28 Aug What are Venture Investors Seeking in an Investment?
When an investment opportunity comes about, a venture capitalist will initially look at the revenue model of the business. A company with a predictable and recurring stream of revenue tends to be favored over a company with seasonal sales and one-time purchases. The marketing cost associated with customer acquisition is high in every industry and venture investors are looking to realize the greatest return possible over the life of each customer.
Example: iPhone vs. Mac Pro
Let’s compare the revenue models for both an iPhone and a Mac Pro.
The base Mac Pro model that I am using to write this article retails for $2,999. Let’s assume that Apple pays a 20% acquisition cost per customer and earns a 40% Gross Margin on each Mac Pro unit sold. Therefore, Apple’s acquisition cost per customer for a Mac Pro is $600 which eats up a rather large portion of the gross margin ($1,200) realized upon sale of each unit. According to the Wall Street Journal, a research firm called the NPD Group reported the average retail price of a PC at $615 as of last November. At the current rate of technological improvement, the average useful lifetime of a computer is typically around 3 years. The market for computers is cyclical and is subject to large economic swings in demand for substitute goods. From this, we can infer that the Mac Pro is not a “must have” item since there are many substitutes available in the market at a much lower price point.
The base 16GB iPhone 5s model retails for $599. At the time of purchase, let’s also assume that the customer commits to a 2-year contract to pay $100/month for unlimited talk, text, and data. 2-year contracts are an industry standard and for this example we will assume that the customer only keeps the phone service for a period of 24 months. Mobile phones are considered to be an inelastic good meaning that the consumer demand stays relatively static given any change in price. As a direct result, we can assume that the acquisition cost per customer on an iPhone 5s is lower than 20%. For our purposes in this example, we will use 12% which puts the acquisition cost per customer at $360 for the device and mobile plan. Total gross margin is estimated to be $1200 assuming that the contract is not terminated pre-maturely.
Game Changer: Acquisition Costs
Regardless if a customer purchases a Mac Pro or iPhone 5s, Apple realizes $2,999 in revenue and turns a healthy profit. In this example, the duration of each good is relatively similar (3 years for Mac Pro & 2 years for iPhone 5s). The key difference is in the revenue model for each item. Our hypothetical example shows the iPhone 5s revenue/initial marketing cost to be 12x compared to the Mac Pro’s 5x multiple over the same 3 year period. That is a 240% difference! Because a Mac Pro lasts for 3+ years, it takes longer for Apple to sell another computer to the same customer than it does to sell another iPhone which makes it less efficient at leveraging its up-front marketing investment. In order to offset the higher acquisition costs, Apple must push more software, accessory, and Apple Care (insurance) sales. Apple computers compete in a niche market given their higher price point relative to PCs. Mobile phones are a “must have” good, so Apple’s marketing efforts tend to be more effective. Given that mobile services continue to offer the hottest phones in the market coupled with good service at competitive prices, customers typically extend their contract for an additional 2 years and upgrade to the newest phone model. The iPhone 5s revenue model lends higher predictability of future revenues which are especially attractive to investors. This makes it easier to predict future cash flows and growth expectations which lead to more accurate valuations. Venture Capitalist offers advisory services to optimize revenue models and can help position your business to secure funding from investors.