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When is a Dollar not a Dollar?
“All dollars are equal, but some dollars are more equal than others.”
- George Orwell’s imaginary capitalist twin
In my college economics class, I was taught that money is fungible because there’s no difference between one dollar and another dollar. Over the last five years as a VC, I’ve learned that that’s not exactly true and that some dollars are much more valuable than others to a business.
From a startup’s perspective, there are three common reasons why the value of a dollar can vary:
Money has different marginal value to a customer depending on where it falls on their balance sheet.
Some types of revenue require a lot more effort and resources to earn than other types.
Timing matters, and a dollar today is worth more than a dollar next year.
This post offers several concrete examples of these principles. The goal is to encourage thinking about revenue, costs, and value from different perspectives.
1. Cost vs. Revenue
Products create value by helping customers increase their revenue or decrease their costs. However, revenue and costs have very different structures.
Example: one of your customers is Etsy, which charges its users 7% for each transaction. If you help Etsy sell $1000 in extra merchandise, you’re creating $70 of value for them. If you save Etsy $1000 in costs, you’re creating $1000 in value for them. You could easily charge Etsy $100 if you reduce their costs by $1000, but you couldn’t charge them $100 if you help them sell an additional $1000 of products.
Lesson: a dollar of cost savings is worth one dollar to the customer, but a dollar of extra revenue is usually worth dimes or pennies (depending on the customer’s profit margin).
Exercise: think about how to maximize your product’s value to a customer while taking their margins into account.
2. The Principal-Agent Problem
According to Wikipedia:
The principal-agent problem occurs when one person or entity (the “agent”) is able to make decisions on behalf of, or that impact, another person or entity: the “principal”. This dilemma exists in circumstances where agents are motivated to act in their own best interests, which are contrary to those of their principals, and is an example of moral hazard.
Whenever the person buying a product is not the person who uses it, the principal-agent problem arises. An agent values things based on his/her own incentives, not the principal’s incentives.
Example: a customer’s VP of Engineering has ten direct reports and feels very overworked. If a product saves each engineer 1 hour every month but creates 2 hours of work for the VP, that will be a hard sell if the VP is the buyer. But if the product saves each engineer 30 minutes while also saving the VP three hours, that’ll be a much easier sell. In each case, the customer’s company saves 8 hours of engineering time per month (1 x 10 - 2 = 0.5 x 10 + 3 = 8), but the second product will be much easier to sell than the first.
Lesson: a dollar of value for the person buying your product will be worth much more to them than a dollar of value for someone else in their organization.
Exercise: think about how to create value for your buyer – especially if they are not the main user of your product.
3. Existing Expense vs. New Expense
Companies and teams often have existing budgets for common expenses. It’s easier to sell something if it fits into an existing budget.
Example: a company has a $500/mo learning budget for each employee. If you’re selling training software, then the company can pay you out of its learning budget. But if you’re selling something new, like “employee happiness monitoring” (EHM), then there’s no budget for that. Even if the company wants your EHM product, it’ll be hard to find a concrete buyer because no one has a budget for EHM.
Lesson: it’s easier to take a dollar from an existing budget than to take a dollar from a budget that doesn’t exist yet.
Exercise: if your product is creating a new spending category, think about whether there’s a way to reframe the product or adapt it to an existing category so that it’s easier to fit into an existing budget.
4. Above vs. Below Discretionary Spending Limits
For lower-priced products, customers often have discretionary spending limits. Products priced under these limits are much easier to sell.
Example: a customer’s engineers are allowed to spend $500/mo on whatever they want without their manager’s approval. If your engineering tool costs $499, then you’ll be able to sell it quickly. But if you raise the price to $501, then your sales cycles and conversion rates will worsen. In this case, the 501st dollar is very different from the 500th dollar.
Lesson: a dollar from someone’s discretionary spending limit is much easier to capture than a dollar that requires layers of approvals.
Exercise: figure out your customers’ spending limits. What kind of additional approvals or effort are required as you exceed each of those limits? How does that affect your product and pricing tiers?
5. Selling Services vs. Customized Products vs Off-the-shelf Products
Different types of revenue have very different scaling characteristics. Revenue that requires human labor is worse than revenue that doesn’t because the latter is much easier to scale.
Product #1: you’re selling consulting services. Each employee can generate $300k in annual revenue.
Product #2: you’re selling software that requires some initial customization by an employee. Each employee can handle customization for $2m worth of annual revenue.
Product #3: you’re selling software that doesn’t require any labor. You can scale up very quickly without adding employees.
The difference between these alternatives is clear: if your startup is presented with a $30m consulting opportunity tomorrow, there’s no way to take it because you’d have to hire 100 people overnight. If the $30m opportunity is for customized software, then you’d “only” have to hire 15 people quickly. That’s doable, but still hard. But if you close a deal for $30m in off-the-shelf software, you should be able to deliver that without a hitch. The less labor a dollar of revenue requires from your company, the more attractive that dollar will be.
Lesson: selling a dollar of software has much better margins and scalability attributes than selling a dollar of services.
Exercise: are there specific use cases or customer segments where your product requires less customization and manual labor? What can you do to grow your sales for those use cases/segments?
6. Selling to Many Stakeholders vs. One Stakeholder
Products with a single stakeholder are straightforward to sell. Products with many stakeholders are hard to sell because you have to make everyone happy – but different stakeholders will have different, often conflicting, incentives and preferences. This example is loosely related to the earlier principal-agent example.
Example: healthcare systems have a lot of parties whose incentives may not be aligned. There’s the patient, the doctor, the hospital, the insurer, the government, and so on. As a result, healthcare software can be notoriously difficult to sell because it’s hard to please everyone. Maybe a patient wants a service, but the service is time-consuming for the doctor or not something that insurers will pay for. Or maybe a doctor loves a productivity tool, but the hospital doesn’t want to pay for it. In each of these scenarios, the likelihood of a sale is very low.
Lesson: the more parties a product involves, the harder it will be to sell. On the other hand, the fewer people have to approve a dollar of spending, the more likely you are to see that dollar. (This is related to discretionary spending limits, where going just above a limit triggers additional stakeholders.)
Exercise: can you sell a variant of your product that involves fewer stakeholders?
7. Monthly vs. Upfront Payments
A dollar today is worth more than a dollar next year. If you are paid today, you can use the proceeds to cover costs or to grow your business. If you’re paid later, you have to figure out how to stay afloat until the revenue finally comes in.
Example: you sell your product for $60k/year and you have $50k/mo in expenses. If you can close a new customer every month and your customers prepay annually, then you’ll be profitable every single month. If customers pay $5k monthly instead of $60k upfront, then you’ll be losing money until you land your tenth customer in month #10.
Lesson: it’s best to collect revenue upfront so that your business has a better cash cushion.
Exercise: are there incentives you could provide, both to your sales/marketing team and to your customers, that would help you receive more revenue upfront?
8. Selling vs. Upselling
It’s typically easier to sell more products to an existing customer than to find a new customer. According to the Pacific Crest SaaS Survey, the median SaaS company spends $1.13 to acquire each dollar of annual recurring revenue, but only $0.27 to generate an extra dollar of recurring revenue from an existing customer.
Example: it might take Dropbox $50 of marketing spend to acquire a new user who pays them $100/year, but only $20 of marketing spend to get an existing user to upgrade from a $100/year plan to a $200/year premium plan. Dropbox earns an extra $100 in both cases but pays a lot less to acquire that revenue from an existing customer.
Lesson: making a dollar from an existing customer is usually easier and cheaper than finding a new customer who will pay you a dollar.
Exercise: if you’re mostly focused on finding new customers, think about whether there are products or services that you could upsell to existing customers.
As you build out your business, consider the value of each dollar in the system to everyone involved. The better you can align your product with your buyers’ needs and constraints, the healthier your business will be. Your goal should be to find areas where your customers get more value and to find areas where you can expend less effort to produce that value.