Secondary as a New Primary Investor Capital Deployment

Recently I was talking to an investor that lamented how hard it was to invest in startups the traditional way. Today, there’s so much money for the “hot” startups that rounds fill up quickly and investors are aggressive (read: more sharp elbows). Historically, that was the end of the story, but now there’s more capital that wants in. Over the last five years, there’s been tremendous growth in capital applied to liquidity for founders, early employees, and early angel investors.

Secondary capital, where one shareholder sells equity to a new or existing investor, doesn’t directly benefit the company and used to be rare in startupland. Primary capital is when the company sells shares to put more cash into the business, usually to grow faster. Even today, primary capital is significantly more common than secondary capital for startups, but things are changing.

When thinking about many of the growth stage startups in our region, secondary sales of equity occurred in a material number of their recent financing rounds. Investors, with larger funds and stronger deal competition, often negotiate to buy X dollars more of the common shares of the startup at a discount (e.g. buy up to $10M of common shares at a 20% discount to the preferred price). Look for more investors to employ this model of buying a large chunk of preferred shares from the startup and a smaller chunk of common shares for the early shareholders.

Secondary sales, while rare in the past, are fairly prevalent today. Founders and early employees would do well to take secondary sales into account, especially when their startup hits escape velocity and reaches the growth stage.

Funding Climate Outside the Money Regions

Whenever I talk to a startup person outside our region (investor, journalist, etc.) they like to ask about the current funding climate in our region. Money is always a popular topic, especially when the economy is hot and startups are en vogue (bonus: public SaaS valuations are at an all-time high). Only, the funding climate outside the money regions (CA, NYC, etc.) hasn’t appreciably changed in the last 2-3 years.

More money is sloshing around on the sidelines waiting to be put to work. Limited partners have huge commitments in funds and venture investors are trying to put the money to work. Yet, this is primarily for growth/later stage investments when the metrics are solid and it’s clear the startup is going to win, simply a question of how much. For these growth/later stage investments, investors will travel. Distance is a pain but not that big a deal. If you can write a $50M check and underwrite a 3-5x return in 3-5 years, it’s a pretty easy ‘yes’, especially if there’s a direct flight (the money people still hate layovers).

Early stage investments — primarily post-seed and Series A — are still quite limited. The number of investors that focus on this stage (say, $750k – $3M in revenue) hasn’t appreciably changed, thus the number of startups that raise rounds in this stage hasn’t change (without more investors, the quantity of these types of fundings won’t increase). Investors at this stage often write checks that are larger than angels can put together, so it isn’t possible to bypass this funding source with more non-institutional money.

Seed/angel rounds are still the most challenging area. Idea stage startup are plentiful, but highly risk-loving capital is not. Local investors are still primarily wealthy people who didn’t make money in technology, and thus their appetite for startup investing is relatively low. To grow the angel community, we need to have more large startup exits. Today, there’s a strong cohort of local growth stage startups valued in the hundreds of millions and a few in the billions. Once this wave of startups, typically 5-10 years old, reaches exit maturity, expect the local angel community to ramp up and hit a new high.

While the funding climate hasn’t changed recently, the overall tenor of the startup community is humming along nicely. Look for the funding climate in the idea/seed stage to grow nicely in the next 3-5 years once we have a wave of big startup exits.

The Rise of Revenue Financing Loans for SaaS

Recently, several entrepreneurs have asked me about revenue financing loans. Revenue financing is a fancy way of saying a semi-complicated loan where payback is dictated by a number of elements including a percentage of revenue, not just a traditional interest rate. The good news is that it provides for a more aggressive, non-dilutive (usually) form of financing for Software-as-a-Service (SaaS) companies. The bad news is that it’s much more expensive than a bank loan, but still not nearly as expensive as venture capital.

Here’s how an example revenue financing loan might work:

  • Loan amount equal to 20% of current annual recurring revenue (e.g. $10M in ARR, $2M loan)
  • Loan covenant where one month’s operating costs in cash required on hand at all times (e.g. $800k of monthly expenses, with a $2M loan, only $1.2M can actually be used)
  • First 18 months interest-only monthly payments (on the full $2M, not the usable $1.2M) where the “interest” is 3% of the monthly cash receipts (hence the name revenue loan as the interest rate is directly driven by the revenue of the business)
  • 3.5 years of equal principle payments after the first 18 months plus the continued interest of 3% of the monthly cash receipts (so, the loan is paid back after five years and the interest payments keep rising assuming revenue keeps growing)
  • Additional 10% of original loan amount payment due after final payment or at time of next financing event (payment can be cash or equity)
  • Minimum of 1.7x the original amount back to the loan provider with a max of 2.5x (since the interest rate is a percentage of revenue, if the business grows faster than expected, the interest rate could be much higher and up to 2.5x would be paid back)

Wow, it is complicated! Net net, it’s roughly a 25% interest rate loan with variability based on how fast revenue grows. SaaS, with its amazing margins and cash flow predictability, makes this type of financing uniquely suited to both the investor and the recipient, especially compared to most types of other businesses.

SaaS entrepreneurs looking to grow faster, but reluctant to sell equity, would do well to talk to the newish crop of revenue financing firms out there.

What else? What are some more thoughts on revenue financing loans?

Raising Venture Capital Isn’t Right for Most Entrepreneurs

Earlier this week I was on a panel at the excellent 36|86 Entrepreneurs Festival in Tennessee talking about bootstrapping vs venture capital. Reflecting on the panel discussion, and other conversations at the event, it’s clear that raising venture capital is still viewed as too much of a default path for tech entrepreneurs. In reality 99% of entrepreneurs, tech or otherwise, shouldn’t raise venture capital.

Here are some of the common reasons raising venture capital isn’t right for most entrepreneurs:

  • It limits exit opportunities
  • It puts a timeline on the business
  • It requires a 5x greater exit for the founder to make the same money
  • Most markets aren’t winner take all

Beyond the common reasons, the reality is that most entrepreneurs can’t raise venture capital because they don’t have enough traction (revenue!), growth (much be growing super fast), unit economics (strong gross margins and profit possibility), and market opportunity (must be a huge market). Too many entrepreneurs spend time trying to raise institutional money when that time is better spent building the core business.

The solution: find a trusted advisor or mentor in the community to help think through financing options. Most of the time venture capital isn’t the right path, and isn’t even an option due to the business characteristics.

Entrepreneurs would do well to better understand venture capital and know that most of the time it doesn’t make sense.

When SaaS Valuations Weren’t So Rosy

With Thomasz Tunguz’s recent post The 5 Forces Driving Startup Valuations Today it reminded me that SaaS valuations weren’t always so rosy. Today, the median forward multiple for public SaaS companies is 8.5x (meaning, these companies are valued at 8.5x expected revenues).

10 years ago we were out actively raising money for Pardot after hitting $1M in annual recurring revenue. We met with 29 different venture firms in Atlanta, D.C., Boston, and Silicon Valley. After being turned down several times with the message that the total addressable market for marketing automation was too small (hah!), we had three interested parties that floated valuations and wanted to talk potential term sheets.

By the time of these advanced conversations, we had $1M in trailing twelve months recognized revenue, $1.3M annual run rate, and 300% growth rate. Here were the verbal offers:

  • $500,000 investment at a $2M pre-money valuation
  • $1M investment at a $2.5M pre-money valuation
  • $5M investment at a $7M pre-money valuation

After doing some spreadsheet math it became clear that we were better off not raising money and continuing to go it alone. We decided not to raise money and kindly discontinued conversations with the VCs. If the valuations back then were what they are today, the spreadsheet math would have likely turned out differently.

Know that SaaS valuations have never been better but that we’re in unusually good times — it wasn’t that long ago when they were substantially lower. Still, do what’s best for the business and don’t raise money just because valuations are high.

What else? What are some more thoughts on SaaS valuations?

3 Alternative SaaS Funding Strategies

One of the things I love about startups is that every week I’m learning something new. Naturally, there’s no one way to do things and so entrepreneurs are always trying out different ideas and occasionally sharing them with the world. Earlier this week three different blog posts came out detailing alternative SaaS funding strategies a) Raise one time from angels ($1.3M) and might do more, b) Raise from multiple rounds but smaller amounts ($2.5M) each time depending on the progress of the business, and c) Raise a tremendous amount of money ($700M+) as quickly as possible over multiple rounds. Let’s dive into some of the highlights.

SparkToro Raised a Very Unusual Round of Funding & We’re Open-Sourcing Our Docs

  • “We believe that there’s room for a company that can be successful for its customers, employees, founders, and investors (generally in that order) without demanding a multi-hundred-million or billion-dollar outcome. We spent a lot of time discussing the frustrating binary (succeed on a massive scale or die trying) of the classic tech startup model, and how we might craft a creative structure that would allow for the potential of a huge outcome without forcing an unhealthy growth rate or a destructively impatient approach.”
  • Only raise from non institutional investors so that there’s no timeline
  • Investors initially expected to get their money back via dividends (1x non pref)
  • Keep optionality open to go the venture route but don’t drive towards that

Anatomy of our $5 million seed round

  • “SaaS companies do not require large amounts of capital all at once in order to fund expensive R&D, brand marketing, or giant sales teams. Instead, we require small amounts of capital over an extended period of time, in order to experiment and continuously push harder on the things that work. This is why most SaaS companies today should raise several smaller rounds of funding during their “seed phase” before raising a series A. The ideal funding for a SaaS company looks closer to an IV drip than a shot of adrenaline to the heart. We need more funding sources that understand this.”
  • Most SaaS startups don’t warrant the traditional VC model of go big or go home
  • Raise enough money each round to get to breakeven at another milestone
  • SaaS supports dripping in more modest amounts of capital and still producing great outcomes

Domo IPO | S-1 Breakdown

  • “Domo recently drew down $100M from their credit facility and currently only has ~6 months of cash left with their current burn rate. Given they raised $730M in equity capital from investors and another $100M through their credit facility, it implies they have spent roughly $750M over the past 8 years to reach a little over $100M in ARR, an extraordinary and unprecedented amount of cash burn for a SaaS company.”
  • Last quarter burned $40M to add $8M of new ARR
  • CAC of $430k with avg ACV of $67k
  • Median payback of 98 months

It’s great to see people detailing different funding strategies as there’s room for innovation and new ideas. Figure out what’s best for the business and execute accordingly.

Implications of Raising Venture Capital

Last week I was talking to an entrepreneur that was dead set on raising venture capital. Naturally, I wanted to understand more and asked a number of questions. Turns out, this entrepreneur just thought it was the next step to being successful. Venture capital shouldn’t be viewed as just another step in the startup journey — raising venture capital is a serious decision that shouldn’t be taken lightly.

Here are several implications of raising venture capital:

  • Growth – Startups are growth-oriented organizations. Raising venture capital takes the emphasis on growth and raises it to max — everything is focused on growth. If growth stalls, more money needs to be raised or the company needs to be merged with someone else that is growing faster. Grow, grow, grow.
  • Timeline – As soon as you raise institutional capital (as different from angel capital, family office capital, etc.) the business is now on a timeline to sell in as little as 3-5 years and as long as 7-10 years. No matter how you feel, the business has to be sold (or go public) in an effort to generate returns for the limited partners (the people and institutions that provide capital to the venture capitalists).
  • Partnership – Selling a piece of equity is signing up for a long-term partnership with the investor. The relationship should be viewed as a partnership and not merely as an investment. Only raise money from investors you want to work with indefinitely.

Raising venture capital puts the startup on a path to grow at all costs, and has serious implications. Most startups fail and most startups that raise venture capital don’t make any money for the founders. Entrepreneurs should deeply study the pros and cons of this type of capital and know that most of the time it doesn’t make sense. Yet, when everyone is aligned and the startup does well, it’s a beautiful thing.