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?

3 Reasons Founders Might Not Make Any Money After Raising Venture Capital

Yesterday’s post on Most Founders that Raise Venture Capital Don’t Make Any Money prompted a number of comments and questions. One of the popular questions was “why?” If a startup raises millions of dollars of institutional capital, why would a founder not make any money? Here are three reasons:

  1. Stacked Preferences – Most venture investments are either participating or non-participating preferred equity such that investors get their money back first in the event of a sale. For example, if the startup raises $25 million in capital and ends up exiting for $20 million, the $20 million would go to the investors and the founders wouldn’t make anything (unless there was a carve out or incentive plan to join the new company). The more money the startup raises, the higher the bar to sell where everyone is happy.
  2. Down Round – If a startup raises a round at a valuation lower than the previous round, a variety of anti-dilution clauses kick in that “true up” the previous investors’ quantity of shares to reflect their previous investment in the context of the new, lower valuation. Depending on how much lower the valuation, these anti-dilution measures can completely wipe out the common shareholders including the founders.
  3. Bankruptcy – Not all venture-backed startups succeed, and a small percentage go bankrupt even after raising institutional capital. With a bankruptcy, shareholders are wiped out, including the founders.

A general rule is that if the startup sells for 3x the amount of money raised, things are usually OK for the founders. If the startup sells for 10x the amount of money raised, things are great for the founders.

Most founders don’t make any money after raising a venture round and these are a few reasons why.

What else? What are some more reasons founders might not make any money after raising venture capital?

Most Founders that Raise Venture Capital Don’t Make Any Money

TechCrunch has a great article up titled A longtime VC on the virtues of not swinging for the fences where the author interviews Jodi Sherman Jahic. Jodi’s fund, Aligned VC, focuses on capital efficient B2B startups where the entrepreneurs aren’t trying to build the next unicorn. From the post:

The majority of the time — something like 75 percent of the time, according to [the benchmarking company] Sand Hill Econometrics — founders who take venture money get not a dime.

Think about that for a minute: with all the focus and hype around raising venture money, the majority of founders that go that route don’t make any money at all. Of course, entrepreneurs choose to raise institutional capital for a variety of reasons, primarily to grow faster and build a large, valuable business. Only, the majority of entrepreneurs that go down this path don’t make a dime when the company sells.

The next time an entrepreneur says they want to raise venture capital, let them know that the majority of entrepreneurs that do so don’t make any money.

What else? What are some more thoughts on the idea that most entrepreneurs that raise venture capital don’t make any money?

3 Quick Ideas When Thinking about SaaS Valuations

With ServiceMax’s great exit to GE, it’s clear that SaaS valuations for high growth market leaders continue to be strong. When thinking about SaaS valuations, here are three quick ideas to keep in mind:

  1. Rule of 40% – Growth plus profitability should be 40% or greater. Meaning, if the company isn’t profitable, it should be growing revenue at a rate of 40% or higher. If the company has 20% profit margins, it should be growing at least 20%. If no growth, it should have 40% profit margins.
  2. Growth Rate Multiplier – A simplistic formula to quantify how growth rate translates into valuations is as follows: (2 * Annual Recurring Revenue) + (Annual Recurring Revenue * (1 + (2.5 * Growth Rate))). A no growth SaaS company would be 3x ARR. A $1M ARR company with a 200% growth rate would be $8M (hot startups command much higher multiples).
  3. Type of Equity – Not all equity is the same. As an example, equity with cumulative dividends and participating preferred rights makes the effective valuation much lower than the stated valuation. When reading about valuations online, know that different terms can make for different valuations.

A variety of factors contribute to valuation with growth rate and scale being two of the biggest drivers.

What else? What are some other ideas when thinking about SaaS valuations?

The Barbell Strategy of Startup Investing

After yesterday’s post on Investing in Idea and Growth Stage Startups, But Not Seed and Early, a friend mentioned that it’s similar to the Barbell strategy in bond investing. From Wikipedia:

In finance, a Barbell strategy is formed when a Trader invests in Long and Short duration bonds, but does not invest in the intermediate duration bonds.

Instead of bonds, investing in idea stage startups and growth stage startups aligns with the Barbell strategy in that idea stage startups have a long time horizon to exit (7 – 10 years, with most going out of business within 18 months) and growth stage startups have a shorter time horizon to exit (3 – 5 years). Due to the varied time horizon, there’s an opportunity for the larger growth stage investments to recycle capital sooner, and provide needed liquidity, that can then be used to do more idea stage investing.

Another component of growth stage investing is that once a startup hits some level of scale — say $20 million in annual recurring revenue — a much larger pool of investors emerges that buy secondary shares from existing shareholders. Meaning, there’s more opportunity to sell part or all of the investment to new investors, and achieve some liquidity, even if the company doesn’t have an exit. With idea stage investments, there’s no such opportunity.

What else? What are some more thoughts to this Barbell strategy of startup investing?