Post Entrepreneurial Exit —Bias Towards Action

Over the last couple weeks I’ve had the opportunity to talk with multiple entrepreneurs that have had nice exits and are thinking about what’s next. After putting thousands of hours into a venture and going through so many low lows and high highs, it makes sense that an entrepreneur would be thoughtful about what’s next. Building a company is incredibly taxing, both mentally and physically. Now, with financial freedom, a good deal of urgency and ambition is often tempered.

When talking to these entrepreneurs, my main point always stays the same: don’t lose your bias towards actions.

Keep moving.

Keep pushing yourself.

Keep exploring.

Keep tinkering.

Many years ago, I was on the other side of the table after we sold Pardot. I was talking to a successful entrepreneur, seeking advice as to what to think about now that it was time for the next chapter in life. He said something that has always stuck with me, “Your skills will immediately start atrophying if you don’t stay in the game.”

Figure out what game you want to play next.

Join/buy an existing business?

Invest in startups?

Do board work?

Do nothing?

Most of the time, the entrepreneurs I talk with want to do something. Rarely do they want to jump in and grind out another startup from scratch. For me, I think of it like the parent vs grandparent analogy.

As a parent, you always have to be on. You have a deep responsibility that’ll likely last a lifetime, but often at least 18+ years. It’s an experience that’s immensely rewording and challenging at the same time.

As a grandparent, you don’t always have to be on. You care deeply but can come and go with no day-to-day responsibility. The highs aren’t as high and the lows aren’t as low, yet the joy is still there.

Entrepreneurs post exit would do well to maintain their bias towards action, figure out what game they want to play, and what level of responsibility they desire. While there’s no right answer, it’s important to be thoughtful and keep moving forward.

Equity Strategy for Late Co-Founders

Last week I was talking to an entrepreneur and he asked about equity compensation for late co-founders. Late co-founders are senior team members given the co-founder title after the company has already been started. Also called a junior co-founder, these people are key recruits early in the life of the business. Once a late co-founder has been engaged and is interested, inevitability the topic of compensation and equity comes up.

Here are some initial compensation questions to answer for a late co-founder:

  • What was their W-2 compensation (or equivalent) for the last two years?
  • What’s the cash component of the compensation in this new co-founder role?
  • What is the company worth now based on the last (or next financing round)?
  • What will the company be worth in three years (subjective!)?
  • What’s the equity target value multiplier for taking the risk (e.g. by joining as a co-founder, how much should the equity hopefully be worth in three years to take a pay cut)?

Now, let’s run through a hypothetical scenario:

  • Average W-2 compensation for the last two years of $150,000
  • Cash compensation as a co-founder of $100,000/year
  • Company valued at $5M in the last round
  • Plan to be valued at $50M in three years (10x increase from today)
  • 50x multiplier for each $1 of cash pay cut (e.g. make $1,000 less, get $50,000 in equity)
  • Formula: $50,000 pay cut times 50x multiplier = $2,500,000 of year three equity, which equals 5% of the company’s overall equity (assumes a $50M valuation)

Of course, this doesn’t take into account items like salary increases to get to market rate and other potential compensation enhancements. This also only looks out three years for the valuation — if everything goes well, the equity will appreciate even more dramatically in future years.

Equity for a late co-founder is always a subjective negotiation. This example provides a framework for thinking through different elements and coming up with a value based on a combination of pay cut and future company valuation.

I Don’t Know, But Let Me Get Back to You

Meeting with entrepreneurs is incredibly fun as there’s always something new to learn. Tell me about the team, the market, the product, and the raison d’être — plus 100 more questions that come up along the way. During this exploration process, inevitably there’s something the entrepreneur doesn’t know yet or hasn’t thought through.

While some entrepreneurs are more confident than others, it’s often apparent when the entrepreneur is just making something up or saying what he or she thinks you want to hear. Instead, the best answer is as follows:

I don’t know, but let me get back to you.

On the surface it seems so simple and obvious, yet few entrepreneurs do it. First, it shows a level of humility and honesty that’s not common. Entrepreneurs aren’t expected to know it all. With that said, entrepreneurs should be curious and have an innate desire to learn and grow. Second, it provides a next action giving the entrepreneur a chance to show how they follow through and execute on a commitment. Again, small on the surface but powerful in the context of potentially working together over a long period of time.

The next time you ask an entrepreneur a question where they don’t have the answer, listen to the response and see what they do with it. The type of response and potential follow through tells a great deal about the person.

More Capital Often Needed for Exit Opportunities

Years ago I was much more averse to startups raising capital. I believed, naively, that the best businesses grew at the natural rate of customer acquisition and needed that governor to scale elegantly and cohesively. With time, and more varied experiences, I’ve seen hypergrowth, fueled by substantial amounts of capital and customer demand, scale in a quality manner while maintaining a strong culture.

Now, knowing there’s more math around when it makes financial sense to raise capital, I’ve also come to believe that if you’re going to get on the fundraising train, it’s important to plan for enough capital to get to a scale that provides for some exit opportunities in the event the business doesn’t achieve hypergrowth. Translation: the business needs to get to $10M of annual recurring revenue growing 30% or more for potential acquirers, especially private equity, to get interested.

Over the years, I’ve talked to a number of entrepreneurs that raised some money, achieved single digit millions in recurring revenue, and stalled. The startup had enough gross margin to keep the lights on indefinitely, but didn’t have enough scale or growth to find a home that made everyone happy. Herein lies the land of zombie startups. Too big to die, too small to matter.

Often, the solution is to manufacture growth with more capital. While not always efficient, more capital allows the startup to get to more scale which provides more outcome options. Scale matters to potential acquirers much more than entrepreneurs realize.

The next time an entrepreneur is on the fundraising train, make sure they know that getting to scale is one of the most important things needed to have options, so raise a bit more money than needed, or plan for another round sooner than desired. More capital is often needed for exit opportunities, so plan accordingly.

7 Recent Entrepreneurial Books

As part of my personal rhythm, I read for 30 minutes daily on a physical Kindle Paperwhite next to my bed and keep my phone on the other side of the house. My approach is mostly that of snacking on books — reading a chapter here or there based on what’s resonating with me at that moment in time. I like to jump around different books and look for new ideas or concepts.

Here are some recent entrepreneurial books I’ve snacked on:

  • Amp It Up: Leading for Hypergrowth by Raising Expectations, Increasing Urgency, and Elevating Intensity
    Frank Slootman brings the heat sharing stories from his incredible career, with a focus on expecting more from the team
  • Endurance: Shackleton’s Incredible Voyage
    Alfred Lansing tells one of the all-time great stories of perseverance and resilience in the face of unimaginable difficulty.
  • Leadership and Self-Deception: Getting Out of the Box
    The Arbinger Institute’s classic managerial story about leadership being defined by who we are, not what we do.
  • Be Where Your Feet Are: Seven Principles to Keep You Present, Grounded, and Thriving
    Scott O’Neil shares a number of excellent life stories from the world of professional sports, family, business, and life in general.
  • The End of Jobs: Money, Meaning and Freedom Without the 9-to-5
    Taylor Pearson makes the case for entrepreneurship, entrepreneurship, and more entrepreneurship. The best future is to create your own.
  • Becoming Trader Joe: How I Did Business My Way and Still Beat the Big Guys
    Joe Coulombe shares his amazing journey creating Trader Joe’s from scratch and building what we know it for today.
  • The Innovation Stack: Building an Unbeatable Business One Crazy Idea at a Time
    Jim McKelvey, founder of Square, unpacks his theory of innovation and lessons learned along the way.

I’ve enjoyed this list of books and I’m always looking for new ones.

What should be added that you’ve read recently?

Go Help an Entrepreneur

One of the ways we promote the Atlanta Tech Village is that it’s a community of entrepreneurs helping other entrepreneurs. Entrepreneurs are typically great at one thing — say fundraising, product development, or sales — and not as strong in other areas. Yet, entrepreneurs are almost always glass-half-full people that want to help and bring out the best in others. So, by having hundreds of entrepreneurs in the same building, they inevitably help each other with the ultimate goal: increasing the chance of success for the whole community.

Only, this isn’t unique to entrepreneurs helping entrepreneurs. Anyone can make a difference and help an entrepreneur.

Know any potential customers?

Know any potential mentors?

Know any potential employees?

Know any potential investors?

See, entrepreneurs always need help with something. The best way to find out? Just ask.

The next time you talk to an entrepreneur, ask them where they need help. Who knows, you just might have the solution.

Go help an entrepreneur. Let’s increase everyone’s chance of success.

Focus on One Main Goal

Last week I was meeting with an entrepreneur and he described a number of projects in flight. They were raising money, launching a new product release, hiring two new VPs, and the list went on and on. We were about to drill into a few things he mentioned when he said, “With all that said, we have one main goal for the year: raise gross customer retention to 85%.” Then, he shared how everyone is driving towards that common goal.

If there are too many priorities, there are no priorities.

If there are too many goals, there are no goals.

For this startup, everyone was 100% aligned that raising their retention metrics was the most important thing.

For sales, it was was selling better-fit customers (won’t reflect in this year’s numbers but will in subsequent years).

For marketing, it was more messaging around value and ROI.

For support, it was improving customer satisfaction scores and going deeper than just resolving a ticket.

For product, it was prioritizing bug fixes and more difficult edge cases.

Every team, and every team member, was completed aligned around raising customer retention rates as the main goal for the year.

The next time the desire emerges to have more goals and more priorities, fight the urge and focus on one thing. Achieving one critical goal is more important than chasing multiple less important ones.

What’s your main goal for the year?

When it Makes Financial Sense to Raise Capital

One of my favorite types of entrepreneur meeting is the successful bootstrapped founder contemplating how to grow faster. Partly, this is because I was in this situation in the past, and partly because it’s a nuanced topic with no easy answer. Outside of considerations like personal dreams/aspirations, capital availability, and lifestyle, the most tactical area to drill into is the financial aspects. More specifically, how to answer the question: when does it make financial sense to raise capital?

To answer this question, I imagine a business as a machine. The goal of the machine is put money into it and generate an output that’s a more than what was put in plus a return for the effort, cost of capital, etc. Taking this one step further in the context of raising money, and the corresponding dilution to the founders and the team, the value that’s created taking on the capital has to more than make up for the reduced ownership in the business.

Let’s break it down into a company valuation formula:

Valuation

  • Annual Recurring Revenue (ARR) * Growth Rate (GR) * 1.5(Net Dollar Retention (NDR)) * 15 (this number goes up and down dramatically based on the public markets, gross margins, customer acquisition costs, total addressable market, etc.) = Valuation
  • Example: $10M ARR growing 50% YoY with 120% NDR is roughly valued at $10M * .5 * 1.8 * 15 = $135M
  • Note: BVP Cloud Index is at a 14x average revenue multiple, so this example at ~13.5x ARR is inline (this example is growing faster than the public company average but doesn’t have public company scale)

So, the primary levers are recurring revenue and growth rate with a secondary lever being net dollar retention (if net dollar retention is below 100%, it starts penalizing the valuation quickly).

For simple math, let’s peg it as costing $2 to add $1 of recurring revenue. Assuming growth rate and net dollar retention stay constant (growth rate as an annual percentage usually declines 10% per year), we now know that for every $2 we put into the business we add $13.50 in value (or $1 for $6.75 in value). A good trade! This value then compounds on itself due to the net dollar retention above 100%, making the business grow in value each year without additional investment (assuming growth rate didn’t change, which it would).

If the example startup is worth $135M and a new investor puts in $10M, the business will become $67.5M more valuable by adding $5M in new annual recurring revenue. Assuming 7% equity dilution for this new money ($10M/$145M), and a 50% increase in valuation, this is an accretive deal to the founders. Ideally, there would be a large difference between equity value reduced from dilution and equity value gained from increased valuation to account for uncertainty.

Entrepreneurs should consider a formula that takes into account valuation, dilution, and valuation changes due to capital deployment in an effort to assess if it makes financial sense to raise capital. When the engine is working well, it often makes sense. When the engine isn’t working, it’s time to fix the engine before raising money, if possible.

Friedberg’s Rubric for Business Value Creation

In the last All-In Podcast, David Friedberg laid out a great rubric for business value creation. While visionaries get excited by a future state and entrepreneurs get excited by an idea, it takes all that, and more, to create real value.

David Friedberg’s rubric for value creation in a business All-In podcast episode 62 (at the 50 minute mark):

1. Can you make a product?

2. Do people want to buy your product?

3. Can you make a positive gross margin selling the product?

4. Can you make a return on the marketing dollars you have to spend to
generate the gross profit?

5. Can you scale the amount of money to grow your business such that
as you grow the return goes up, not down?

6. Can you transition to being a platform (multi-product company)?

This articulation of the business value creation journey is the best I’ve ever seen. Share this with every entrepreneur you know and ensure they think through it on their journey.

The Simplicity Tradeoff

Last week I was looking at the pricing plans for a startup and it screamed complexity. Tons of plans, tons of upsells, tons of dimensions — it felt like optimizing for the business as opposed to the consumer. Of course, we see complexity on a regular basis (healthcare invoices, etc.), unfortunately making them feel more acceptable.

Instead of having 50 questions on the quarterly survey, have the 10 most important.

Instead of having six pricing plans, have three and a “call for custom” option.

Instead of providing a four page menu, have a two page menu with the best items.

The simplicity tradeoff is worth it.

Yes, some money might be left on the table. Yes, some options will have room for more variability.

Fight the urge to optimize. Fight the desire to add more complexity.

Instead, focus on reduced friction. Focus on higher effort to value for everyone involved.

Erring on the side of simplicity is worth it. Similar to the famous quote, “If I had more time, I would have written a shorter letter”, take the time to cut out the complexity and make it simpler.