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.

VC Alternative Startup Financing Options

Back in the Pardot days, we had exactly one alternative financing option to venture capital: bank venture debt. While that was a great option, and we maxed out our line, being a bootstrapped startup we didn’t qualify for venture debt until we had millions of recurring revenue — an extremely high bar.

Today, there are a number of interesting alternative funding sources that are very different from venture capital, and available for startups at much earlier stages. The big driver here is entrepreneurs want to maintain optionality and/or don’t have a business that fits traditional venture capital (e.g. too small a market). Let’s take a look at a few providers:

  • Lighter Capital – Revenue financing for subscription businesses, Lighter Capital typically collects 2-8% of monthly revenue to pay back the loan until some cap is reached (e.g. 2x the loan). This model is better for a lower payout over time but requires making payments immediately.
  • Earnest Capital – A profit-sharing model where the more profit shared, the lower the equity percentage in the event of an exit with an overall higher target return (e.g. 4x the investment). Profit is defined as any salaries above some modest amount for founders as well as standard distributions/dividends. This model is better for using cash flow to grow in the near-term (payments are only required if profit is distributed) but more expensive in the long term if everything works out.
  • Indie.vc – A hybrid that can be equity or revenue financing where it’s equity if a traditional round of funding is raised but defaults to a revenue based financing model after 12-36 months where 3-7% of revenue is paid monthly until a target return is met (e.g. 3x the investment). This model provides the most direct optionality benefits but could be more expensive depending on the path taken by the entrepreneur.

Ultimately, these are all great market developments for entrepreneurs as historical venture capital was only suited to a microscopic percentage of startups striving for billion dollar outcomes. More providers serving a larger variety of startups will help grow the number of entrepreneurs that raise money, and, hopefully, help them achieve a greater level of success.

Start 2020 With a Simple Strategic Plan

With the end of the year upon us, it’s a great time to put together a 2020 Simplified One Page Strategic Plan. I’ve written about it many times before and I’ll write about it many more times. After being an entrepreneur for 20+ years, I truly believe it’s one of the best exercises an entrepreneur can do on a regular basis.

Put these topics in a shared Google Doc and ensure they are no more than one side of one page. Be clear and concise; keep it simple.

Simple Strategic Plan

  • Purpose – Why does your company exist?
  • Core Values – What values (or virtues) are most important for your actions?
  • Market – What customer base do you serve?
  • Brand Promise – What can customers expect working with you?
  • 3 Annual Goals – What are three SMART goals for this year?
  • 3 Quarterly Goals – What are three SMART goals for this quarter?
  • 3 Quarterly Projects – What are the three highest priority projects that must be accomplished this quarter?

Share this plan with employees, partners, advisors, investors, and anyone else that wants to help you succeed. Finally, make it a living document that’s reviewed on a weekly basis to align everyone on your team. While simple, it’s incredibly powerful.

 

Happy 7th Birthday to the Atlanta Tech Village

Exactly seven years ago to the day we closed on Ivy Place at 3423 Piedmont Rd and called it the Atlanta Tech Village. At the time, it seemed like a crazy idea. Why take a perfectly good building at one of the busiest street corners in Atlanta, one that’s full of credit-worthy tenants with long-term leases, and parse it up into tiny offices for unprofitable startups with no leases? Simple: we believe in the power of entrepreneurs helping entrepreneurs to increase the chance of everyone’s success.

Today, the Tech Village has exceeded all expectations. Over 300 companies and 1,000 people call the Tech Village home. Tech Village graduates like SalesLoft, Calendly, Terminus, and others are collectively valued at billions of dollars. The It Takes a Village pre-accelerator program has graduated four cohorts of under-represented founders. Village startups have raised nearly $1 billion in capital.

Ultimately, the Tech Village’s success comes down to the people. David and Karen set the tone internally. Jewell sets the tone when you walk in the door. And, of course, the entrepreneurs make it the vibrant, thriving community it is.

Happy birthday Atlanta Tech Village. Here’s to your first seven years, and many more to come.