Month: February 2023

Last week I was talking to an entrepreneur and I had a hard time understanding the pitch. After a few rounds back and forth, I worked to simplify and repeat the pitch back to him. It was OK but not great. Then, I realized the problem: he was stating the idea based on what he thought I wanted to hear. AI this, cloud that, etc. I wanted to hear the problem being solved, the value derived by the customer, and the prospects for becoming a large business.

My advice to the entrepreneur: go talk to 10 customers. Ask how they describe the solution. Ask what value they receive from the product. Do this in a way that doesn’t lead the witness. Be patient and quiet as they think through their answers. The point of the exercise isn’t to change the vision or mission of the company. Rather, the point is to refine the messaging and pitch to more accurately reflect the market. The market always decides no matter how hard you want it to be a certain way. 

Ultimately, the clearer the message, the better people will understand it and the faster they’ll be able to know if they need it. Messaging and positioning are harder than they appear. Entrepreneurs would do well to lean on customers and better understand the value from their perspective. 

One of the hot topics right now among venture-backed entrepreneurs is the trade-off between growth and cash burn. Growth is being challenged due to higher churn from tech layoffs (startups often sell to other tech companies) and uncertainty in the economy. Views on cash burn have changed dramatically due to much lower public market valuations and a higher cost of capital from alternative sources like venture debt.

In order to balance growth against cash burn (or profitability!), the Rule of 40 was created. The Rule of 40 is a score defined as the growth rate over the last 12 months plus the free cash flow (FCF) margin over the last twelve months. As a simple example, if the business grew 30% and had 10% profit margins, it’d have a score of 40 (30 + 10), and would be considered great. While a basic methodology, it gives the entrepreneur a framework for analyzing trade-offs.

Last week Kyle Porter, founder of Salesloft, shared with me a more nuanced way to think about it. Instead of growth and free cash flow margins being exactly a percentage turned into a score, there should be a multiple modifier that represents market sentiment. Sometimes growth is more highly valued, like the last few years, and sometimes less valued, like today. This can be expressed as a multiplier to the score.

While there’s no exact formula, a multiplier example right now might be 1.25 growth and .75 FCF margins. So, growth is still favored over profitability, but it’s not as dramatic as two years ago when it was closer to 2.0 (or 10.0!) for growth and 0.0 for FCF margins.

Here’s an example:

$10 million SaaS startup

40% growth rate

-10% FCF margin

Basic Rule of 40 score: 30 (40 + -10)

Growth Multiplier Rule of 40 score: 42.5 ((40*1.25) + (-10*.75))

In the basic model, this startup would have a Rule of 40 score of 30, which is good, but not great. With the growth multiplier set to 1.25x to represent growth being somewhat more important than FCF margins, the startup gets a score of 42.5, which is great.

Entrepreneurs with a venture-backed startup should decide on a target Rule of 40 score that’s appropriate for their business and consider incorporating a growth multiplier that reflects the market.

Over the last two weeks the book The Five Dysfunctions of a Team by Patrick Lencioni has come up multiple times. If you haven’t read it, it’s one of the all-time great leadership books, and especially applicable to entrepreneurs. In classic Lencioni style, it starts with a parable of a team making common mistakes followed by a journey of reflection and teamwork improvement.

From the listing:

Like it or not, all teams are potentially dysfunctional. This is inevitable because they are made up of fallible, imperfect human beings. From the basketball coach to the executive suite, politics and confusion are more the rule than the exception. However, facing dysfunction and focusing on teamwork is particularly critical at the top of an organization because the executive team sets the tone for how all employees work with one another. Fortunately, there is hope. Counter to conventional wisdom, the causes of dysfunction are both identifiable and curable. The first step toward reducing politics and confusion within your team is to understand that there are five dysfunctions to contend with, and address each that applies, one by one.

DYSFUNCTION #1: ABSENCE OF TRUST

The fear of being vulnerable with team members prevents building of trust within the team.

DYSFUNCTION #2: FEAR OF CONFLICT

The desire to preserve artificial harmony stifles the occurrence of productive, ideological conflict.

DYSFUNCTION #3: LACK OF COMMITMENT

The lack of clarity or buy-in prevents team members from making decisions they will stick to.

DYSFUNCTION #4: AVOIDANCE OF ACCOUNTABILITY

The need to avoid interpersonal discomfort prevents team members from holding one another accountable for their behaviors and performance.

DYSFUNCTION #5: INATTENTION TO RESULTS

The pursuit of individual goals and personal status erodes the focus on collective success.

While it might sound like commonsense, there’s a large gap between knowing something can be better and knowing the best practices to make it excel. Every entrepreneur should read The Five Dysfunctions of a Team individually and as a team with their employees.

Last week I was talking to a growth stage software investor. We were discussing a recent round they lead and I asked how they thought about the revenue multiple for this SaaS business. Revenue multiple? I was quickly corrected that they didn’t underwrite it as a Rule of 40 multiple of recurring revenue, growth rate, and gross margin (see Rule of 40 Valuations). Rather, they made the investment based on an estimated EBITDA, and EBITDA multiple, five years from now.

Coming from the grow-at-all-costs for several years to the current grow-reasonably-efficient times, making the leap to EBITDA multiples isn’t as dramatic, but it’s still problematic with so many software companies burning cash. EBITDA (earnings before interest, taxes, depreciation, and amortization) is form of profitability calculation made popular by the Cable Cowboy John Malone many years ago. In rough numbers, a smaller business is worth 4-6x EBITDA, a mid-sized business is 6-8x EBITDA, and a large business or one with an exceptional business model is 10-15x+ EBITDA (also varies dramatically by industry, growth rate, etc.).

SaaS companies, due to characteristics like the stickiness of the product, high gross margins, revenue predictability, and more make for an exceptional business model. Let’s do some basic math to see how a growth stage investor might underwrite a SaaS company at scale to make 3-5x the investment in five years.

Initial Deal
$20M Revenue
$0 EBITDA
$80M pre-money valuation
$20M investment for 20% ($100M post-money valuation)

End of Year 1
$27M Revenue
$0 EBITDA

End of Year 2
$34M Revenue
$5M EBITDA

End of Year 3
$41M Revenue
$10M EBITDA

End of Year 4
$48M Revenue
$15M EBITDA

End of Year 5
$55M Revenue
$20M EBITDA

This is a fairly basic example with a static $7M revenue growth per year (meaning the growth rate slows each year with scale) and tremendous EBITDA growth in the later years due to economies of scale and a higher base of recurring revenue.

Here with a $50M revenue software business, $20M of EBITDA, and a 15x EBITDA multiple, you arrive at a valuation of $300M. A sale of $300M returns 3x the original investment, assuming no further dilution along the way, and the investors achieved their goal.

Theoretically, businesses should always have a floor valuation that’s based on the expected value of the future cash flows. For SaaS and other SaaS-like business models, this is a good exercise to think through potential valuations from a cash flow multiple perspective.