Today I was chatting with a “spotter” entrepreneur about the details of an opportunity he’s considering pursuing. He plans to build a business to solve an overlooked problem of solopreneurs. He needs capital to launch the business but doesn’t have experience raising capital from investors, so he asked for my thoughts on structuring a deal that includes investor capital and bank debt.

As we chatted about the business model and numbers, we began discussing the bank debt portion of a possible deal. In the past, he’s used his own capital and bank debt to launch businesses. But interest rate increases mean that debt service on a loan would materially reduce cash flows from the business. This spotter has his own capital, but not enough to finance this entire project. Nor does he want to take on that much risk. Given this reality, he’s considering, for the first time ever, raising capital from investors. The problem is, he doesn’t know where to start.

When interest rates were low, spotters could partner with banks exclusively. The principal and interest on their loan payments didn’t materially impact cash flow, and they maintained 100% ownership. They preferred to work with a banking partner and cheap debt rather than give up equity to investors and have to report back to those investors.

In today’s interest-rate environment, selling an equity stake to investors can be a more attractive alternative. Deals where bank debt would significantly reduce returns or cash flows because of high rates can be more palatable with investor capital. Of course, this depends on how the deal is structured. The devil’s in the details.

Today’s conversation got me thinking. How many more spotters are doing the same math and coming to the same conclusion: I should consider raising capital from investors. If it is—or will be—a material number of people, this could be an interesting market that will likely be underserved.

I want to follow up on yesterday’s post about recurring and transactional revenue with an example. Coinbase is a publicly traded company whose financials are publicly available. It offers a variety of products, but most of its revenue is made on fees charged when customers buy or sell cryptocurrency assets on its platform. This fee-based revenue is transactional since Coinbase doesn’t know when customers will transact or how much revenue it will receive when they do.

Coinbase’s latest 10K filing for the fiscal year ending December 31, 2022, shows us how the transactional nature of its revenue affected its financial performance:

• 2020: $1.27 billion in revenue and $868 million in operating expenses for $409 million pretax income (profit). Pretax income was ~32% of revenue. Operating expenses were ~68% of revenue.‍
• 2021: $7.83 billion in revenue and $4.76 billion in operating expenses for $3.02 billion pretax income (profit). Pretax income was ~39% of revenue. Operating expenses were ~61% of revenue.‍
• 2022: $3.19 billion in revenue and $5.90 billion in operating expenses for a $3.06 billion pretax loss. Pretax loss was ~96% of revenue. Operating expenses far exceeded revenue (~185% of revenue).

Coinbase’s transactional revenue fluctuated wildly during those three years. As revenue soared from 2020 to 2021, Coinbase’s expense structure also increased. This makes sense because you need more people and resources to service an increase in customer demand. As revenue plummeted from 2021 to 2022, the company’s expense structure continued to increase, causing a massive pretax loss.

Revenue increased over 600% one year and dropped almost 60% another year. While this is an extreme example because of macro factors, Coinbase demonstrates how hard it can be to forecast and plan when there are no agreements between a company and its customers that produce recurring revenue.

I’ve chatted with a few founders who proudly share their recurring revenue numbers to show how their businesses are growing. But their revenue isn’t recurring. They aren’t trying to mislead—they often don’t know what “recurring revenue” means.

Revenue is recurring when the customer has agreed to pay a predetermined amount over a predetermined time. Subscription revenue is a great example. A customer signs an annual contract for $1,200 and agrees to pay $100 per month on the 1st of every month. Alternatively, the customer could give you the entire $1,200 up front to gain access to your solution for the year. Either way, the duration is a calendar year and the amount paid is $1,200.

Another wrinkle on subscriptions is monthly software with no contract. Let’s say a customer signs up for a SaaS tool such as Calendly, agrees to pay $10 per month, and can cancel anytime. This is still subscription revenue. It’s a one-month subscription that auto renews at the end of every month unless the customer cancels. The duration is a month, and the agreed-upon amount is $10.

The great thing about recurring-revenue businesses is that they start with a known amount of monthly revenue that customers have agreed to. Customers must notify the company when they plan to stop paying, which gives the company prior knowledge of when revenue from a customer will decline. This revenue base makes planning and forecasting more accurate for small and large companies.

If revenue isn’t recurring, it’s likely transactional. Transactional revenue doesn’t involve predetermined amounts, and the frequency of payments varies. Grocery stores are great examples of transactional-revenue businesses. Customers can walk in whenever they want and buy as much or as little as they want. There’s no commitment between the store and the customer. Every month, the store starts with a revenue base of zero. Customers don’t have an obligation to notify the store if they’ll stop shopping there. This can make planning and forecasting difficult until the company has a large customer base.

If you’re building a transactional-revenue business and want to demonstrate that revenue is growing, don’t use terms like “recurring revenue” or “annual recurring revenue.” Consider something like “revenue run rate” or “annual revenue run rate” if it makes sense for your business.

In yesterday’s post, I shared the difference between wealth and income. Here are some ways for founders to think about wealth, income, and company building.

A business that makes creating income for the owners top priority is usually optimized to do so. That means that cash generated by the business is removed from the business for the benefit of the owners. And it usually means that the company isn’t reinvesting in growth opportunities as heavily as it could. The focus is on how much cash the company can generate and distribute to owners.

A business focused on creating wealth is focused on growing the value of the business. To make that happen, the business is trying to scale its solution quickly. Cash generated by the business is reinvested in growth opportunities within the business. The company may even raise outside capital (i.e., venture capital) to accelerate growth. The founders of these companies usually target getting a windfall when they sell all or part of the company after it reaches material scale.

Most companies I see fall in one of these two buckets. But there are exceptions. Some founders build companies that are hybrids: extremely profitable and high-growth companies that generate income for owners and increase the owner’s wealth rapidly because the business value skyrockets. The hybrid businesses I’ve seen have high profit margins, which drives their profitability, and solve a painful problem well, which drives their growth. This type of business is very attractive and tends to be valued richly. The founders of these companies (if they have majority ownership) control their destiny because they’ve created an asset that both materially increases their wealth and provides income.  

You’re unlikely to build a big company in a small market. The solution may be great, but if there aren’t enough people with the problem, the company’s upside potential is limited. Today I read a blog post from Bling Capital that provides a simple framework for quickly sizing a market. Here are a few takeaways:

• Bottoms up – Don’t take a top-down approach that focuses on getting a percentage of a known market. That can severely underestimate a market. An NYU professor made this mistake when he claimed that Uber was overvalued. A bottoms-up approach that also considers new use cases enabled by a superior solution is better.
• Customer segmentation – All customers aren’t equal. Different customers will require different go-to-market strategies.
• Penetration rates – Be realistic about how much of the market you’ll capture. Fifty percent isn’t realistic for most companies, but 5% is. Penetration may vary by customer type (e.g. urban vs. rural).
• Gross profit – The cost of delivering a solution matters a lot. It’s an indication of whether the company can become profitable. Growing revenue or GMV quickly but with low gross profitability makes the path to turning a profit much harder.

Every market is different and founders should consider the nuances of their market when sizing it, but this framework is a good starting point.

Today I had a chat with a friend who made a comment that stuck with me.

I’m not a start-from-scratch kind of person. It’s not my strong suit. I need there to be something in place already that I can improve and scale.

My friend, over an accomplished career, has learned this about himself. He isn’t a blank-canvas person. He has no desire to start a company. He needs there to be pre-drawn lines to a bigger picture or vision. He can then work within the outline of that picture to turn it into something amazing. He considers only opportunities that align with this criterion. His skill set makes him well suited to be the right-hand man of a big-picture entrepreneur who knows exactly how he or she wants to solve a particular problem.

As a former founder, I’m comfortable starting from scratch. A blank canvas is attractive to me. I enjoy the process of coming to understand a problem and creating a solution from nothing. Once I know what needs to be built, I can draw the lines on the canvas and start building a masterpiece.

For anyone who wants to be a founder, a comfort level with a blank canvas is necessary.

I read a quote that’s stuck with me:

I hear and I forget. I see and I remember. I do and I understand.

                                                                                  ~ Unknown

Seeing something being done is helpful, especially if you have a blank canvas and don’t know where to start. You’ll remember what you saw, but that doesn’t guarantee you’ll understand why it was successful or unsuccessful. When you try to replicate what you saw, that’s when it starts to click and make sense. The true learning and understanding happen by doing. We learn what we do (or attempt to do).

Today I was thinking about names for a new business idea. I’m not great at marketing or branding, so I was curious about what tools exist that could help. I found a few of them and ended up exploring Namelix.

This tool is a name generator. Using AI, it helps create short, brandable business names. I wasn’t sure what to expect, so I spent time playing with it. It allows you to enter a few words or phrases that describe the business. You choose the naming style (i.e., non-English words, compound words, etc.) and creativity level. You then get a list of names presented as simple logos.

If you’re thinking about what to name a new venture, consider Namelix.

I recently caught up with an angel investor who shared what made a founder stand out in a cold inbound and what made her want to help after their initial meeting. She defines a “cold inbound” as an email she gets without an intro from someone she knows. She’s open to cold inbound and responds to them, but she doesn’t meet with everyone who emails her. Here’s what she told me:

• Research – The founder read about the angel in an online list. Her email showed she’d done her homework and researched the angel investor’s background before emailing her. She cited what she learned about the angel’s background, why it impressed her, and why she wanted to chat.
• Connection – The founder’s research uncovered a connection the two had. She mentioned that they’d gone to the same university.
• Bought, not sold – The founder was enthusiastic about what she was working on. She demonstrated that she was thoughtful in her responses to challenging questions. By the end of the conversation, the angel had bought into trying to help this founder.
• Follow-up – The founder followed up on action items from their initial meeting quickly and was responsive by email. And she showed that she was acting on items from each meeting and building momentum.

This angel was genuinely excited to work with this founder and is now invested in her success. And it all started with a cold email!

An early-stage founder gave me his pitch recently. He’s just finishing the first version of his product and looking to raise investor capital. One of the things I noticed was that he listed multiple problems he’s trying to solve and multiple types of customers he’s solving problems for (consumers, small businesses, etc.). I wasn’t sure exactly what he’s solving, who he’s solving for, and what exactly his solution does. We talked, and he clarified the main problem, the target customer, and the solution, improving his pitch and my understanding.

Early-stage companies have limited resources. Given this constraint, they can’t be everything to everyone. It’s best to focus, get proficient in your area of focus, and then expand when you have more resources.

Investors, especially early-stage investors, are aware of resource constraints and are less likely to invest in founders who are solving multiple problems for multiple customer types.

For early-stage companies, focus is the name of the game. If you can’t get great at one thing, you likely won’t get great at several things.