Valuing a Pre-Revenue Startup

Last week an entrepreneur reached out for help on an estimated valuation for his pre-revenue startup. After building a prototype and getting some non-paying early testers, he’s looking to raise an angel round and wanted thoughts on what’s normal in the market. I asked a number of questions and offered up a few ideas:

  • Base Valuation – Pre-money valuations are usually $1-$2 million for a startup with a prototype and a handful of users. Typical funding rounds are for $300-$500k whereby the entrepreneur sells around 20-25% of the business.
  • Management Team Premium – If it’s an experienced management team or highly-regarded prior employer, there’s a large increase in pre-money valuation to $3-$4 million. Investors view an experienced management team as more likely to be successful and pay up for it.
  • Half the Next Round Valuation – Figure out the milestones for this round (e.g. revenue targets), and estimate the corresponding valuation for the next round with those milestones. Then, with the expected next round valuation, divide it in half to value this round. Investors want to believe that they can double their money on paper in 18 months, and see a clear path to get there.

Pre-revenue valuations are always subjective and come down to how eager either side wants to get a deal done. There’s no exact number but these are good guidelines for normal deals.

What else? What are some other ideas for valuing a pre-revenue startup?

Notes from the Okta S-1 IPO Filing

Okta, a SaaS identity management platform (software to manage which corporate applications people can use), just released their S-1 IPO filing to go public. You might wonder how big the market is to manage authentication and authorization in the cloud, and as we’ll see, it’s quite large.

Here are a few notes for the Okta S-1 IPO filing:

  • Founded in 2009 (pg. 1 – Note: founding to IPO in eight years is fast!)
  • 2 million people use Okta daily (pg. 1)
  • 2,900 customers (pg. 2)
  • Revenues (pg. 2)
    • 2015 – $41 million
    • 2016 – $86 million
    • Last nine months – $112 million
  • Losses (pg. 2)
    • 2015 – $59 million
    • 2016 – $76 million
    • Last nine months – $65.3 million
  • Estimated $18 billion global opportunity (pg. 3)
  • Over 5,000 integrations available (pg. 4 – Note: strong network effect)
  • Product modules (pg. 4)
    • Universal directory
    • Single sign-on
    • Multi-factor authentication
    • Lifecycle management
    • Mobility management
    • API access management
  • Original company name: Saasure (pg. 6)
  • 12% internation revenue (pg. 34)
  • Accumulated deficit of $270 million (pg. 51)
  • 11% of revenue from professional services (pg. 57)
  • Weighted-average contract duration of 2.4 years (pg. 62)
  • Define contribution margin as the annual contract value of subscription commitments, or ACV, from the customer cohort at the end of a period less the associated cost of subscription revenue and sales and marketing expenses (pg. 63 – Note: this is the SaaS Magic Number)
  • 443 customers with an annual contract value over $100,000 (pg. 65)
  • Deferred revenue of $100 million (pg. 78 – Note: this means customers pay their annual subscription upfront making for a significant amount of “free” working capital)
  • “Okta” is the unit of measure for cloud cover in meteorology (pg. 88)
  • Ownership (pg. 132)
    • Co-founder/CEO – 10.3%
    • Co-founder/COO – 6.2%
    • VCs – 65.7%

Okta is like a utility providing a core service that everyone needs but doesn’t get much attention. Identity management in the cloud is critical infrastructure with a massive market and Okta, as the leader, will have a successful IPO.

Congratulations to Todd and the team!

What else? What are some more thoughts on Okta’s S-1 IPO filing?

4 Reasons Investors Shouldn’t Do Convertible Notes

Over the last week the topic of convertible notes came up in two different conversations. Convertible notes are essentially a loan to a startup that converts to equity on a certain date or if the startup raises a certain amount of capital. Convertible notes (and subsequently the safe) became popular several years ago as investors wanted to move fast, keep initial legal costs down, and defer the valuation topic to the next investor. Basically, a much simpler transaction. Only, it put convertible note holders in a poor position.

Here are four reasons investors shouldn’t do convertible notes:

  1. Misalignment on Valuation – Convertible notes often have a cap which represents a maximum valuation for the investor (e.g. a cap of $3 million such that if the startup raises money at a $4 million valuation, the investors’ debt converts at the lower of the two valuations). Only, the convertible note investor is incentivized for the startup to raise money at a lower valuation so that they’ll get more equity for their money (assuming everything else about the terms is equal). Entrepreneurs want to raise money on good terms and good valuations, but that isn’t aligned with the convertible note holders as they have negative benefit with a higher valuation.
  2. Limited Initial Upside – Most convertible notes have a discount of 20% to the next round of financing (e.g. if the round is at a $5 million valuation, the convertible note holders get their equity at a $4 million valuation as that’s 20% less). Yet, raising convertible debt doesn’t guarantee a subsequent round of financing happens quickly. If the financing round takes 6-12 months (or more), the investor is only getting a paper return of 20% for taking on outsized risk. Investors typically want to see their portfolio companies raise money each round at a minimum of twice the last valuation.
  3. Lack of Future Qualified Financing Event – Most convertible notes only convert at a qualified financing event (some have a conversion date far in the future). If the startup doesn’t raise more money, or can’t raise more money, the investor is essentially stuck with a low interest loan in a high risk investment.
  4. No Governance – Convertible notes are simple debt with limited covenants and no governance rights. Ideally, the startup will raise a “normal” round and have the governance that comes from a board and a lead investor in the future, but there’s no definitive timeline. Without governance, the entrepreneurs can do what they please with the money with limited recourse.

Investors would do well to understand the pros and cons of convertible debt. Personally, I require equity and don’t invest via convertible debt.

What else? What are some more reasons why convertible debt can be worse off for investors?

4 Quick Ways to Evaluate a Startup Idea as an Investor

Earlier this week an entrepreneur casually threw out an idea he had on the side that wasn’t related to his startup. My recommendation: don’t judge an entrepreneur’s idea. Push them to do customer discovery and let the market plus their internal motivation decide if the idea makes sense or not.

Now, as an investor, once you get past the common requirements of a great team and market, there are four quick ways I like to evaluate an idea:

  1. Must-Have vs Nice-to-Have – If the app is taken away from customers tomorrow, how much do they complain? How replaceable is the app if they just went back to email and spreadsheets?
  2. In the Path of Revenue – Where the app in the path of revenue? How clear is it that the app helps the company make more money?
  3. System of Record vs Utility – What functional category does the app fall in? Do people live in the app most of the day? Once a week? Set it and forget it?
  4. Timing – Where’s the market in the adoption lifecycle? Is it too early? Too late? Timing is 10x more important than people realize.

Evaluating an idea is hard. These four quick ways help me develop a mental model of a startup idea to see if I should pursue it further.

What else? What are some other quick ways to evaluate a startup ideas as an investor?

Startup Funding and Optionality

One of the challenges entrepreneurs face after achieving a repeatable customer acquisition process with great metrics in a big market is just how much money to raise. Initial thinking might be to raise as much as possible at the highest valuation possible. Only, investors have an expectation to make at least three times their money at the later stages and many more times that at the earlier stages. Couple this with the fact that only 2 out of every 100 venture-backed startups ever sell for $100 million or more, and raising substantial amounts of money greatly reduces the potential chance of a “successful” outcome.

Here are a few thoughts on startup funding and optionality:

  • Discuss this topic with potential investors before raising money to understand expectations and see if there is a fit
  • Ensure the founders, management, and board are aligned around desired outcomes
  • Recognize that not all outcomes are to sell the entire business as high growth tech companies are staying private longer and have more access to secondary liquidity
  • Sometimes raising money at a valuation lower than what’s possible makes sense to get the startup to the next milestone and keep more options open

The next time an entrepreneur wants to raise more money at all costs, explain how startup funding affects optionality. Raising too much money has made many acquisition offers not feasible due to the underlying motivations.

What else? What are some more thoughts on startup funding and optionality?

Notes from the AppDynamics S-1 IPO Filing

AppDynamics, a fast-growing application performance management software company, just filed their S-1 IPO filing to go public. AppDynamics has raised a huge amount of money ($300+ million) and is growing super fast (>50%), making it one of the higher profile B2B software companies to file recently.

Here are a few notes from the S-1:

  • The integrated suite of applications monitors the performance of software applications and IT infrastructures, down to the underlying code, and automatically correlates them into logical “business transactions,” such as booking a flight in a web browser, transferring money on a mobile device, getting directions through a car’s navigation system or locating physical goods in an inventory system. (pg. 1)
  • 1,975 customers (pg. 2)
  • Revenues (pg. 2):
    • 2014 – $23.6 million
    • 2015 – $81.9 million
    • 2016 – $150.6 million
  • Net losses (pg. 2):
    • 2014 – $68.3 million
    • 2015 – $94.2 million
    • 2016 – $134.1 million
  • Industry Background (pg. 2):
    • Enterprises are Undergoing Digital Transformations
    • IT Investments are Moving to Customer-Facing Software Applications
    • Velocity is Critical
    • Accelerating IT Complexity
  • Internally estimate that the total addressable market for the solution is approximately $12 billion (pg. 4)
  • Revenues nine months ended October 31, 2016 (pg. 12):
    • Subscription $110 million
    • License $32.6 million
    • Professional services $15.7 million
    • Total: $158.4 million
  • Accumulated deficit of $476.8 million as of October 31, 2016 (pg. 16)
  • Mix of time-based licenses, SaaS subscriptions and perpetual licenses and the mix of applications sold (pg. 23)
  • Competition for people in our industry, especially in the San Francisco Bay Area is intense and often leads to increased compensation and other personnel costs. (pg. 29)
  • Federal, state and foreign net operating loss carryforwards (NOLs) of $182.1 million, $199.8 million and $94.7 million (pg. 42)
  • Cash, cash equivalents and marketable securities of $142 million (pg. 57)
  • SaaS subscriptions and time-based licenses are typically one or three years in duration, and are bundled with software updates and customer support services (pg. 67)
  • As of October 31, 2016, we had more than 165 customers with a life-to-date total contract value greater than $1 million, an increase from just over 20 such customers as of January 31, 2014 (pg. 70)
  • We have increased our sales and marketing headcount from 157, as of January 31, 2014, to 485, as of October 31, 2016 (pg. 70)
  • 2016 dollar-based net retention rate of 123% (pg. 71)
  • In the fiscal year ended January 31, 2015, we recognized the settlement costs of $10.0 million related to our litigation with CA, Inc. (pg. 75)
  • Founder/Chairman equity: 14.2% (pg. 153)

I think AppDynamics has the scale and growth to have a well received IPO but I think the heavy losses and high percentage of license and services revenue relative to subscription revenue will make it less desirable compared to equivalent SaaS companies.

Congratulations to the entire team at AppDynamics for building a large, fast-growing company.

What else? What are some more thoughts on the AppDynamics S-1 IPO filing?

SaaS Funding Valuations Based on a Forward Multiple

Continuing with last week’s post on 3 Quick Ideas When Thinking about SaaS Valuations, there’s another common way to determine a SaaS valuation for funding purposes based on a multiple of what the revenue or run-rate will be in 12 months. This approach is known as a “forward multiple”, and because the valuation is based on an expected amount in the future, it effectively takes into account the current growth rate, which is one of the largest, if not the largest, drivers of valuation, everything else being constant.

Long term, SaaS companies will likely trade at 4-6x revenue based on strong recurring revenue, great gross margins, and excellent economies of scale. As a simple example, if a SaaS company was put into harvest mode, it could generate 60-80% profit margins and get an EBITDA multiple of 6 – 10x, resulting in the same value as 4-6x revenue.

So, if a startup is doubling year over year, and expects to double again next year, a funding valuation could be 4-6x the expected run-rate in twelve months. If a startup is at $5 million today, and will clearly be at $10 million in 12 months, asking for a pre-money valuation of $40 – $60 million might get funded, assuming a great team and market. Investors would be willing to “pay up” for a fast-growing startup as they believe it’ll continuing growing fast and has the opportunity to be a large, meaningful business.

For entrepreneurs raising money, use the idea of a forward multiple when discussing valuation.

What else? What are some more thoughts on SaaS funding valuations based on a forward multiple?