David Cummings on Startups

Category: SaaS

  • Economics of a Startup Studio

    Continuing with yesterday’s post on High Alpha Studio and Seed, let’s look at the hypothetical economics of a B2B Software-as-a-Service startup studio. Assuming $20 million to be spent over five years to build 20 startups, here’s what it might look like:

    • $4 million per year budget
    • Expenses
      • $3 million/year for 20 full-time employees plus four partners, including benefits
      • $250,000/year for office space (10,000 sq ft at $25/ft)
      • $50,000/year for office items (equipment, supplies, etc.)
      • $100,000/year for legal and accounting
      • $100,000/year for software
      • $100,000/year for miscellaneous
      • $300,000/year for marketing/advertising (this is for the products created, not the studio itself)
      • $100,000/year held in reserve for years after the five years to manage the studio’s responsibilities
    • 20 startups created
      • 10 fail (minimum respectable product built, beta customers signed on, and the plug pulled for one reason or another)
      • 10 raise outside financing (or at least raise money from the separate investment fund)
        • Average ownership stake before outside financing: 75% (assume 25% for the management team and employees)
        • Average ownership stake after outside financing: 56% (assuming 25% dilution)
    • Outcome needed to be successful
      • $80 million in aggregate equity value to generate 4 times the $20 million invested resulting in a 3x return to investors (roughly 1x of return goes to the partners in the studio – see Investor IRR on Paper to Raise Another Fund)
      • With 10 startups, that’s an average of $8 million in equity value per startup
      • With an average 56% ownership stake, that’s an average startup valuation of $14.3 million (so, $143 million in total value for the 10 startups)

    While the studio would produce a number of startups, the reality is that the financial outcomes of the startups produced are more likely to be lopsided where one or two produce the vast majority of the returns and most aren’t worthwhile. Regardless, the economics of building a studio to build SaaS companies is appealing, especially in today’s hot market.

    What else? What are some more thoughts on the economics of a startup studio?

  • High Alpha Studio and Seed

    Earlier today, Scott Dorsey, the former CEO of ExactTarget, and a great team of entrepreneurs, launched High Alpha Studio and High Alpha Seed (see Dorsey, Gravity investors raise $35M to Launch High Alpha) in Indianapolis, Indiana. The idea is a startup studio focused on building business-to-business (B2B) Software-as-a-Service (SaaS) applications combined with a separate seed fund to invest in the startups that spin out of the studio as well as other unrelated startups.

    Here are a few thoughts on High Alpha Studio and Seed:

    • Entrepreneurs are drawn to starting incubators, and this is a great way to do it with a combo incubator and fund
    • Scott and his team have already shown the ability to generate great returns by starting and selling ExactTarget to Salesforce.com for $2.5 billion in cash
    • Having the seed fund ready at the same time as the studio is smart since a number of startup incubators build products but don’t have the corresponding funding to spin the ideas out into their own standalone business
    • Hiring 15-20 people for High Alpha Studio, per the article, makes for a serious staff (assume $100k/year/person and that’s a couple million dollars per year for staff)
    • Getting anchor investments from Emergence Capital (lead investor in SalesLoft) and Greenspring Associates provides a nice institutional investor tie-in for future financings

    I’m excited for Scott, Kristian, Mike, and Eric and look forward to following their progress at High Alpha. Also, if you’re in the Indianapolis area, High Alpha is hiring for a number of positions.

    What else? What are some other thoughts on High Alpha Studio and Seed?

  • The $250,000 Annual Revenue Run Rate Milestone

    While there is much discussion around the large multi-million dollar seed rounds for pre-revenue startups, the reality is that most startups, especially ones outside California, won’t be able to raise any money. For those that haven’t raised any money, or raised a small seed round, one of the first substantial revenue milestone goals should be hitting the $250,000 annual revenue run rate mark. Here are a few reasons why:

    • Assuming strong gross margins (e.g. 80% or higher), the startup should be able to support 3-5 employees, making for a solid core team
    • With 3-5 employees and $250,000 in revenue, the business can be cash flow breakeven, resulting in infinite financial runway and the opportunity to grow indefinitely without outside financing
    • Investors are always looking to mitigate risk, and $250,000 in recurring revenue shows there is the basis of a more substantial market, making it easier to raise a larger seed round (to raise a Series A, investors often want at least a million in revenue)
    • Product/market fit is likely achieved and the start of a repeatable customer acquisition process in place, making the chance of continued success high (see the 4 Stages of a B2B Startup)

    Entrepreneurs would do well to make $250,000 in annual revenue run rate one of their first major financial goals as it represents a level of freedom and progress.

    What else? What are some more thoughts on $250,000 in revenue run rate as an important milestone?

  • SaaS Business Model and Metrics

    David Skok has an excellent presentation over on Slideshare about the SaaS business model and metrics with the 3 Stages of a Startup. David’s blog, For Entrepreneurs, is one of the best out there for startups, especially Software-as-a-Service ones. Here are a few notes from the 85-slide SaaS business model and metrics deck:

    • Conserve cash while searching for product/market fit and a repeatable customer acquisition process. Once found, invest heavily.
    • With SaaS, the company actually loses money for some period of time (e.g. the first 12 months) with each new customer before becoming profitable. Because of this, companies that are growing faster are actually losing more money. More growth = more losses.
    • Cost to acquire a customer needs to be less than the lifetime value of a customer
    • Customer lifetime is defined as 1/churn rate, therefore the greater the monthly churn rate, the shorter the customer lifetime
    • Negative churn is a goal whereby revenue growth from existing customers is greater than revenue lost from existing customers
    • Common variable pricing axes are features, users, and depth of usage
    • Retention rate should be analyzed both as customer retention rate and dollar retention rate
    • Customer happiness index is a way to predict the likelihood of churn as well as the business value of the application
    • Ideal cost to acquire a customer is less than or equal to the first 12 months of revenue
    • Lifetime value of the customer should be 3x or greater than the cost of customer acquisition
    • Monthly recurring revenue is the core metric for the business
    • Salesperson on target earnings should 5x less than their quota (e.g. $60,000 in compensation for a $300,000 new annual recurring revenue quota)
    • Different sales models are increasingly more complex and 10x more expensive at each stage: freemium, no touch self-service, light touch inside sales, high touch inside sales, field sales, field sales with sales engineers
    • 3 keys to SaaS success: acquisition, retention, and monetization

    If you’re in a SaaS business, go read SaaS business model and metrics with the 3 Stages of a Startup.

    What else? What are some other key components of the SaaS business model and metrics?

  • Product Pricing

    Earlier today I got into a pricing discussion with a fellow entrepreneur. We were talking about all the usual topics like number of plans, positioning in the market, and competitor pricing. Then, I shared the biggest pricing mistake we made at Pardot in the early years: our pricing model didn’t grow well with the account. Meaning, as our customers became more successful, and got more value from the product, there was little opportunity to capture more revenue. Eventually, we shifted from pricing based on email volume to pricing based on the size of the database, and that made a huge difference.

    Here are a few thoughts on product pricing:

    • Consider having two value axes: one based on functionality/modules and one based on usage (e.g. seats or metered)
    • Err on the side of being too expensive as it’s easier to give a discount to win a deal and customers are more likely to give pricing feedback when things are more expensive (no one ever tells you your product is too cheap and they’d pay more)
    • Balance capturing the most value with the pricing plans vs making them easy to understand (lean towards keeping things simple)

    Pricing is an area many entrepreneurs struggle with, especially if the product isn’t in the market yet or only has a few customers. As the business develops and more prospects consulted, pricing becomes more obvious. Even then, make sure and capture more value as product usage grows.

    What else? What are some more thoughts on product pricing?

  • Net Promoter Score and Customer Referrals

    After manually sending out customer surveys on a regular basis for years, we decided to put an automated net promoter score (NPS) question in the application. Every 90 days the user would see the question “How likely are you to recommend this product to a friend?” with numeric choices ranging from 0-10, a simple “Comments” box, and a link “I’ll pass on answering” for people in a hurry.

    Immediately, we started getting feedback from customers, including specific comments on things they liked and disliked. Many customers, even with a “Need help?” link prominently displayed in the header, wouldn’t tell us when something was bothering them. Now, once a quarter, they’d use the NPS prompt to help us help them.

    After running this new module for a few months, we had an idea internally to try and entice customers that gave a 9 or 10 (promoters) an incentive to actually recommend their friends to us. Upon entering a 9 or 10, the dialogue box showed an offer for a $100 Amazon.com gift card if they referred a friend that completed a demo of our product. This message was linked to a landing page that provided more details and had a form to capture the referral information. Then, as hoped, referrals started flowing in and never stopped.

    Casually asking customers to answer the net promoter score question and then prompting for a referral from the biggest fans is a great way to grow the business.

    What else? What are some thoughts on the idea of using net promoter score with customer referrals?

  • Bronto and the Big Bootstrap Exit

    Back in 2002, a year after I started Hannon Hill for content management software, I was introduced to Joe Colopy, CEO of Bronto, as he had just started a new email marketing company with Chaz Felix. Both of us were based in Durham, NC, and even with the Duke/UNC rivalry, entrepreneurs enjoy connecting with entrepreneurs. After talking briefly on the phone then, we connected again in 2008 as Bronto was one of the first Pardot customers.

    Well, last week, Bronto announced that NetSuite was acquiring them for $200 million, making it a huge exit, especially for a bootstrapped company.

    Here are a few notes on Bronto:

    • 271 employees on LinkedIn (source)
    • 2013 revenue of $27 million (source)
    • 2014 revenue of $38 million (source)
    • 18 billion emails sent per year (source)
    • Definitive agreement signed but actual closing of deal not expected until end of 1H 2015 (source)

    It’s awesome to see another big bootstrap exit and congratulations to Joe, Chaz, and the whole Bronto Nation!

  • More Vertical, Niche SaaS Startups

    Over the past few months I’ve talked to a number of entrepreneurs with vertical, niche Software-as-a-Service (SaaS) products. As expected, mainstream SaaS platforms are being carved up into small, specialized point solutions, while also providing a better experience to their customers. Most venture investors are looking for large, platform-like SaaS startups, but more entrepreneurs are going to build sustainable SaaS products that aren’t venture backable, yet very successful.

    Here are a few thoughts on more vertical, niche SaaS startups:

    • SaaS, with strong to recurring revenue, predictability, and renewal rates (hopefully!), makes for a sustainable business, even at limited scale
    • Costs to develop and deploy software has continued to drop due to open source and the cloud, making it easier to get products to market and carve out a niche (scaling a business is still capital intensive)
    • Depth of product functionality is going to be stronger the more narrow the market, and thus serve the customers’ needs better
    • Marketing and sales prospecting is more straightforward with a focused market, especially messaging and talking points

    Look for the SaaS cottage industry to continue to grow, especially as more more vertical, niche products reach a sustainable size.

    What else? What are some other reasons there will be more vertical, niche SaaS startups?

  • Comparing SaaS Against the 7 Better Business Model Ideas

    Continuing with yesterday’s post 7 Ideas for Better Business Models, I wanted to take it one step further and compare Software-as-a-Service (SaaS) to the seven ideas and see how it stacks up. I’ve been a huge fan of SaaS for 8+ years now since the co-founding of Pardot, and want to help other entrepreneurs understand why it’s such a great model.

    Here’s how SaaS compares to the seven better business model ideas:

    1. Switching Costs – This varies depending on the type of product. Basic email marketing tools have low switching costs whereas heavily customized enterprise resource planning products have high switching costs. Generally, this is neutral for the average SaaS product.
    2. Recurring Revenues – SaaS, by its very definition, has recurring revenue, making for tremendous predictability. This is a strong positive for SaaS.
    3. Earning vs Spending – Most SaaS products are monthly pre-pay with a good number of annual pre-pays. Monthly pre-pay is a slight positive for SaaS and annual pre-pay is a strong positive for SaaS.
    4. Game-Changing Cost Structure – Having one version of the product that’s automatically updated for all customers is more cost effective compared to installed software for engineering. But, most of the revenues are spent on sales and marketing, so it isn’t a large cost structure difference from the overall point-of-view. This is neutral for the average SaaS company (the cost structure for the buyer is much better for SaaS as it’s more of a pay-as-you-go model as opposed to a large lump sum up front).
    5. Get Others to Do the Work – This isn’t applicable for SaaS.
    6. Scalability – The nature of the SaaS is that it’s massively scalable and there are minimal marginal costs to add more customers. Market scalability is driven by the actual product and target audience, so this is neutral for the average SaaS product.
    7. Protection from Competitors – Products that have more customization and/or more of a network effect have greater protection from competitors. This is neutral for the average SaaS product.

    SaaS really excels in the recurring revenue and earning vs spending categories, and is often very scalable. Other better business model ideas are hit or miss depending on the actual product and market.

    What else? What are some more thoughts on comparing SaaS to the seven better business model ideas?

  • Public SaaS Company Valuations Q1 2015

    Once a year I like to take an inventory of the public Software-as-a-Service (SaaS) companies regarding their valuation, revenues, and employee count. On the public equities side, I don’t pick individual stocks (I’m a fan of Vanguard Index Funds), so I only hear about things when a stock makes a big swing.

    Here’s a snapshot of public SaaS companies as of March 9, 2015:

    • salesforce.com (NYSE:CRM) – customer relationship management SaaS company.
      Market cap: $40.74 billion
      Last reported quarter’s revenues: $1,444 million
      Employees: 13,300
    • NetSuite (NYSE:N) – enterprise resource planning (accounting, inventory, etc) SaaS company.
      Market cap: $7.26 billion
      Last reported quarter’s revenues: $157.87 million
      Employees:  3,154
    • Constant Contact (NASDAQ:CTCT) – email marketing for small business SaaS company.
      Market cap: $1.30 billion
      Last reported quarter’s revenues: $88.05 million
      Employees: 1,400
    • LogMeIn (NASDAQ:LOGM) – remote desktop access SaaS company.
      Market cap: $1.28 billion
      Last reported quarter’s revenues: $59.90 million
      Employees: 804
    • LivePerson (NASDAQ:LPSN) – live chat SaaS company.
      Market cap: $614.14 million
      Last reported quarter’s revenues: $58.23 million
      Employees: 796
    • Demandware (NYSE:DWRE) – ecommerce SaaS company.
      Market cap: $2.45 billion
      Last reported quarter’s revenues: $52.50 million
      Employees:  383
    • Marketo (NASDAQ:MKTO) – marketing automation SaaS company.
      Market cap: $1.09 billion
      Last reported quarter’s revenues: $42.34 million
      Employees: 519
    • ServiceNow (NYSE:NOW) – IT asset management SaaS company.
      Market cap: $11.15 billion
      Last reported quarter’s revenues: $198.00 million
      Employees: 2,826
    • Workday (NYSE:WDAY) – HR and financial management SaaS company.
      Market cap: $15.45 billion
      Last reported quarter’s revenues: $226.27 million
      Employees: 3,500
    • Cvent (NYSE:CVT) – Events management SaaS company.
      Market cap: $1.20 billion
      Last reported quarter’s revenues: $39.33 million
      Employees: 1,450
    • ChannelAdvisor (NYSE:ECOM) – Ecommerce channel management SaaS company.
      Market cap: $243.30 million
      Last reported quarter’s revenues: $23.83 million
      Employees: 683
    • HubSpot (NYSE:HUBS) – B2B marketing platform SaaS company.
      Market cap: $1.22 billion
      Last reported quarter’s revenues: $34.16 million
      Employees: 719
    • Zendesk (NYSE:ZEN) – Help desk management SaaS company.
      Market cap: $1.76 billion
      Last reported quarter’s revenues: $38.54 million
      Employees: 806

    Clearly, SaaS is hot with Salesforce.com far and away the most dominant vendor. All companies have had an increase in valuation compared to last year, except for ChannelAdvisor.

    What else? What are some other thoughts on the valuations for publicly traded SaaS companies?