Startup Cash Considerations in Crisis

With most startups in crisis mode, one of the top considerations is cash management. The ability to raise capital has been greatly diminished and things are likely to get more challenging before they get better.

Steve Blank has an excellent post from Jeff Epstein titled Action Today for CFOs with recommendations like:

  • Evaluate your when you run out of cash in a worst-case scenario
  • If you don’t have 24 months worth of cash, consider the following:
    • Draw down your lines of credit and view the interest payments on them as buying insurance
    • Sort all vendors by how much you spend and call each asking for a discount or loan to spread out payments further into the future
    • Cut marketing programs that don’t have a demonstrable ROI
    • Implement a hiring freeze
    • Let people go
    • Cut all salaries by a certain percentage
    • Tightly monitor collections and mitigate problems

Some more cash saving ideas:

  • Eliminate all discretionary expenses (require any purchases over X to go through the CFO or CEO)
  • Remove any subcontractors or consultants
  • Determine which vendors you much have and which ones are nice-to-haves
  • Suspend the 401 (k) match
  • Ask employees to take unpaid time off, convert to part-time, or a leave of absence

Entrepreneurs are generally optimistic, glass-half-full people, and now is one of the most challenging economic climates we’ll see.

Cash is always critical, especially so in a crisis.

The number one reason startups die is that they run out of cash.

Weekly Communication

In Patrick Lencioni’s latest book The Motive, he writes that leaders make their organizations healthier by “reducing politics, confusion, and dysfunction and increasing clarity, alignment, and productivity.” In today’s turbulent world, the need for strong organizational health has never been more important.

Entrepreneurs often struggle with a lack of clarity and alignment due to weak communication.

The more turmoil, the more communication required.

The more uncertainty, the more communication required.

The more chaos, the more communication required.

Regardless of the times, entrepreneurs should send a weekly email update to their constituents — employees, advisors, mentors, and investors. People want to know what’s going on. People want to help. Regular email communication is the most repeatable, and scalable, method.

As for the format of the email, go with something simple:

  • Purpose of the company (repeat it every time!)
  • Recent customer story
  • Recent culture story
  • Goals with current progress
  • Any other highlights (employee, team, department, etc.)

That’s it. Communicate in a variety of manners, repeat the message, and make the foundation a weekly email.

Churn, Churn, Churn

For years I’ve been telling entrepreneurs that a high net renewal rate (and net dollar retention) is one of the most important SaaS metrics. While net renewal rate is important, two people in the last week have told me gross churn — both logo and dollar — is more important. And I believe them.

Why is gross churn more important? Let me count the ways.

  • Black and White Value – With gross churn, the math is straightforward: how many customers (or dollars) are up for renewal at the start of the time period vs how many renewed. Pretty easy. Now, for net renewal rate, things get more complicated. Do temporary upgrades/downgrades count? What about deals with subsidiaries or related businesses? You could ask 10 different SaaS companies how they calculate net renewal rate and get 10 different answers. Gross churn calculations should always be the same.
  • Ability to Understand – Similar to the first point, it’s much easier to rally the team around a gross renewal rate since it’s easier to understand and calculate. Say we start the year at $10 million in annual recurring revenue and have 20% gross churn, we know directionality that we need to sign more than $2 million of new recurring revenue to grow (assuming no upgrades/downgrades). Now, if we can get better and only have 10% gross churn, we only need to sign more than $1 million of new recurring revenue to grow. Pretty simple.
  • Recurrence of Upgrades – People love talking about their > 100% net renewal rate, myself included. Only, it’s much more nuanced than upgrades outweighing churn and downgrades. Are the upgrades across every cohort or do customers primarily upgrade in their first year (implying they’re still rolling it out) and not upgrade after that? Do customers often downgrade in year two or three implying they finished a component of a project or transformation? Are the upgrades primarily from a specific vertical and has that vertical been tapped out? Net renewal rate can become less compelling with a more detailed analysis of the cohorts.

SaaS entrepreneurs should focus on the gross churn rate and ensure it’s as low as possible (under 20% annually for SMB and under 10% annually for enterprise). The old saying that’s it cheaper to retain a customer than sign a new one has never been more true, and is even more important with SaaS.

Make fighting churn a top priority of the company.

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.