Businesses are math equations, and the “favorite equation” for many investors is:
Revenues = Retained Revenue + Upsell Revenue + New Revenues
This is a great equation often used for subscription or recurring businesses because it is absolutely accurate. Therefore, investors look for strong gross retention (retained revenue), strong net retention (retained + upsell), and strong new sales performance, which ultimately leads to revenue growth and scale. From these metrics, investors will derive a lifetime value of the customer and apply it against acquisition cost and look for all of this to be accomplished in an economic way through LTV:CAC (3x+).
However, what if a business retains virtually no revenue and has virtually no upsell? Under this equation, the first two variables would be essentially zero, and it would look like this:
Revenues = 0 + 0 + New Revenues
Is this, by definition, a terrible business? This is the question we face with businesses that are predominantly single transaction businesses. Are they investable or not?
ARE THERE VALUABLE SINGLE TRANSACTION BUSINESSES?
Let’s start with a sanity check. Are there any predominantly single transaction businesses that are in fact valuable? The short answer is yes, there are – just to name a few:
- Tesla (90%+ of revenues is vehicle sales) and other auto manufacturers (with low % of services revs)
- Multiple $1B+ motorcycle brands (Harley Davidson, Polaris, Piaggio, etc.)
- Multiple $1B+ mattress brands (Purple, Tempur Sealy, Sleep Number, etc)
So, if there are valuable businesses built without much if any recurrence, what does this say about our favorite equation? It just says that it is not the perfect equation with which to assess all businesses. It is better geared for subscription or recurring businesses.
WHAT’S A BETTER EQUATION FOR PREDOMINANTLY NON-RECURRING BUSINESSES?
I’d propose we open up our consulting case study interview prep guides and revisit this equation for single transaction businesses:
Revenues = Market Share x Market Size
Much like our favorite equation, this equation is absolutely accurate. However, it re-frames our thinking from analyzing retained, upsell, and new revenue to the two new variables of market share and market size. Let’s dive deeper on both.
Using this equation, here’s how it predicts revenue growth:
- Market Share (Up) x Market Size (Flat) = growth
- Market Share (Flat) x Market Size (Up) = growth
- Market Share (Up) x Market Size (Up) = growth
- Market Share (Flat) x Market Size (Flat) = flat
- Market Share (Down) x Market Size (Flat) = decline
- Market Share (Flat) x Market Size (Down) = decline
All of these scenarios are mathematically and empirically true. Of course, there are scenarios where the amplitude of an up or down trend on one variable might more than offset the amplitude of an up or down trend on another variable, but this frames the conceptual scenarios most simply.
Therefore, unlike our favorite equation, in these single transactional businesses, the focus is not on deeply understanding retention/upsell/new revenue dynamics, it is about developing informed conviction on market share and market size dynamics.
Understanding Market Share and Market Size
Let’s dissect those two variables, then, starting with Market Size which is very simple:
Market Size = Units Sold x Price
Units Sold and Price are the two variables that empirically drive market size. Therefore, to believe in market size growth, you generally need one or both of these variables to go up. Once again, you can have the amplitude of an up on one variable outweigh the amplitude of down on another variable and still achieve growth.
I’m not a fan of investing in single transactional businesses where the market is mature and therefore the market size is likely to be flat or slow growth going forward. This creates tremendous pressure on the company to gain market share as the only path to growth rather than having the tailwinds of market size growth. Therefore, while I typically love to invest in existing markets where spend is known, I lean in non-recurring businesses to high growth new markets where there are significant market tailwinds to supplement growth.
Now let’s discuss Market Share. Market Share is technically Revenues divided by Market Size.
Market Share = Revenues / Market Size
Therefore, Market Share Growth can only be achieved if Revenue growth outpaces Market Size growth.
In this context, it is important to appreciate that Market Size is the sum total of the actual revenues of the companies in the market. Therefore, growing revenues faster than market size really means growing revenues faster than the median performance of all of the other companies in the market, weighted by revenue scale.
Given that, here are the three key variables to revenue growth and the question is can you be better than your competitors along these variables – because if you are, you will likely grow market share:
- Customer Demand
- Product Distribution
- Product/Service Supply
These three variables play off each other to drive revenue growth. If you have any 2 of the 3 without the remaining variable, it’s very difficult to drive revenue growth. However, if you are equal to the market on 2 of the 3 variables, but well above the market on the remaining variable, in most scenarios, you can gain market share.
It stands to reason that in most scenarios if you can be above market on two of these variables and equal on the other, that’s a recipe for potentially very strong market share gains depending on the amplitude of the above market performance.
With all of this said, for any of these business dynamics to be economic, the revenue still needs to be economic, for which the LTV:CAC ratio is equally applicable here. If the LTV:CAC is uneconomic, all bets are off. Additionally, because it’s a non-recurring business where CAC dynamics can change, you really need a high Average Order Value (AOV) with strong margin structures to believe that you can withstand changes to CAC that inevitably happen over time. In short, a non-recurring business with an AOV of $100 is almost certainly off limits, but a non-recurring business with an AOV of $5,000 or $50,000 is far more palatable all else being equal.
Now, let’s apply this framework to a real life example.
THE ULTIMATE NON-RECURRING REVENUE BUSINESS: TESLA
Let’s evaluate Tesla on the equation of Revenues = Market Share x Market Size. In this example, I will define the market as the new market of electric vehicles.
Market Share Drivers:
Customer Demand = Above Market
- Strong secular drivers towards sustainable transportation
- Passionate following among customers – clear love of product
- Huge pre-order demand, customers willing to wait
- Dominant brand leadership
Product Distribution = Above Market
- No reliance on dealer network – first automotive manufacturer to go D2C
- Broad distribution on day one
Product/Service Supply = Equal/Below Market?
- Generally insufficient product to meet tremendous demand
Due to the amplitude of the customer demand and the ubiquity of their distribution, Tesla was able to overcome some product supply constraints to aggressively grow market share in the electric vehicle market. Points to Tesla on Market Share.
Now let’s look at Market Size drivers:
Units Sold = aggressive growth
- Huge growth in electric vehicles sold globally, strong secular growth in a new market
Price = moderating down
- The market started at a high price point, but with competition and manufacturing efficiencies, the average selling price is coming down in the market.
In the electric vehicle market, the growth in units sold has more than offset the moderate declines in average selling price to drive tremendous growth in market size for many years.
Therefore, Tesla has found itself in the strongest spot of our new equation:
Market Share (High Growth) x Market Size (High Growth) = Revenues (High Growth)
They are in a secular high growth new market of electric vehicles with a $50,000+ AOV and brand leadership – it’s been a winning formula. Hence, Tesla has now become a $400 billion market cap company despite being predominantly a single transaction, non-recurring business.
Rethinking Non-Recurring Revenue Businesses
Can you create real enterprise value in non-recurring businesses? Absolutely. It’s really helpful to have significant market size growth as a tailwind for the business. And, then it comes down to whether the company has the brand strength and value proposition to maintain or gain share during that market growth – which comes down to having some disproportionate strength in customer demand, product distribution and product/service supply.
[What are your thoughts? Would you invest or start a non-recurring business? Do you have alternate ways to think about these types of businesses? Please share your thoughts or questions in the comment section and if you have any other questions for future blog posts, do email me at firstname.lastname@example.org.]