The Revenue-Reality Gap

Stuart J. Ellman Mar 02, 2012 Back to blog


Today startups live in a world of “haves and have nots".  The current capital efficient reality of company formation (dramatically reduced cost structures enabled by cloud infrastructure, free open source software and dramatically more efficent development environments), startups will typically raise between $700k and $1.5mm in a seed round to prove out the concept.  This is most often done at a single digit valuation (between $3mm and $8mm).  


If the company proves successful and starts to show traction, a series A of $5mm to $10mm gets raised, usually somewhere between $15mm and $35mm.  This is where the “haves” and the “have nots” are now being separated.  If a deal captures the imagination of the venture community, we see valuations skyrocketing into the $100mm range and even higher altitudes.  Prices are even racheting up on deals that are pre-launch if they have some “buzz”.


It sounds great for the CEO’s of these hot startups.  You have created huge equity value for yourselves and your early investors.  You have plenty of cash in the bank.  So what is the problem?  In my view, a company should raise money at the right valuation, not the highest valuation.  Otherwise it causes what I refer to as the "Revenue-Reality Gap". If you raise a round such that you are in this gap, you run the risk of waking up after raising a hot round and realizing that this $5mm revenue company now has a last round valuation of $140mm.  


Now here is the problem.  In order to have the next round of the company be a positive and momentum-continuing up round, the revenues (or whatever critical metric drives the value of the business) have to completely hockey stick for the next 12 months.  The first 6 months of that growth will help the company grow into its last round valuation, the next 6 months will get it to attain a new one.  I believe e-commerce companies in particular will have a hard time with this trajectory given the historical challenges seen with operational scale and margin compression in this sector.


E-commerce companies need to have people open their wallets and order on the sites.  The first $5 to $25mm in revenues are always early adopters.  These guys move quickly.  The next $100mm are the mainstream adopters and they almost always take longer.  The late adopters, longer still.  Another problem happens with suppliers.  When you are a tiny company, your suppliers may be willing to cut you a deal to get you going so that you can move more of their product.  When you are a hot company with a high valuation, those suppliers may want some value back in the form of higher prices or fewer deals.  Both of these add up to slower growth and lower margins than expected.  This is not to say the companies will not ultimately be successful, many will, but it will not just be a hockey stick straight to the sky.  If the company misses its hockey stick projections, it may be a flat or down round.  Then all the shaudenfreude of the startup community will come out to mourn that company.


People will argue that this is not true.  Companies like Facebook and Twitter raised money at high valuations and the companies blew through those valuations in little time.  But, this is different with a social media company where they can simply go viral at little cost.   They will not be fairly valued on revenues for a long time (Facebook) and maybe never (Twitter).  They have value because of the networks, not just because of the revenue being derived from these networks.   History in venture shows that revenues take longer and cost more than expected.  Right now select companies are being valued as if this general rule is not true using social media as an excuse for a new paradigm.  E-commerce companies and those valued on revenues, not networks, should be careful.