Recurring Revenue is Dead
Backlog is Back
If we look back at the last 20+ years of venture, one of the defining features was Annual Recurring Revenue (“ARR”). Build something once, sell it many times on a recurring basis. Because of the recurring nature of this (high margin) revenue, companies were rewarded with high revenue multiples and beloved by public markets. With AI, that reality is changing.
Though companies still make their best attempt to call their contracted revenue ARR, what they really have is backlog. Backlog is revenue that is contracted but hasn’t yet made its way through the production queue into realized revenue. This can be AI implementation service revenue, hardware sales, or government testing data collection, as a few examples. In this world, pipeline is king.
For investors, this new normal also changes how we diligence companies as they grow. Instead of doing SaaS cohort analysis and applying revenue multiples to companies, investors now need to prioritize a more rigorous pipeline analysis. They need to do customer references, analyze contract termination clauses, evaluate cash conversion cycles, and really understand where the marginal revenue will come from when they can’t safely assume that every year there will be a 10% price increase per seat license.
So if we’re headed into a world where backlog is the key metric, what should we look for at each stage of a company’s lifecycle to determine company progress? We look to answer four (often qualitative) questions:
Why are customers choosing this company (defensibility, product differentiation, GTM effectiveness)?
How big is the pipeline (TAM, “surface area for luck”)?
What is the near-term and long-run margin structure for the products and services sold to this pipeline? (e.g. what are the substitutes, how urgent is the need, how unique is this product, etc.)
How repeatable is the current sales motion? Has the team distilled GTM down into a core capability or is it scatter shot?
Depending on the category a company is operating in, the answers to these questions vary.
In hardware, product differentiation and defensibility are two of the easiest things to see. Relative to the digital world, building in the physical world is slower and has a more limited universe of alternatives to assess. The risk in hardware land more often tends to be TAM, margin structure, and sales repeatability.
In software today, long-run defensibility is the challenge. Short-run numbers may be great, but avoiding margin erosion and slowing top-line growth feel increasingly difficult to avoid. Without a hardware or network effect moat, unique GTM motions/unfair advantages and extreme talent advantages on the path to economies of scale are more important here than ever.
TLDR; Fun times and lots of opportunity for those willing to forego heuristic-based investing and go back to business valuation basics!