Ask Investors How They Think About Zeroes

Over the years I’ve invested in a number of venture funds as a way to learn about venture in general, dive deeper in selected startups, and see what’s out there. One topic that’s popular now in VC fundraising decks, but was non-existent five years ago, is the firm’s historical loss ratio.

A historical loss ratio is represented as the number of previous investments that the venture firm has lost money on, most commonly going to zero (an investment that’s completely worthless). I’m not an insider in the venture and limited partner industry, so my guess is that someone published a paper that become popular arguing that the better venture returns came from firms that didn’t lose money very often on individual deals. Venture capitalists that have to work hard to raise money from LPs (most firms!) have glommed on to this theory and worked hard to paint themselves as good at not losing money.

Of course, more focus on limiting the downside can be inverted as more focus on limiting the upside. The highest alphas in venture don’t come from limiting the downside, they come from the positive outliers — the power law of distributions.

In a recent venture deck I saw a famous Warren Buffet quote as the only content on a slide:

Rule #1: Never lose money.

Rule #2: Never forget Rule #1.

Seeing this was an immediate turn off. It’s much more interesting, and intellectually stimulating, to attempt something with a 1 in 50 chance of succeeding as opposed to something with a 9 in 10 chance of succeeding, assuming the upside is correspondingly larger. Yes, we want to control our own destiny, but we also want to take big risks that have the opportunity for big impact.

Humans are conditioned to feel more pain from losing money than gaining the same amount of money. Losing hurts more than winning.

As an entrepreneur, it’s important to understand where a potential investor stands. Is the investor focused on maximizing upside, or minimizing downside? Don’t know? Just ask.

Ask investors how they think about zeroes and you’ll understand a critical part of their core psychology.

SaaS Valuations as a Rule of 40 Multiple

In the past I’ve argued that a quick and dirty SaaS valuation was 10 times the annual revenue run-rate times the trailing twelve months growth rate. This formula is a good proxy for valuation but misses a major characteristic: profitability.

Profitability, or lack thereof, is a huge factor in valuing a SaaS business, especially in the age of a pandemic when private investors are more conservative.

The Rule of 40 is a metric that adds the past 12 month growth rate to the past 12 month profitability rate with a value of 40 being good. A value higher than 40 is even better and a value lower than 40 is OK, or even bad depending on how low (or negative) the number.

Personally, I’m a huge fan of the Rule of 40 as it captures the tradeoff between growth and cash burn for startups. Put another way, it presents executives and investors with a simple formula and target using the two most important startup metrics: growth rate and cash consumption.

So, if growth rate and profitability/cash burned combined with revenue run rate are the biggest drivers of valuation, there’s another, more nebulous factor that fluctuates called market sentiment. Take the BVP Cloud Index which has an enterprise value to revenue multiple of 17.3x right now. Wowza, SaaS is hot! This says that for the public SaaS companies, their enterprise value (valuation less debt and cash on hand) divided by their revenue over the last twelve months is 17.3x. Put another way, a company with $100 million of trailing twelve months revenue and no debt or cash would be worth $1.73 billion. The average growth rate for these public SaaS companies is 35.5%. Very impressive. Let’s assume a free cash flow percentage between 5 and 10% and public SaaS companies, on average, are right around the Rule of 40 as a collection.

Now, we know that public SaaS companies at the Rule of 40 are worth 17x trailing 12 month recognized revenue (a lower number than revenue run-rate because there’s growth). Assuming a 35% growth rate, to calculate the rough enterprise value to revenue run-rate multiple, we’ll go back to our example and do $1.73 billion divided by $135 million ($100 million times 1.35 to reflect the 35% growth rate, which isn’t exact as growth usually slows with time) to get a multiple of 12.8.

With the public market average right at the Rule of 40, and the public market average revenue run-rate multiple of 12.8, we can use that are our market sentiment number.

A simple SaaS valuation is the annual revenue run-rate times the Rule of 40 number times the market sentiment. As an example, a $10 million revenue run-rate SaaS company right at the Rule of 40 would be valued $128 million, less some discount for lack of liquidity being a private company.

Long term, I believe the market sentiment will be more in the 4-8 range based on how valuations have fluctuated over time. Pick a market sentiment value here, say six, and a $10 million revenue run-rate SaaS company right at the Rule of 40 would be valued at $60 million. If in this example the company is growing 60% per year and negative 20% free cash flow resulting in a Rule of 40 value of 40, this hits our previous SaaS valuation formula perfectly. In the previous formula, companies burning cash were overvalued and company printing cash were undervalued.

Using the Rule of 40 to think about SaaS valuations captures how growth and cash burn contribute to the value of the business and is a simple, albeit powerful tool.

Atlanta’s Startup Community Brimming With Early Stage Capital

For years, one of the biggest knocks on Atlanta’s startup community was the dearth of early stage capital. Capital is hard to come by outside the money-center regions in the country, but people assumed most big city startup communities still had enough. This was not the case, especially for Atlanta, which has a vibrant startup scene.

With last week’s announcement that Tech Square Ventures just closed on the first $26 million of their new $75 million fund, it dawned on me that Atlanta now has a respectable amount of early stage capital. Finally. With so many funded startups (see Crunchbase Atlanta), and most of the funding come from outside the region, I was optimistic we’d develop local venture funds.

Here are most of the Atlanta funds that invest in seed and Series A startups:

Atlanta’s startup community is brimming with seed and early stage capital. Now, it’s time to start more companies.

The Honorable Zombie Startup Trap

In the past few weeks I’ve talked with several startups that are severely impaired by the pandemic. Before the pandemic their companies were doing well enough to raise venture money, but not well enough to be obvious winners in meaningful markets. Then, the pandemic hit and it exposed their businesses in a way that showed they weren’t great businesses to begin with, and raising money wasn’t the appropriate route to go. 

Now, the founders are in the honorable zombie startup trap.

These founders aren’t willing to shut down their companies and move on. No, they’re too honorable and are going to do everything in their power to at least return the investors’ money. Only, the startup is a zombie.

There’s enough revenue and gross margin to keep the lights on, but with revenue declining there’s no clear path to reverse course and accelerate growth. Unfortunately, with declining revenue and a suffering business, if they were to raise money, it’d be a down round, if at all possible. Down rounds are almost always the kiss of death, due to a number of reasons.

While this desire to eventually return investors’ money is in fact honorable, it actually makes all parties worse off. From a time perspective, investors are better off moving on and focusing their energies elsewhere. Startup investing in its purest form is a game of maximizing upside, not minimizing downside. Some investors would struggle with recognizing the loss if they have limited partners or are trying to raise a new fund, but that shouldn’t be an issue with successful investors.

Founders are often better off shutting the startup down, or going into harvest mode, so as to return some capital to investors and prepare for their next endeavor. Time and energy are two of the most important components of successful founders, and running a zombie startup for years beyond what makes sense depletes both.

Look out for the honorable zombie startup trap, and ensure all parties involved are aware of what’s happening. The best path forward is often moving on from the startup.

2021 Will be a Banner Year for Private Equity SaaS Acquisitions

Earlier this week I was talking to a SaaS entrepreneur and he brought up how much better his financials were now. Curious, I asked what made the difference.

This is a business that was growing modestly while burning cash. With the onset of the pandemic a few months ago, they made the difficult decision to let go of staff, cut all travel expenses, and change the overall focus to profitable growth. Instead of trying to squeeze out a slightly higher growth rate, they’d focus on gross margin and grow at the rate of the market.

The business has grown through the pandemic, albeit more slowly, but the swing from losing money to making decent money has been dramatic.

This is not an isolated case. Hundreds, if not thousands, of SaaS startups that were losing money at the start of the year are cashflow breakeven, if not nicely profitable.

Private equity, as a potential exit route for SaaS startups, has been growing rapidly over the years. Whenever I talk to a private equity investor, they lament that too many SaaS startups are losing money, making them undesirable as acquisition targets. PE is happy to fund growth, but has almost no appetite to fund losses. 

Now, a tremendous number of SaaS startups have made hard changes, and those hard changes have made them much more attractive to PE acquirers.

Look for a large percentage of SaaS startups to stay the new profitable course and next year to be a banner year for private equity SaaS acquisitions.

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.

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.

Rule of 40 and Startups

Last week I was talking to an entrepreneur and he asked what valuation I thought the market would bear for his startup’s next round of funding. I asked for the business state of the union and standard financial metrics like recurring revenue, growth rate, gross margin, burn rate, cost to acquire a customer, renewal rate, and net dollar retention.

After hearing the metrics, I shared that they’re below the Rule of 40 or better. Confused, he asked what that meant. The Rule of 40 is the growth rate, as a number, plus the burn or profitability percentage, as a positive (profits!) or negative (losses) number, added together.

If the business is growing 100% year-over-year, and is burning the cash equivalent to 40% of revenue, it would be 100 + (-40) = 60, which is 40 or better.

If the business is growing 50% year-over-year, and is burning the cash equivalent to 30% of revenue, it would be 50 + (-30) = 20, which is below 40, and not as good.

Let’s look at a more specific example:

  • $10 million of revenue
  • 50% year-over-year growth rate
  • $1 million in trailing twelve months burn (burn is 10% of revenue)

Here, the Rule of 40 calculation would be 50 + (-10) = 40. So, they’re in good shape and are right at the Rule of 40.

Another way to think about the Rule of 40 is that if the startup has a high burn rate relative to revenue, it needs to have a high growth rate. If the startup has a low growth rate, it needs to be profitable.

If some extreme cases like dramatic user growth (e.g. Facebook in the early days) and amazing net dollar retention (existing customers buy significantly more product every year and outweigh the customers that leave), the Rule of 40 is less applicable. For most startups, it’s very relevant.

The Rule of 40 is a great way to assess how a startup is performing in an objective manner and should be a regular topic of conversation for entrepreneurs.

Compounding Revenue 20% Per Year

Two years ago one of the most successful software investors in the country told me he’d never sell a SaaS business that was growing 20% per year, especially if it looked like it would grow that way indefinitely. Last month, another extremely successful investor said he just wants to invest in great companies that grow 20% per year, and doesn’t like the current mentality of growth at all costs. Clearly, there’s something more experienced investors see that isn’t appreciated enough: the power of compounding.

Let’s take a look at a couple of examples:

$10 million revenue start

  • Year 1 – $12 million
  • Year 2 – $14.4 million
  • Year 3 – $17.3 million
  • Year 4 – $20.7 million
  • Year 5 – $24.9 million
  • Year 6 – $29.9 million
  • Year 7 – $35.8 million
  • Year 8 – $43 million
  • Year 9 – $51.6 million
  • Year 10 – $61.9 million

$100 million revenue start

  • Year 1 – $120 million
  • Year 2 – $144 million
  • Year 3 – $173 million
  • Year 4 – $207 million
  • Year 5 – $249 million
  • Year 6 – $299 million
  • Year 7 – $358 million
  • Year 8 – $430 million
  • Year 9 – $516 million
  • Year 10 – $619 million

Growing revenue 20% per year for 10 years results in a 5x overall growth — the compounding effect is impressive, especially in the later years. When looking at these examples, it’s clear that growing much faster in the early years is necessary to get to a larger base by the time the 20% annual growth years set in.

Now, thinking in terms of SaaS, there’s a secret weapon that can make this compounding revenue phenomenon even more attainable: positive net dollar retention. Net dollar retention is the revenue renewal amount plus upsell/cross sell minus churned revenue. Put another way, ensure that existing customers buy more product than the amount non-renewing customers stop spending so that that the business grows forever, without signing a new customer. If you can grow new customer revenue 10% per year organically, and 10% per year with net dollar retention, that’s 20% growth. Now, do that for 10 years and you’ve quintupled the business.

Compounding is hard to appreciate for most people, especially many years out in the future. Build a business that grows fast to some level of scale, and work on the underlying fundamentals to compound revenue 20% per year indefinitely.