In pockets, that dynamic surely still exists, but with the industry having expanded so greatly both in terms of the number of firms and the number of professionals in the late ’90s, it has been harder to find. Two recessions in ten years hasn’t helped, nor has the dismal ten-year returns of the VC an PE asset classes, which has caused firms to scratch and claw for every ounce of return they can extract. All of this has caused the sharp elbows to come out. As my Partner Jack likes to say:

There is alot of schoolyard thuggery. The seventh graders think it is their right to beat up on the fourth grader. No matter what grade you are in, there is always someone bigger than you on the playground.

It is worth calling out when a transaction doesn’t turn into a knife fight. Without naming names (saving that for later), we recently brought a new investor into one of our companies. I have personally worked with this firm before. We don’t just have a relationship, we have a repeat relationship.  While there were terms to be negotiated, the process was filled with a couple of key ingredients; trust, respect, admiration and an understanding that our work together is multi-threaded and won’t end at this transaction.

The result: A speedy and fair transaction that everyone around the table is happy with and where everyone left a little something on the table. No sharp elbows; no fighting over nickels and dimes; the way it should be. It is the repeat relationship that made all the difference.

Its recent decision to lock out third-party ad networks, combined with its clear move in to the edge application space fundamentally alter what Twitter is. It is no longer a platform for application developers to productize around core stream functionality and monetize the edge of the Twitter network. No, if Twitter wanted to be a platform, it would keep its business focused on inspiring innovation on the edge of its network, managing the infrastructure and monetizing the stream.

Truth is, Twitter never was a platform. It has always been a consumer facing application. It is hard (perhaps impossible) to be both a consumer facing application and a platform. A true platform is a true complement with application developers. But a consumer facing application business is a pure competitor with application developers. Because Twitter hasn’t been able to sufficiently monetize the raw stream, it had no choice but to move up stack into the application and monetization layers of its value-chain. I don’t blame Twitter for moving in this direction; it’s totally logical and it was foreseeable.Tacky to quote myself, but in a prior blog post I said:

If you are an application developer on a consumer-facing platform, be sure the platform you build upon has a clear business model for helping you monetize the relationship you develop with the consumer. If not, be wary; what you do may eventually be consumed back into the platform. You may be left with no strategy for monetizing the user base you help to create.

So what is Twitter? Well, lets call it what it is – a consumer application – and a big, but narrow one at that. In the end, that is all it ever was.

I don’t have a dog in this hunt; I have not invested in any Twitter application developers for fear of the very outcome that has transpired – Twitter vertically integrating into apps and monetization with scale. I’m just a student of the platform strategy game. The lesson learned here should be noted by application developers on any consumer-facing “platform”. Be wary unless your platform is a pure complement.

Leo couldn’t do anything right. He couldn’t read. He couldn’t write. He was a sloppy eater…

Leo’s father, playing the classic fatherly role, was very concerned. He couldn’t figure out what was wrong with Leo. He feared that “Leo would never bloom” and raised his concerns with Leo’s mother. Leo’s mother was not phased, saying to Leo’s father:

Leo is a late bloomer.

Being the dutiful father, Leo’s father continued to watch Leo for “signs of blooming”. Seeing none, he asked Leo’s mother:

Are you sure Leo is a bloomer?

To which Leo’s mother responded succinctly:

Patience.

Leo’s father eventually gave up and stopped watching Leo for signs of blooming.

An Example

Like any child, Leo was on a one-way path toward adulthood and beyond. No going sideways, no turning back; one way. Company building doesn’t work that way, success is not in the future for every early stage business. Some fail, some go on to greatness. But regardless of the outcome, as a category, recurring-revenue businesses are late bloomers. Why? Unfortunately, the recurring-revenue model, with all its advantages, has its drawbacks; the biggest being that early in their development, the income statement profile of these businesses rarely reflects the value that has been created.

Product companies have a distinct advantage in this area; sell something and record it as revenue and profit in the period sold. All the value of the relationship with the customer is reflected on the income statement in the period in which the product is sold. Quite the contrary, in recurring revenue businesses; very little of the value is reflected on the income statement in the period the service is sold. Here is an example.

Suppose you sell storage equipment. You sell a tape back-up system to a small business and charge $1,000 for the equipment. You make a 40% gross profit margin on the product. In the period you sold the back-up system, you record $1,000 of revenue and $400 of gross profit on the income statement. Now suppose you change business models and decide to sell storage as a service. You sell under a three-year contract and charge the customer $50 per month; you make a 50% gross margin on your services. In the first month of billing, you book $50 if revenue and incremental gross profit of $25. In the first year, the storage service provider would book $600 in revenue and $300 in gross margin. Comparing these two business models on the basis of income statement performance only, the recurring revenue service company’s income statement looks less attractive than the product companies  for first 12-18 months.

This issue leads to what I’ve referrred to as the Valley of Death in fundraising for SaaS and other recurring-revenue businesses.

Apples, Oranges and Late Bloomers

The trouble with the example above is that it compares apples and oranges. You really can’t compare the income statement performance of a product company to that of a recurring-revenue services business. We need another measurement that puts these business models on equal footing. I have a strong preference for one metric, the lifetime value of a customer. In the product example above, the lifetime value of the customer is $400, presuming the customer never buys another piece of storage equipment from you. The entire value of the customer relationship is recognized on the income statement in the period in which the product is sold. The lifetime value of the “contract” in the service example is $600, the gross profit the company will earn over the three-year contract term. Contract value is an important measure, but only if the contract can’t be cancelled by the customer. More important is the lifetime value of the customer, which requires a more complicated set of calculations including customer acquisition costs, churn, etc. On this basis, ignoring time value of money considerations, I often find that recurring revenue services businesses capture more value per customer than product companies. The example highlights the point.

Customer lifetime value provides an alternative way to measure value that has been created. It is a concept that barely exists in product businesses. However, it is critical to recurring revenue businesses, precisely because – from an income statement perspective – recurring revenue businesses are late bloomers. If you are a recurring-revenue business operator you must measure customer lifetime value and the aggregate value of the all of the customer you have aggregated. If you don’t, can’t or won’t measure it, you are seriously short-changing the value of your enterprise.

Patience, Patience, Patience

Eventually, as they mature and scale, services business show great income statement profiles. Sticky, profitable, long-term contracts with customers lead to that. But because the economics are back-end loaded, it takes a while, and a great deal of patience. Leo’s mother understood that Leo would eventually bloom; she was patient. As the story goes, one day – somewhat miraculously in the eyes of Leo’s father - Leo bloomed. When he did, he turned into one heck of a tiger.

If your recurring-revenue business has a strong product in a big market segment and great customer lifetime economics, it too will bloom. But until it does, best to measure the value of the customers you have acquired so that you know you are creating value before your income statement shows it.

Planning is for big companies.

Our space moves too fast to plan; if we define a strategy we’ll just have to change it in a couple of months.

We’re small, nimble and well-coordinated so we don’t need to plan.

Everyone in my company already knows what they should be working on.

Sorry to be Scroogy, but to those rationalizations I say hogwash! Go ask five of your employees to define the single most important thing the company needs to accomplish next year. Better yet, go ask your executive team; they should know, right? If you get more than one flavor of answer, you need a strategic plan.

Lets be honest, when you cut to the chase, the real reason entrepreneurs and VC’s object to planning is that it takes time, effort and concerted thought. Planning also implies goal setting and goal-setting implies there are objectives you can measure results against, and that implies accountability. Time, effort, concerted thought and accountability; who wants that hassle?

Planning doesn’t have to be complicated or burdensome. For me, planning is like creating a mental map.

Where am I, where am I going and how to I get there?

The process starts with an honest assessment of where you are. Unfortunately, in our reality-bound world, you don’t get to navigate from where you want to be; you can only navigate from where you are. When you are climbing a mountain, you don’t get to start 100 feet from the summit (that is unless you’ve driven to the top of Mt. Evans, in which case you are cheating in my opinion). Planning forces you to come to grips with where you are on a strategy map.

Planning also forces you to define your destination. If you can’t define where you are going, you are wandering aimlessly in the woods.  The rationalization that your space moves too fast to define the destination is not acceptable. At minimum, you should be able to create a directionally correct picture of the future that you are striving to create (ie. Our destination is to the west). The destination you articulate should be worthwhile and aspirational, yet realistic. Don’t worry if the destination changes in a future planning session; that is natural in an emerging market space. But the notion that the destination may change is a lame excuse for not planning at all.

Finally, planning forces you to create an execution path that closes the gap between where you are and where you want to be. If you can’t define the execution focus that will help you to close the gap between where you are and where you want to be, how can you expect your employees know how to close the gap? Tactically focused, execution oriented people you find in most companies need to know how to get from point A to point B in oder to be effective. It is your job to give them the map and show them how their job fits in.

Planning 101: Keep it simple

Planning doesn’t have to be complicated. To really boil it down, we can dispense with the “soft fuzzy stuff”; mission, vision, strategic intent, etc; although I’m a believer that those pieces of strategy have merit. For an emerging growth company, planning should be about two categories of issues:

1. The things that you can accomplish that will make you wildly successful and;
2. The things that you can do to yourself or that can happen to you that will kill your business if you do not prevent them from happening.

My Partners and I at Meritage call these the “Critical Issues”. There should be no more than five to seven of them. If you have ten or more critical issues, you probably don’t have the time, knowledge, resources or capital to execute your plan. Embedded in the critical issues is where you are, and where you need to go (point A and point B on a map). With those points in mind, the next step is to determine the route you are going to take.

For our companies, we like a set of three to five initiatives lined up against each of the critical issues. The initiatives provide tactical guidance regarding what you can to get from point A to B. Initiatives must be within your control; saying that your market must grow 50% next year is not an initiative. Initiatives must also not be prescriptive. “Sell better” is not an initiative, whereas “implement sales training program” clearly is.

Finally, now that you’ve defined the initiatives you are going to execute against, we have our companies establish measurements that define their success against the initiatives. Measurements must be, well, measurable. In other words, use numbers and dates; 10 enterprise customers by year-end, 8.5+ on customer satisfaction survey, version x.x of the product released by June 30, 2009 and on budget. Again, keep it simple; three to five measurements per critical issue is sufficient in our experience.

Putting critical issues, initiatives and measurements into a three column table gets your entire strategy map on one piece of paper. That is remarkable because it provides a simple communication tool to use with employees, Boards and shareholders. Some of our companies use the three columns as the first page of their Board reports and add a red-yellow-green light next to each critical issue to reflect the CEO’s overall assessment of progress against the critical issues. This format makes for an effective visual representative of progress.

This may sound old school, but its my experience that management teams that are honest about where they are, who know where they are going and are able to outline the key steps to get there perform better than management teams that can’t commit these things to paper. If you don’t have the vision to anticipate where you should be by the end of next year, shorten the time-frame; do quarterly or semi-annual planning.

Choosing not plan at all is a massive failure of leadership. So get your management team in a room and hash it out; you will all be better off for it and so will your company’s performance.

Back to my conversation with the CEO. We were talking about the use of proceeds for the financing she is trying to raise. In her case, the business is break-even, but has the opportunity to grow into some oncoming market demand. So I asked a classic VC question; “Assuming you close the financing in Q4, 2009, what will your 2010 revenues be?” Simple question right?

Lets say that this company ended 2009 with $3 million in run-rate revenue and that the Company has two sales reps. Each sales rep. has a quota of $10,000 of incremental monthly recurring revenue (“MRR”) bookings per month. Sales reps. historically produce at 75% of quota in this company, so the incremental new bookings per month, per rep is $7,500. At its current level of sales and marketing resource and productivity, this business can expect to generate $1.17 million more in revenue in 2010 than it generated in ’09. To get there, just multiple the $15k per month of incremental revenue the two sales reps. will generate by 78. Why 78? Because 78 is the ”sum of the digits” for revenue producing months in a year. Incremental revenue added in January will produce revenue for 12 months; incremental revenue added in February will produce revenue for 11 months; …; incremental revenue added in December will produce revenue for 1 month. The sum of digits for 12 is: 12 + 11 + 10 + … + 2 + 1 = 78. So the baseline revenue projection for 2010 should be about $4.17 million.

Now lets talk about the enhanced growth opportunity. The Company wants to hire two additional sales reps. who can be expected to produce at the same $7,500 of MRR as the two existing reps. For purposes of the example it will take a quarter to recruit and hire the two new reps and another quarter for them to build a sales pipeline given the sales cycle. Conservatively, these two new reps. won’t begin generating MRR bookings until June. Lets say there is a one-month install cycle so that June bookings convert to revenue in July. So what kind of incremental growth will these reps. generate in 2010? We don’t get to use the rule of 78 this time; no, because these reps. will produce for only six months during 2010, we use the sum of digits of 6, which is 21. That is a lot less than 78; that six month delay between making the decision to hire two new reps and getting them on board and productive really hurts. In 2010, the two new reps. will generate only $315k of incremental revenue. The business can be expected to generate $4.485 million of revenue in 2010; not meaningfully more than the base scenario without additional investment.

While this looks like meager growth, it doesn’t tell the whole story. Remember, this business came into the year with a $3 million run-rate. Without hiring the two new reps, the business should end 2010 with a run-rate of $5.16 million. By hiring the two new reps. that can be increased to $6.24 million, even though the two new reps. are productive for only six months. That incremental run-rate of over $1 million makes a huge difference and sure makes hiring the two new reps. look a whole lot more attractive than the meager incremental revenue they will generate in 2010.

Here are the key takeaways:

1) Get the Base Right: Recurring-revenue businesses are great because they are highly predictable. Applying the rule of 78s and with a little understanding of your sales resources and their productivity, you should be able to estimate your baseline next year revenue with a high degree of confidence.

2) Scaling Takes Time: The most common mistake I see recurring-revenue entrepreneurs make it to underestimate the time it takes for increased sales and marketing resource to impact the top-line. Hiring new sales people today probably won’t move the needle on your next twelve month revenue. More likely, an investment in sales and marketing won’t have meaningful impact until the following fiscal year.

3) Run-Rate Matters: You will see the impact of an investment in sales and marketing in run-rate much faster than in top-line GAAP revenues. If you are asked about what your revenues will be next year, answer the question directly, but also include a description of the difference in the run-rate you expect to end the year with under the no-growth and growth scenarios. The run-rate difference will impress much more than the top-line difference.

By the way, the CEO of the SaaS company I was speaking with got this analysis dead-right. Well done!