce no revenue.
At TMT one of our favourite sectors is B2B SaaS (software as a service). We like the recurring revenue streams that come from cloud-based services such as collaboration and work management platform Wrike, and Pipedrive, which focuses on software tools for developing and closing business leads. Both these companies have fast-growing revenues and have attracted millions of US dollars in investment at valuations well above those at which TMT invested in.
Another sector that has produced outstanding returns for us are B2C subscription-based services such as perfume and make-up subscription service Scentbird, monthly clothes rental company LeTote and gourmet food subscription service Try the World. These are companies that are generating recurring and increasing revenue streams with superb levels of customer loyalty driven by rich data analysis. These types of companies can track the conversion into revenue very closely and are not reliant on ad hoc purchases, thereby improving the visibility of earnings.
Alexander Selegenev is the executive director of TMT Investments, which invests in high-growth companies and is traded on the AIM market of the London Stock Exchange.
