Reset the Internal Valuation and Focus on Value Creation from a New Starting Point

Lately, one of the big challenges I’ve been discussing with entrepreneurs is the massive reset in valuations. The huge ARR multiples are gone for all but the most exceptional of business models. If the last funding round valued the business at X, and the public markets value businesses with similar metrics at 2/3rd to 1/4th the value, the reality is that the business is considerably less valuable now. Human nature is to ignore the data and try hard to grow into the valuation so that the next round is at least flat, if possible.

The better solution is to make the hard call and reset the valuation and mental anchoring internally.

Internal valuations, for stock options, can be set at any amount equal to or higher than the 409a valuation from a third-party. The 409a looks at the landscape of similar company valuations, does a variety of calculations, and comes up with a valuation for the startup. A recent 409a will reflect the latest data, and likely a lower valuation than the last round.

Now for the tough part: what to do with the existing stock options that are underwater (the strike price is significantly higher than the the company’s valuation)? It’s time to make a plan and roll out new options to employees. As the company valuation is likely lower, this will result in more dilution to achieve a similar level of equity ownership for employees. My favorite methodology for equity grants is from Fred Wilson’s post: Employee Equity: How Much?

The sooner the internal valuation is reset, the sooner the team can start buying into the creation of new value from a lower starting point. Of course, it’s incredibly hard as everyone has the last valuation in mind. By reseting the mental anchoring, and issuing new stock options in a corresponding manner, alignment around the creation of new value becomes achievable. No one wants to go back to then go forward, yet that’s a common theme in life. 

Entrepreneurs would do well to evaluate cutting the internal valuation and focus on value creation from a new starting point.

The Calculated Marathon to $10M ARR

Last week I was talking to an entrepreneur about his latest progress and growth plans. After a few minutes into the conversation it was clear the main issue to be discussed was the dilemma between selling future investors on a grand vision of becoming a unicorn vs the personal desire to build a solid business and have the optionality to sell for high eight figures and set up his family financially for life. With the news stories over the last few years, it’s easy to get sucked into the hype that the only path forward is a billion or bust. In reality, most tech entrepreneurs want to work on cool things, make an impact, and get fairly compensated for the value created.

My advice to this entrepreneur based on his personal goals: think of it as a calculated marathon to $10M ARR. To have financial optionality for a full or partial sale, the SaaS startup typically needs to get to $10M in annual recurring revenue growing >30% per year to be valued in the $50M – $100M range based on gross margins, net dollar retention, addressable market, capital efficiency, etc. Now, working back from this $10M ARR target, we know the yearly milestones:

Year 8 – $10M ARR @ 35% growth

Year 7 – $7M ARR @ 45% growth

Year 6 – $4.5M ARR @ 55% growth

Year 5 – $2.8M ARR @ 65% growth

Year 4 – $1.6M ARR @ 75% growth

Year 3 – $900k ARR @ 85% growth

Year 2 – $500k ARR @ 95% growth

Year 1 – $250k ARR @ 100% growth

The huge assumption here is that growth slows down ~10% per year and the company can be capitalized in a way where everyone is aligned around this strategy. On paper, this isn’t a venture-backed business. In reality, there are so many seed funds and angel investors that it’d get funded with the hope (yes, hope!) that’s there’s an opportunity to grow faster and build a bigger business should the opportunity reveal itself.

Entrepreneurs would do well to think through how their personal goals align with their current strategy and consider a calculated marathon to $10M ARR, when appropriate.

Think Dolphin Strategy for More Measured SaaS Growth

Todd Gardner has an excellent post up titled Use the Dolphin Strategy for Efficient SaaS Growth (with Lowered Risk) where he shares a strategy many entrepreneurs, SaaS or otherwise, would do well to consider, especially in uncertain times. Much like dolphins can stay underwater for long periods of time, they do need to come up for air regularly before heading back down. For investor-backed entrepreneurs, venture or debt financed, the default approach is losing money perpetually until the sale of the company. Instead of constantly losing money — being underwater — the entrepreneur would achieve a quarter of profitability — coming up for air — every 18-24 months. This is profoundly different from today’s standard playbook of growing as fast as the growth metrics and capital markets allow.

Here are a few quick thoughts on the dolphin strategy:

  • Less capital will be burned and, correspondingly, the business won’t grow as fast
  • If capital markets change quickly, as they have this calendar year, the business will always be on a plan to control their destiny — profitability — and isn’t as subject to market timing
  • Employees actively looking for a more measured approach to the startup playbook will appreciate this while others that want the go-big-or-go-home approach will be repelled
  • Profitability, even if only for a quarter on occasion, provides clarity to future investors and acquirers, especially private equity, what the business actually looks like when operated for cash flows, even if operating income is modest

The dolphin strategy will appeal to entrepreneurs that already have a capital efficient lens to their style and want to take it one step further and demonstrate real sustainability in their business model. Unfortunately, the dolphin strategy doesn’t work as well for smaller startups as it requires some level of scale and predictability — at least a few million in recurring revenue — to work unless the startup is super lean.

Entrepreneurs would do well to understand the dolphin strategy for more measured SaaS growth and consider it for their business. 

Why Grow the Startup Community

One of the conversations we’ve been having over the last few months is about more intentionally growing the startup and entrepreneurial community in our metro region. This is a meaty topic that comes and goes regularly. While it’s an important topic, and one I’m focused on, there’s a “why” component of it that needs to be addressed more directly. Yes, we want to grow our community but what are some of the benefits of a larger startup community?

Here are a few ideas:

  • Regional Dynamism
    Cities and metro regions that are growing are more dynamic. Infrastructure investments, quality of life improvements, and other livability factors get emphasized when there’s optimism and growth in an area. People want to be part of a winning movement, and growth, both population and investment, is the strongest indicator good things are happening.
  • Job Growth
    By definition, a startup is a business focused on growth. Growth creates jobs. More jobs provide more opportunities for both existing residents and for people to relocate to the area. While remote work has changed this equation slightly, it’s still easier and more fun to work with people face-to-face, at least some of the time.
  • Local Headquarters
    When the business is headquartered locally, a number of secondary benefits emerge like stronger engagement with community issues, more donations to local non-profits, and general caring about their city. A company that’s locally headquartered will have a greater impact than a company that has a regional office, everything else held constant.
  • High Quality Jobs
    Not only will more jobs get created, the jobs will be of a higher quality as startups are often in technology and other high paying fields. Raising the average salaries and household income of a region helps the entire community as well as creates secondary jobs across traditional industries.
  • Wealth Creation
    Startups, when successful, are enormous wealth creation engines. An important, but not often discussed, element of the startup industry is that there’s a pronounced power law where a tiny percentage of startups create the majority of the gains. Having just a few startups that hit it big can materially move the needle for wealth creation in a community.

Intuitively, it makes sense that more entrepreneurial activity in a community is a good thing. Only, it’s important to go up a level to think about why a larger, broader, and deeper startup scene helps the region, especially in the context of a long, multi-decade horizon.

Let’s grow the startup community.

The Closing Dinner Post Startup Exit

Last week we had the closing dinner for a startup that was acquired earlier this year. A closing dinner is a ritual to celebrate the success of a transaction with the founders, executives, investors, advisors, bankers, and anyone else heavily connected to the company. Put more simply, it’s a feast to give thanks.

Much like the name implies, the closing dinner is both the closing of the deal and the closing of that chapter of the business. In this case, it’s an opportunity to recognize everyone involved, share stories of key moments along the journey (especially the early days), and talk about lessons learned. There’s a bit of nostalgia — acknowledging that a major phase is done often brings this one — along with a bit of poking fun at how little we knew at the beginning. In other words, cathartic.

Human connection is one of the deepest desires and memories are the glue that binds us together. Closing dinners are a time-honored ritual to bring the team together and reflect on a major accomplishment. 

Make No Little Plans

For many years we’ve been pushing the idea to entrepreneurs that it’s the same amount of work to create a company that has a huge impact as it is to create a company that has a more modest impact. Impact can be defined as lives touched, jobs created, revenue generated, wealth created, or any other measure. Regardless, it requires working thousands of hours over 7-10 years to build anything successful, so it’s best to strive to make the biggest impact possible. This is even more so if the entrepreneur is going to raise money from investors and take on capital, adding pressure to create an out-sized return.

While the concept might be new to me in the last 10 years, it’s clearly been well understood historically in many different contexts. I was reminded of this recently seeing the famous Make No Little Plans on a historical sign:

Make no little plans. They have no magic to stir men’s blood and probably will not themselves be realized. Make big plans, aim high in hope and work, remembering that a noble, logical diagram once recorded will never die, but long after we are gone will be a living thing, asserting itself with ever growing insistency.

Daniel Burnham, Architect and Urban Planner

Human nature is to look at the ideas directly ahead. What problem do I have right now? What idea do I care most about? While these are the logical starting point, and should be encouraged, it’s important for entrepreneurs to step back and think big. If everything went stunningly well, what could this become? Does that meet my ambitions? While some ideas start small and become bigger than expected, most often, small ideas start small and stay small. During idea selection, take the time and energy to think more about what could be and ensure there’s the potential for greatness.

Make no little plans.

5 Notes from the 10-Year Anniversary of the Pardot Exit

Last week marked the 10-year anniversary of the Pardot exit to ExactTarget. Like all great experiences in life, I have fond memories of the team, customers, partners, advisors, and everyone else we worked with along the way. Of course, there were plenty of high highs and low lows as that comes with the territory when building a startup. I’m most proud of partnering with Adam Blitzer to build an incredible business that made our own little mark on the marketing technology community and Atlanta startup community.

Here are 5 random notes reflecting on Pardot in the context of the 10 years since our sale:

  1. The Pardot Name – Incredibly, the Pardot name lived on as part of Salesforce.com all the way until April of this year when it was renamed “Marketing Cloud Account Engagement.” While there is some debate about the quality of the new name selection, for the Pardot brand to live on for 9.5 years is amazing. Most brands in the Salesforce.com portfolio are removed and a generic one created within a couple years, so Pardot had a great run.
  2. pi.pardot.com – The sign-in URL lives on as thousands of sites point back to this address to run mission critical functionality on their own site (e.g. visitor tracking and forms). A little known fact is that we chose pi.pardot.com in the early days because Pardot was the company name and Prospect Insight was the product name. Plus, pi is nice and nerdy. Note to founders: make the company name and product name the same until you’re a massive success and need to introduce other products.
  3. Co-founders Reunited – Early this month Calendly announced Adam Blitzer as the newest board member. I’m excited to work with Adam again after our 10 year hiatus. Fun fact: in the 5.5 years Pardot existed from start to exit, Adam and I never had a board meeting. Our last Calendly board meeting was the first board meeting we participated in. Hah!
  4. Today’s Pardot Revenue – Before Salesforce.com renamed Pardot earlier this year, the business, as a standalone product, was over $500 million in annual recurring revenue. To put that in context, when we sold the company we had less than $14 million in annual recurring revenue. Depending on the growth rate, gross margins, and renewal rate, a company of that size today would be worth billions of dollars.
  5. ExactTarget Friends – Pardot was bought by ExactTarget which was then quickly bought by Salesforce.com. After the ExactTarget leaders left Salesforce.com a couple years later, they started a venture firm called High Alpha. We’ve worked with High Alpha since inception and co-invested in several companies including Salesloft and Terminus

Being a part of the Pardot journey brings me incredible joy. Seeing the team and product continue to thrive a decade later makes it even more special. A big thanks to everyone involved and my sincerest thanks.

The Last Round Extension Goal

Last week I was talking to an entrepreneur that was out raising money. As they had raised their Series A in the middle of 2021, made good but not great progress, and spent all their capital, they were in a tough spot. When I asked how much they were looking to raise, and at what valuation, I received the expected answer: we’re raising X as an extension of our A round at the same valuation. 

Entrepreneurs that raised rounds at 20, 30, 50, or even 100x revenues have a challenge on their hands. The public market multiples for cloud companies have gone down 40 – 80% this year. Companies that were previously trading for 20x run rate, with strong metrics, are now routinely trading for 6x run rate. Public market multiples have a serious influence on private market multiples.

Why the push for an extension of the Series A round at the same valuation? Simple, to avoid a down round and provide an easy path forward. When a startup raises money at a valuation less than the last round, anti-dilution measures kick in. Say investors put in $10M in the last round at a $100M post-money valuation and own 10% of the company. If the new round is at a $50M post-money valuation, those previous investors that owned 10% of the company for $10M now own 20% of the company ($10M is 20% of the new $50M valuation) and didn’t put any additional capital in the business (assuming basic anti-dilution rights). Everyone, especially the founders and employees, are heavily diluted by both the existing investors owning a larger percentage of the business as well as the new investors that supplied capital in this most recent round. It’s a tough pill to swallow after things were frothy for so long. 

Down rounds also create challenges around employee equity, especially stock options. If some employees were issued options at a strike price of X, and now the company is valued at 50% of X, those options are much less desirable. Does the company issue new options at the new strike price for everyone? Only some employees? Do they issue the new options at the lower price with an aggregate dollar value that’s the same as before resulting in more option pool dilution? There are ramifications throughout.

Entrepreneurs would do well to seek new capital as an extension of the last round if the startup hasn’t made enough progress for an up round. When it hasn’t, and a down round is inevitable, it’s much more challenging, but all is not lost. Figure out the options, get capital in the business, and most importantly, get momentum back. 

SaaS Renewal Rate Reduction with the Economic Downturn

With the large number of startups that have already announced layoffs this year, and the belief that more layoffs are on the horizon due to the economic downturn, there’s a second-order effect that will exacerbate the challenges for SaaS companies: reduced renewal rates. Most SaaS companies sell their solution on a per user basis, and a material number of SaaS companies sell to other venture-backed startups. When the customer comes up for renewal, even when they’ve had a great experience and received real value, now needs fewer users because they’ve downsized the team, they’ll renew a smaller contract. The SaaS company hasn’t done anything wrong, and likely has delivered a valuable solution, only to see the account shrink.

Reduced renewal rates then have several third-order effects. First, with additional churn, it’s harder to grow as more of the newly signed customers are required to offset the customers that have downsized. Second, with a lower growth rate, the valuation premium is reduced as growth rate is a major driver of the valuation multiple and the Rule of 40 score goes down. Third, budgets and annual plans have to be updated to reflect the reduced demand, and this often results in reduced hiring or layoffs, especially in the context of capital being more expensive and valuations being lower. It’s not a death spiral, but it is a serious change in the playbook.

Thankfully, SaaS as a category is still growing incredibly fast with public SaaS companies growing at an average rate of 35% annually. The growth won’t come to a complete halt, but it will be impacted. Ideally, the economic downturn would be temporary (12 – 24 months, hopefully!) as inflation is tamed and the normal creative destruction process plays out. Entrepreneurs would do well to know that their growth metrics, especially renewal rates, will likely be challenged for a period of time, and to plan accordingly.

4 Years to Achieve Material Traction

In the startup world there’s a common narrative that if the business is going to work, it’ll take off exponentially in a year or two from creation. Either you have crazy success right away, or it’s not happening. While that does happen on occasion, and many startup stories embellish the outliers, the reality is that it often takes longer, much longer.

Just this past week, two more unicorn stories were in the news and for each it took four years before the startup took off.

First, the startup world has been enthralled by the news that Adobe is acquiring Figma for $20 billion. At 50x the approximately $400 million of annual recurring revenue, deals like this make the venture capital industry work (extreme power laws). While Figma was founded in 2012, it wasn’t until 2016 when growth exploded. Four years of working through the details, refining product/market fit, earning those first loyal users, and still not knowing what lies ahead.

Second, this week’s Invest Like the Best show featured Trina Spear in the episode titled Billion Dollar Scrubs. Trina, the founder of publicly traded FIGS (note the random “fig” connection between the two companies), shares her story and recalls how the early years were a slow grind building a direct to consumer online scrubs business. In her words, it wasn’t until year four that growth and scale made it clear they were onto to something large.

While we all want the instant success, when it does work out, it almost always takes several years. From these anecdotal stories, and my personal experiences, four years feels like a more common length of time to know the startup is going to work and have enough traction to see a big opportunity ahead. Pace yourself, four years requires tremendous commitment and fortitude.