Authentic Demand’s Role in Startup Success

One of the old startup adages that rings true, yet can be hard to appreciate, is “build something people want.” Why wouldn’t an entrepreneur build something people want? I’ve been there, building things no one wants, and the answer is simple: I thought I was right and other people would eventually come around. I was wrong. No matter how hard I tried, if the market had no interest in it, there was no chance the startup would work. A dangerous middle ground traps many entrepreneurs into years of hope that rarely pans out — there’s a bit of market interest and an internal belief that one more feature, one more module will help unlock the demand. Many entrepreneurs were defeated in the search for one more thing.

The most successful entrepreneurs uncover authentic demand in a fast-growing market and deliver a stellar product.

When we started Pardot, we believed there was authentic demand, but we didn’t really know. B2B marketers at the time were using B2C tools, and they didn’t meet their needs. Huge amounts of B2B marketing spend was shifting from offline to online (e.g. print ads in magazines to online keyword and banner ads). It was only after we got the product into the hands of early customers that we heard amazing comments representing authentic demand.

Some of my favorite feedback from customers:

I don’t know how I did my job before using Pardot.

Pardot changed our business.

I tell everyone I know about Pardot.

Pardot data is included in every board deck.

We grew our marketing budget 10x because of Pardot.

We quickly knew that this business was special. Word of mouth was spreading. Prospects started showing up ready to buy. The business grew like clockwork.

Find authentic demand. Prove there’s an undeniable need for the product. Fulfill the unmet need.

Success starts with finding authentic demand.

When Debt is Better than Equity for SaaS Startups

Much has been written lately about the future opportunities for debt financing of SaaS startups. Of course, there are already a number of excellent debt options under the moniker of revenue loans. Personally, I’ve seen the upside and downside of debt for SaaS companies.

Let’s take a look at when debt is better than equity for SaaS startups.

When Debt is Beneficial

Limiting Dilution

Every entrepreneur hates the heavy dilution that comes with a round of financing. Revenue loans and other forms of debt often have no equity component, and when one is present, it’s minuscule (typically 1% or less). At Pardot, we never got on the venture funding treadmill and used $3M of bank debt to fuel growth while limiting dilution (most venture-backed startups only use debt as a safety net).

More Optionality for a Future Exit

Each up-round of equity funding also raises the valuation, and corresponding minimum target for an exit as investors often want to make a return of at least 3-5x the investment valuation. Debt provides a funding mechanism for entrepreneurs wanting to grow faster without changing any expectations as to potential exit outcomes. Generally, the less equity raised, the more optionality for a potential exit.

Ability to Reach a Value Milestone

In SaaS, there are certain financial milestones, like $10 million in annual recurring revenue, that open up a variety of new investors and exit opportunities (e.g. many private equity funds). Debt has the potential to extend the runway enabling the startup to reach a key value milestone.

Now, debt can be worse than equity in many ways as well. Here are a few of the more common.

When Debt is Problematic

Lack of Repeatable Customer Acquisition Process

One of the main tenants of SaaS is the predictable nature of recurring revenue. Only, a SaaS startup can have a number of customers without actually having a repeatable customer acquisition process. When debt is used in an attempt to accelerate growth, and customer acquisition isn’t repeatable, things are actually made much worse due to ballooning costs without the corresponding growth in recurring revenue. This is premature scaling, and funding it via debt or equity has killed many startups.

Inability to Fund Potential Growth

SaaS growth is terribly expensive (see Startup Killer) as costs to acquire customers are spent upfront while the new customers often pay monthly over an extended period of time. When signing customers faster, cash consumed increases. SaaS debt often maxes out at 3-5x the monthly recurring revenue, making it difficult to fund potential growth as cash is consumed faster than recurring revenue grows.

Covenants Constraining Cash Usage

Debt comes with strings attached. Capital providers often require covenants like one month’s cash on hand, gross renewal rates better than 75%, and sales to board-approved plan of at least 80%. When covenants are broken, a variety of penalties apply, which can force more limited use of future cash and tighter restrictions. Breaking a covenant or missing a debt payment can lead to serious challenges.

Conclusion

Debt isn’t the ultimate funding source but does work well for scaling SaaS startups looking to limit dilution, maintain optionality for exits, and striving to reach a value milestone. Currently, debt funding comes with a number of challenges, the biggest one being there isn’t that much debt available as a function of recurring revenue to move the needle. All said, SaaS startups should add a potential debt strategy to their plans.

5 Variables for a Quick SaaS Valuation

SaaS continues to be hot and shows no signs of slowing down. Of course, the strong gross margins, excellent recurring revenue, and overall predictable nature of the business model make it worthy of its praise. These same characteristics also provide the fundamentals for quickly assessing a rough valuation of the business as outlined in Premium SaaS Metrics Required for Premium Valuations.

After feedback and questions on that simple valuation, it’s clear there’s appetite for a slightly more complex formula whereby a couple additional variables are introduced.

The first variable to add: gross margin. As you can imagine, a SaaS company with 90% gross margins (extremely low cost of goods sold) is substantially more valuable than a SaaS company with 60% gross margins (high cost of goods sold for SaaS). A gross margin that’s 50% higher should be reflected in the valuation of two otherwise comparable SaaS businesses.

The second variable to add is much fuzzier: market sentiment. Sometimes SaaS is hot. Sometimes SaaS is white-hot. The fastest way to assess this market sentiment is through the public markets. Take the BVP Nasdaq Emerging Cloud Index and pull an easy-to-consume revenue multiple. That is, looking at all public SaaS companies, what’s the enterprise value divided by the revenue. This revenue multiple is the fastest way to gauge market sentiment. Today, that number is 12.6. Wow!

In the previous formula there was a generic 10x multiplier. This multiplier is better represented by the market sentiment.

Now, here’s the slightly expanded formula:

Market sentiment x

Annual recurring revenue x

Growth rate (use trailing twelve months) x

Net renewal rate x

Gross margin =

Valuation

Let’s take a look at an example using today’s market sentiment multiple of 12.6.

12.6 x

$3M in ARR x

70% TTM growth x

100% net renewal rate x

80% gross margin =

$21.2M valuation

Naturally, for an imperfect market with a limited set of buyers and sellers, this valuation formula is merely a directional number as each startup is unique. For entrepreneurs wanting to understand how to think about SaaS valuations, this basic five variable equation is immediately valuable.

Investor Sweeteners in Term Sheets

During my time trying to raise money in the early 2010’s, investor term sheets were expected to have a number of strings attached — the questions were how many and how onerous were they. Now, with a much more entrepreneur-friendly market and a long bull run, investors have come up with a variety of ways to sweeten the term sheet in an effort to increase the chance of selection by the entrepreneurs.

Here are a few of the sweetener strategies:

  • Give the Founders New Stock Options – Every round of funding comes with dilution, often a heavy amount (e.g. 30%+ when an expansion of the stock option pool is factored in). One strategy is to write into the term sheet some level of new stock options for the founders (similar to a refresher grant) such that the financing round dilution is slightly less painful.
  • Buy Founder Common Stock – Founders often have the majority of their net worth tied up in the startup. By buying some of the founder’s common stock, the founder gets liquidity and the investor gets a larger ownership position. Win, win.
  • Buy Existing Shareholder Common Stock – If certain shareholders have been in the business a long time and/or there’s a substantial step up in valuation, there’s often an appetite to sell a portion of the holdings (much like dollar cost averaging out). The new investors will buy all preferred equity, then have a portion of that new capital buy common stock at 15-20% discount, and retire it. The retired common stock is an effective increase in ownership for all shareholders — common and preferred — such that the new investors gets a larger ownership percentage and existing shareholders don’t get diluted as much (the ones that don’t sell any of their holdings).

As expected, money and ownership percentages are the drivers of these sweeteners. Thankfully, entrepreneurs now have more options and investors are more creative at getting deals done. The next time you see a term sheet, look for the sweeteners.

Inspired By the Realization Entrepreneurs are Merely Human

Recently I was emailing with a successful entrepreneur in town and it reminded me of the first time I met him over 15 years ago. Back then, I was involved in a local networking organization for technologists and received an email that this entrepreneur was giving a keynote talk — I immediately signed up. Here was the chance to learn from a serial entrepreneur that had taken his most recent company public and sold it for billions of dollars.

As I sat in the auditorium and listened to his talk of the struggles, of having to beg friends for money, of being on the brink of bankruptcy multiple times, it dawned on me: entrepreneurs are human like everyone else.

As a struggling entrepreneur myself, I had this internal myth that successful entrepreneurs were different. It was as if they played by different rules, breathed different air, and were doing unattainable things. Hearing live, for the first time, an entrepreneur share their journey, warts and all, inspired me.

Seeing him in person and shaking his hand made me feel like if he could do it, I could too. If he got through his struggles, I could too. If he could build something meaningful, I could too.

Entrepreneurs find inspiration in a number of different ways. For me, seeing, hearing, and touching a successful entrepreneur inspired me and helped stretch my belief in what was possible.

Premium SaaS Metrics Required for Premium SaaS Valuations

When talking to SaaS entrepreneurs, inevitably the topic of valuations come up. Right now, public SaaS companies are trading at all-time highs, so entrepreneurs expect those valuations to apply to their startups. While the valuations of public and private SaaS companies have a direct correlation, it’s important to understand that not all SaaS revenue is created equally, regardless of public or private markets, thus valuations as a function of revenue vary wildly.

As expected, premium SaaS valuations are driven by premium SaaS metrics. Here are a few of the most important ones:

  • Annual Recurring Revenue – The annual run-rate is the most talked about SaaS metric. Ensure that it’s contracted, recurring revenue as different from other revenue sources like services revenue and payment processing revenue.
  • Gross Margin – The money left after the cost of goods sold are taken out. SaaS company gross margins vary dramatically from the low 60s to the high 90s. Anything below 60% gross margins isn’t SaaS (startups masquerade as SaaS but often aren’t). A SaaS company with 90% gross margins is 50% better than a SaaS company with 60% gross margin, and correspondingly much more valuable per dollar of revenue.
  • Growth Rate – The year-over-year growth rate reflects the potential to continue growing fast, and ultimately achieve a much greater scale in the business. Investors pay a huge premium for high growth.
  • Net Renewal Rate (also Net Revenue Retention) – The gross renewal rate plus upsells and cross-sells represents how the annual recurring revenue will change assuming no new sales. Investors pay a huge premium for high net renewal rates.

Directionally, the simplest formula for SaaS valuations is as follows:

  • 10 x
  • Annual recurring revenue x
  • Growth rate x
  • Net renewal rate =
  • Valuation

Here’s a quick example:

  • 10 x
  • $5 million in annual recurring revenue x
  • 50% growth rate x
  • 105% net renewal rate =
  • 10 x $5,000,000 x .5 x 1.05 = $26,250,000

So, a $5M SaaS company with good growth and good net renewal rates would be worth a bit more than five times annual run rate.

To make it more complete, you’d add in gross margin and elements to reflect more nuanced variables like the potential size of the market (e.g. a valuation premium for bigger markets).

One SaaS company might be worth 15x run-rate (due to high growth rate and high net renewal rate) while the next one might be worth 2x run-rate (due to no growth and high churn).

Premium SaaS metrics are required for premium valuations. Look at the entire picture, not just annual recurring revenue.

Entrepreneurs Should Pick a High Growth City

Last week I was reflecting on different contributors to entrepreneurial success. Topics like luck, timing, hard work, and persistence come to mind. Only, for me, picking a high growth city like Atlanta has been one of the most important decisions I’ve made as an entrepreneur.

High growth cities, by their very definition, are attracting people. As an entrepreneur, it’s all about recruiting and retaining amazing people to join in the journey (distributed teams are easier to recruit but are harder to work together). Great people are drawn to cities with opportunity and growth.

One of the big challenges recruiting people to cities that aren’t the pre-eminent hub in their industry is the worry that if the gig doesn’t work out, there won’t be other comparable opportunities. Who wants to move to a new city, realize their new job wasn’t right, and not have similar jobs available? High growth cities represent more jobs, more opportunities.

High growth cities also represent a changing environment. New construction, new restaurants, new experiences — all part of growth. There’s an energy and excitement being part of something on the rise, city or otherwise. People gravitate to what’s winning.

Entrepreneurs should pick a high growth city — a city that attracts people, a city with opportunities, a city that’s changing. The entrepreneurial journey is incredibly difficult and a growing city makes it slightly easier.