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The post on Customer Value Financing from a couple months ago triggered several questions and comments from entrepreneurs, including quite a bit of interest.

Customer Value SaaS Financing

Fellow entrepreneur Jermaine Brown shared with me information on how customer value financing works via the business Lemonade and it’s filing.

Being publicly traded, Lemonade has to share some details, not just ones dressed up in marketing speak. From the Form 8-K:

Under the Agreement, the Investors will provide up to $150 million over a period of 18 months to the Company for the Company’s sales and marketing (“Growth”) efforts. Under the Agreement, subject to certain terms and conditions specified therein, at the start of each Growth Period, the Investors will provide an Investment Amount equal to up to 80% of the Company’s Growth Spend with respect to a particular Reference Cohort.

During each Growth Period, the Company will pay to the Investors an amount equal to the Investor Sharing Percentage of Reference Income generated during the Growth Period corresponding to such Disbursement Date for each Reference Cohort for every Growth Period until the Investors receive an amount sufficient to attain an effective Internal Rate of Return of 16% across all cash remittances associated with specific transactions, at which point all future Reference Income is retained by Company.

Loosely translating, this describes the following arrangement:

• Up to $150M available over 18 months
• Effective loan amount of 80% of sales and marketing spend per month (defined as a cohort and potentially a different time period like quarterly)
• Company pays back investors using the new revenue from each cohort until there’s a 16% internal rate of return (roughly an interest rate compounded annually)

In this high-level example, the costs assigned to customer acquisition and the percent of customer revenue that goes to pay back the investors is not described. As a guess, it’s likely some type of 90-day average of sales and market costs and the full gross margin as the answers.

As part of the deal, Lemonade put out a press release announcing the arrangement as a thank you to their capital provider, General Catalyst.

Finally, a corresponding blog post that provides more details titled Lemonade’s “Synthetic Agents”:

Lemonade’s “Synthetic Agents”

The term “synthetic agents” is an analogy to revenue sharing with insurance agents, and the thing they are pitting their model against, yet this also applies to other types of businesses that have a cash flow gap between the cost of signing a new customer and the gross margin received. David Skok captured this best in his SaaS Economics post showing how more growth requires more cash. Customer value financing is just as applicable to digital insurance companies as it is to SaaS companies.

Look for customer value financing to become more popular and common in all recurring revenue businesses. It’s a huge win for entrepreneurs and much needed in the market.

Recently I was talking to an entrepreneur about the changing startup landscape and the big slowdown in growth rates and funding. After initial frustration that the boom times were over, he’s now excited for this new era with a focus on excellence across the board. Many elements of the business were given less attention or hastily constructed due to the frenetic pace of growth.

Now’s the time to upgrade the startup’s functional areas.

While growth rate is still one of the biggest drivers of valuation, there’s a mind shift, albeit for a limited period of time, to focus on refurbishing core elements of the business in anticipation of the next level of scale. Internally, the trick is to frame it as a rebuilding or upleveling mission, one that’s aligned with the larger vision.

Many years ago at Pardot, we debated this intensely for product development. Our heavily funded competitors were constantly rolling out new features and modules while we were more resource constrained. We made the decision to alternate quarters between extensive new feature development and general product health (code cleanup, refactoring, technical debt, DevOps, etc.). Internally, we knew that if it was a “features” quarter, we’d be cranking out new product releases, and new features to help customers be more successful. If it was a “bugs” quarter, we’d put much more focus on fixing issues, cleaning up technical debt, refactoring clunky components, and many other important areas of the product. One quarter for aggressive new innovation, one quarter to upgrade the quality of the existing functionality.

When we sold the business, the acquirers commented that in most cases a startup’s sales and marketing is far ahead of the product’s robustness and reliability. In our case, the product’s technical underpinnings were ahead of our sales and marketing. We focused on technical excellence and delivered.

Now’s a great time to assess every functional area of the business and spend internal cycles leveling up people, processes, and technology. Cruft builds over time and needs to be revisited on a regular basis. Now is an exceptionally good time to upgrade functional areas.

For several months now ChatGPT has been one of the most popular, and profound, topics of conversation. It’s still mind-blowing to see it write an article, then change the writing style (make it sound like a pirate!), then give it feedback on what you like and don’t, via chat. From numerous conversations with friends and family, the big question keeps coming up: do you use it on a regular basis, and, if so, how?

Well, after signing up for it 6+ months ago, my weekly usage of it is for brainstorming.

Need a new product name? ChatGPT.

Need some ideas for a new blog post? ChatGPT.

Need insight for a new market? ChatGPT.

Need a starting point for a new initiative? ChatGPT.

Lack of effort to start brainstorming no longer exists. Let ChatGPT do it for you. Writer’s block no longer exists. Tell it what you want and it gives you something. Occasionally, it’ll hallucinate but the vast majority of the time it’ll give you value.

And, no, this wasn’t written by ChatGPT. Yes, I was tempted.

Time to brainstorm? Think ChatGPT.

As an entrepreneur who’s interviewed hundreds (thousands?) of people over the years for jobs, I’ve developed a set of “go to” questions that I like asking. Only, as with anything, the list has evolved over time as some become stale and new ones feel more effective. Having done it so many times, I’ve become a connoisseur of interview question and enjoy continually tweaking them.

Just recently, I heard a new one that I really like and added to the list:

How lucky are you?

I want to hear that the candidate believes some part of their success came from timing, other people helping, and/or other contributions that were lucky along the way. It’s also a form of asking if a person is humble and grateful without using those words. For these reasons, and more, I like this new interview question.

The most important interview question is related to the startup’s core values. Whatever the values, there should be one or more questions per value that pertains to it without asking about the value explicitly. With our people values of positive, self-starting, and supportive, we have a unique line of questioning that are traditional interview questions. Value-question alignment is the most important part of the interview process, even more than the subject matter competency.

Another set of questions I like is based on the chronological in-depth survey of the candidate’s past. The goal is to spend 3-4 hours with the candidate to understand their career arc and details that paint the most complete picture. Simple, superficial chats aren’t enough.

Entrepreneurs would do well to put together a Google Doc or Notion Doc with a running list of their favorite interview questions. It should be a living doc that’s visited regularly, and when a new question emerges, add it to the list and continually experiment with them. The better the interview questions, the better you understand the candidate.

One of the concepts I stress to hope-to-be entrepreneurs is that they’re best off starting something, anything, and learning from there. Today, one of the fastest things to start is an online store on eBay/Amazon/Etsy. Even though it’s turnkey, there are so many things to learn: inventory, shipping, taxes, SEO, advertising, gross margins/cost of goods sold, etc. Doing something is a forced learning experience that will help inform if you enjoy it or not, as well as spark new ideas. The best way to find a great idea is to work on any idea first. 

Personally, I’ve been starting businesses my entire life. Here are a few I did as a kid before I could be a full-time entrepreneur:

• Hamster Breeding
  One day I was talking to the local pet store owner about the dwarf hamster I had and he offered to buy any babies from me for $1. Well, the next thing you know I had dozens of them in my room at home and I was raising hamsters as a little business. Quickly, I realized the limitations and the amount of effort required for little payoff. The business lasted six months.
• Shareware Apps
  After a friend gave me the book “Teach Yourself C in 21 Days” in 8th grade, I was hooked on computer programming. I built a number of shareware apps and sold them on AOL, CompuServe, and Prodigy. This was a great lesson in dreaming up new product ideas and bringing little apps to market. Customers didn’t even know I was in high school! The business lasted three years and I sold hundreds of copies.
• Flea Market Dealer
  Back in the 90s there was a program known as the Columbia House BMG Music Club where you’d get a certain number of music CDs for a penny followed by monthly CDs at normal prices. Well, I signed everyone in my family up for the promo pricing at both the home and office addresses amassing hundreds of CDs. I’d then cancel the accounts and not continue the monthly program. Finally, to sell them, I’d rent dealer tables at the local flea market and sell the CDs for $5 each making hundreds of dollars of profit. This business helped me look for arbitrage opportunities. The business lasted one year and three trips to the flea market. 
• Sports Cards Dealer
  Sports cards were always a personal passion of mine as far back as I can remember. I would obsess over the prices in the Beckett magazine every month and memorize them all, especially the 1989 Upper Deck Ken Griffey, Jr. rookie card. One day, I realized that I could buy cards online for the hottest players in my area (Atlanta Braves stars like Chipper Jones) at half the cost of the local sports card stores using Newsgroups (think Reddit) and eBay. Well, I bought as many cards as I could afford and then became a dealer doing shows in Tallahassee, Pensacola, and Jacksonville. The online to offline arbitrage was a homerun. The business lasted two years.
• Website Development
  My final childhood business was building websites for local companies first in my hometown and then in college. This was the ultimate gateway business as I learned web development which lead to a number of “real” startups. I’d charge $1,000 for a site and marvel that I’d make $50/hour doing something I really enjoyed. The business lasted three years. 

While I’ve always loved entrepreneurship, these small endeavors early on set the foundation for a lifelong pursuit of startups and company building. 

Starting on an idea — especially something simple — is the best entrepreneurial training possible. There’s no perfect idea and too many people use searching for an idea as an excuse. Just like with anything new, the sooner you start doing, the sooner you start learning. Start now. 

Last week I talked to two different entrepreneurs working on side hustles. We talked about the big ideas, progress so far, what’s working, what’s not, etc. Then, I asked the hard question: what will it take to go full-time? Going full-time is a huge milestone, and rarely achieved. I’ve talked to hundreds of entrepreneurs over the years working on side hustles and it’s easily less than 5% conversion from part-time to full-time status. And therein lies the ultimate problem.

Working on a business part-time almost never provides for enough progress due to lack of rapid iteration.

Sure, you can make some progress. There are simple items to complete, basic infrastructure to organize. Things like customer discovery and business model canvas can be started. These are all worthwhile and part of the journey. Ultimately, startups are all about speed. The faster you translate market needs into solutions, the faster you find product/market fit. The faster you iterate on the customer acquisition process, the faster you find a repeatable, scalable business model. The faster you achieve these milestones, the faster you can raise capital (if needed!). Speed, speed, speed.

Startups require a herculean effort. A day job, plus a side hustle, plus a family, plus other obligations is often too much. If the vast majority of full-time entrepreneurs fail, what are the odds of a part-time side hustle? I realize not all entrepreneurs can go full-time and that other facets of life create their own opportunities and challenges.

Startups are hard. Doing it part-time makes it 10x harder. If possible, figure out a path to being full-time as quick as possible and improve the chance of success.

Continuing with the thread that there are a number of anomalies in startup land now, there’s another one worth discussing. While the vast majority of startups have slowing growth rates, many will reaccelerate. Yes, the new growth rates will be slower than during the pandemic, but these are excellent businesses where growth is masked by extenuating circumstances. In addition, reaccelerating growth rates improve a number of aspects of the business from morale to recruiting to valuation. 

First, let’s dive in why reaccelerating is imminent. COVID pulled forward a tremendous amount of demand taking companies from good growth to hyper growth in a span of 6-12 months. Today, a startup that might be at $50M of revenue would likely be at a much lower number if the pandemic didn’t happen — still a great business but a smaller business. In addition to growth being pulled forward, startups often sell to other tech companies as they’re early adopters. Of course, these tech companies had a COVID boost as well so they hired a huge number of new team members, resulting in even more software spend. Now, these tech companies and startups are doing many rounds of layoffs, and reducing their non-employee costs a corresponding amount. Finally, one more added challenge: the cost of capital went through the roof due to significantly higher interest rates and lower valuations. Startups that would have kept their burn rates up in the past cut even deeper to conserve cash, and that resulted in more layoffs. 

Bringing all these factors together results in higher churn rates and reduced consumption revenue that is worse than anticipated. Record high downgrades and cancellations translates into even lower growth rates. Premature increased customer growth plus premature downgrades and cancellations paint an incorrect picture. Startups would do well to take their historical gross and net renewal rates applied to their core business and project out potential scenarios. Core growth plus traditional renewal rates will likely result in reaccelerating growth in the near future.

The good news: once this painful series of adjustments works its way through the system and we’re at the new normal, growth rates will improve. Many startups have strong business models delivering tremendous value to their customers. The lack of growth is masked by remnants of one-time extra growth and one-time extra churn. Higher, renewed growth is on the horizon.

Several weeks ago General Catalyst, a large investment firm, announced a new type of SaaS financing in their post The Unbundling of “Growth” Equity. Now, there have been a number of alternative financing solutions in the SaaS world for many years now and they all center around lending money as a percentage of annual recurring revenue. This offering from General Catalyst is different: it’s lending against sales and marketing spend with a payback based on the value of the customers signed (disclaimer: I haven’t talked to General Catalyst and I’m interpreting their messaging without any feedback). Let’s dig in.

The most common form of alternative SaaS financing, often called revenue-based financing, lends against committed recurring revenue and a few other factors. Before this type of offering, there were generally only three funding options: customer funded (bootstrapping!), equity (usually venture capital), and specialized bank debt (venture debt that’s going to be much harder to get now with the bank failures). Revenue-based financing is usually less restrictive than venture debt and but often has higher fees and effective interest rate.

Let’s look at an example. Imagine a startup has $4M in annual recurring revenue. Revenue-based financing would provide $1M of debt (roughly 20 – 33% of the annual revenue depending on a number of factors like gross margins, renewal rates, and growth rate) in exchange for a percentage of total revenue for the next three years. The revenue-based lender is making a bet about growth to achieve an outsized return. If the startup doesn’t hit the growth targets, the lender won’t make as much money. Here’s a simplified example where the lender gets a flat 10% of revenue for three years:

Year 1

$5M of revenue

Lender receives $500k

Year 2

$6M of revenue

Lender receives $600k

Year 3

$8M of revenue

Lender receives $800k

So, in this example, the lender receives $1.9M in payments for the $1M loan. While it’s an extremely high effective interest rate, it can be “cheaper” than equity in some instances. Also, if the startup doesn’t achieve their revenue goals, the lender would make less money (or potentially lose money if there was a default). For the startup, that $1M debt might turn into $2M of incremental revenue at the end of the third year, potentially creating an extra $10M in enterprise value. Trading $1.9M in payments for $10M in additional value is a worthy trade.

Now, let’s look at the General Catalyst (GC) offering. From their site:

Traditional debt and variations of it such as ARR financing, credit lines, or revenue based financing can be a cheaper source of capital, but are not designed to fund S&M, for the simple reason that debt has to be repaid or refinanced on a fixed schedule. The payback on S&M is variable in nature, but a company’s debt repayment is typically fixed. 

GC argues that with revenue-based financing the business has to pay a percentage of revenue regardless of results. Customer acquisition doesn’t have a linear outcome (e.g. some quarters are better than others for a variety of reasons), so ideally they payback would flex with results and not be fixed.

Continuing from the GC site:

GC pre-funds a company’s S&M budget. In return, GC is entitled only to the customer value created by that spend, and GC’s entitlement is capped at a fixed amount. After GC reaches that fixed amount, the remaining lifetime value of the customers is the company’s to keep forever.

Sales and marketing (S&M) is often 50%, or more, of the annual budget — a huge percentage for most startups. In this passage, GC talks about funding that budget (loaning the money) in exchange for the “customer value created.” That piece isn’t clear. Is that the enterprise value of an incremental $1 of revenue? Something else?

Let’s assume it’s some multiple of new customer revenue, like 4x. If GC funds $10M of customer acquisition costs (S&M spend), and that returns $5M in new customer revenue, then GC would get paid $20M (a 2x return on the loan). Of course, there’s a wrinkle with how to allocate what new revenue came from that new spend vs previous spend as well as second order sales from brand, word of mouth, etc. The easiest answer is the most likely: all new customer revenue gets counted. 

Finally, from the GC site:

GC only gets paid if and when the company gets paid.

This is a nice touch — only pay down the loan when the cash comes in from the new customers. Aligning cash flow with funding is a great feature.

The other question is over what time period and at what rate does that “customer value” loan get paid back. My guess is that it’s over 5-7 years based on a percentage of that new customer revenue (e.g. add $5M in new annual revenue, 50% of that amount paid towards the debt until the customer churns or 2x the original loan is paid).

It’s great to see more innovation in the non-dilutive SaaS financing space. Entrepreneurs would do well to consider all their financing options, and not just venture capital, when looking for ways to grow faster. Hopefully customer value financing catches on and becomes more popular.

Update: A friend reached out and said it doesn’t work the way I thought from GC. He said that GC effectively does a new loan each month of ~80% of spend and it’s paid back with the revenue of the customers signed that month with a target interest rate of 12-14% repaid in 12-18 months.

One of the common mistakes I see entrepreneurs make when pitching investors is regarding the ask. See, the ask is one of the critical components of the meeting, only entrepreneurs take it too far. Too many work on getting to an investment decision in the first or second meeting, “Will you invest in us?”

Instead, entrepreneurs need to sell hard on getting to the next step, not the final sale. 

Investors usually have a process. First meeting, send me more information based on questions and let me do research, meet my partners or someone I respect to hear the pitch, call a few customers for references, meet again, and so on — it takes time, especially these days (life was different 24 months ago!).

The best question to ask: what’s the decision making process?

The next best question: what do we need to do to get to the next step?

While the answer received might not be always be what’s desired, the experience and expectations will be much better. A one call close isn’t possible, so play for the best next action: making it to the next step.

Of course, this is applicable to most things in startupland (and life). Whether it’s selling a piece of software, earning a mentor, or signing that strategic partner, it’s a process, not a single event. Figure out the process, understand what’s needed for the next step, and work towards it.

Entrepreneurs would do well to sell hard on the next step, not the final sale. 

In the world of startups, there’s a category of product that’s unusually challenging: does solve a problem, more important than a nice-to-have but nowhere near a must-have, and only valuable enough to build a small business. I call these types of solutions the green vegetables of startupland. 

Why green vegetables? We all know that we should eat more green vegetables, yet most of us don’t do it — that burger and fries sure tastes good. Green vegetables are clearly one of the healthiest choices, only we go for what has more dramatic flavors (sweet or salty or fried!). The cravings and urges just aren’t there for this type of food. Now, this isn’t commentary on the value of green vegetables, this is focused on human wants and desires. We want something that’s tasty. We want something that satiates our hunger quickly. We want something that triggers the pleasure receptors in our brain.

These green vegetable products are better than nice-to-have solutions. There’s clearly nutritional value and we should consume them. Only, they aren’t the main course. They aren’t what gets people excited when sitting down to dinner. People buy enough of them to build a business, but the share of wallet and willingness to spend isn’t great enough to build a big business.

When a startup with a green vegetable product raises money from institutional investors, another problem occurs. There’s some momentum, otherwise the startup wouldn’t be able to raise money. Only, for whatever reason, it was hard for the investors to see this wasn’t a must-have product in the path of revenue or truly mission critical. Then, as cash is burned in an effort to grow faster, the rapid market adoption just isn’t there. Modest growth is attained, but hypergrowth isn’t achieved. This often results in a zombie startup that’s big enough to survive indefinitely while being too small to raise more money on reasonable terms or have a decent exit.

Green vegetable startup products are more common than you think. Entrepreneurs would do well to stay as close to the customer as possible and focus on products that are mission critical or clearly help make more money. If there’s any doubt on either of those criteria, go back to the drawing board or dive deeper with the customer to figure out what needs to change. Eat your green vegetables and know how to identify them in startupland.