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Yesterday I was meeting with a pair of entrepreneurs and the current fundraising/valuation climate came up. These entrepreneurs had been grinding on their startup for many years. Only, it wasn’t the proverbial hockey stick growth with everything up and to the right. It was slow to get going, but thankfully, now things were growing super fast — the hypergrowth badge was unlocked.

We talked about how some of their friends had raised money at crazy valuations — 25x or 35x annual recurring revenue (ARR) — just 24 months ago. Today, we’re a long ways from seeing that again, if ever, with valuations in the 4-8x recurring revenue range. I emphasized that while the valuations might be more rational now, the amount of enterprise value they were creating was still huge. In fact, most of the startup’s value accrues in the later years, assuming growth rates stay high.

Let’s look at an example with $1 of ARR being worth $6 in enterprise value (for simple math):

• Year 4
  • $1M ARR
  • Add $1M of new ARR
  • $2M total ARR
  • $12M valuation (6x ARR multiple)
• Year 5
  • $2M ARR
  • Add $2M ARR
  • $4M total ARR
  • $24M valuation
• Year 6
  • $4M ARR
  • Add $3M ARR
  • $7M total ARR
  • $42M valuation
• Year 7
  • $7M ARR
  • Add $4M ARR
  • $11M total ARR
  • $66M valuation

In this example, there wasn’t much value created in the first four years. Yes, the early years were critical for building out the technology, recruiting a team, signing the early customers, and assembling the pieces for growth. Looking at the next four years, the valuation shot up dramatically as the business scaled, with the majority of the value accruing in the last 24 months.

This phenomenon of when value is created makes startups especially hard. Tremendous amounts of work in the early years, and no knowing if or when things will take off, is a hard risk/reward equation for most people. When it works out, it’s an incredible accomplishment. Entrepreneurs would do well to know that most startup value accrues in the later years.

While current startup difficulties deserve the most attention (broken cap tables, valuations lower than capital raised, slowing growth rates, etc.), venture firms, especially ones that deployed significant amounts of capital in 2020 and 2021, are challenged as well. Writing checks into startups whereby their real valuations are likely 30 – 70% lower, even after a couple years of growing, makes for an exaggerated J curve (rates of return are negative in the first few years due to the drag from management fees). Only, the story is worse, and more complicated.

While venture fund fees are usually 2 and 20, meaning a 2% management fee and 20% of the carry (profits). The 2% management fee is paid on committed capital. With a $500M fund, that’s $10M/year in fees. Most funds are 10 years with two optional one year extensions, so best to think of the management fee side as really 20% of the fund (2% per year for 10 years). Instead of 2 and 20, 20 and 20 is the real way to think of it (20% of the fund as management fees and 20% of the profits as carried interest). Yes, the fees can be substantial, but it’s best to think of venture as get rich slowly, as most don’t beat the S&P benchmark and take 7+ years to see any distributions.

With venture funds, the general partners (GPs) are required to put 1-3% of the capital in themselves. So, if it’s a $500M fund, and the partners collectively are putting in 2%, they’re committing $10M. Many of the younger partners, while they’re making a good salary, often have to borrow money for their portion of the GP commit. Well, that debt they’ve taken on looks even more distressing considering it could be years before their portfolio company valuations are back to the original investment value, let alone at a scale where they’ll make good money on an exit. 

Net net, the chance of this cohort of VCs making substantial profit is low yet personal debt is high. VC is a tough job to get, and right now, quite a few VCs are thinking about their current careers. Vintage 2020 and 2021 venture funds are likely to perform poorly save for the occasional power law winners. Venture is still an important part of our economy that has an outsized impact, and should be supported and encouraged, even if a couple years prove difficult.

One of the topics we’ve discussed several times as of late is the declining renewal rates, and therefore growth rates, in cloud software. While a major driver of reduced renewal rates comes from layoffs, and the corresponding reduction in seats or user licenses due to fewer staff, a second major driver is the budget pressures and heightened expense scrutiny across companies. 

As a software startup, it’s easy to say that a customer let go of 20% of their staff and their corresponding renewal value was roughly 20% lower (not counting escalations or price increases). This becomes more challenging when the renewal doesn’t happen (churn!) or the downgrade is more dramatic than the layoffs. In today’s climate, it likely means that the company chose not to renew because it wasn’t mission critical or the customer switched to a lower cost provider (another renewal blemish).

In software, we like to talk about must-have products vs nice-to-have products. Of course, it’s a continuum and not binary, but the most successful startups are in the must-have category and the vast majority of failed startups are in the nice-to-have category. Only, when times are good, it’s often hard to know just how much a must-have or nice-to-have a product is as budgets are loose and grow-at-all-costs is the mantra. The easy spending can make products look more must-have than they really are. Then, when budgets contract, the truth comes out. 

This is especially challenging as many startups with nice-to-have products raised tremendous amounts of money over the last few years. After their own layoffs and efforts to conserve cash in order to push out raising another round, they’re getting hit even harder with renewal rates being lower than expected. Look for more investor scrutiny in future rounds to tease out what’s really a must-have vs a nice-to-have solution.

Entrepreneurs would do well to continually work towards making their products must-haves and staying as close to the customer as possible. Budget pressures are highlighting the true mission critical software apps, and many startups are finding out where they exist in the eyes of their customers.

Last week I was talking to an entrepreneur that worked out of the Atlanta Tech Village for several years. When his original startup didn’t work out he went and joined a different startup. Now, he’s on his third one. Only, this one is with someone he met at the Tech Village during his first one.

Seeing this “recycling” of entrepreneurs where startups are regularly shut down and new ones formed — often with serial founders and friends from the startup community — was an early dream and vision of the Tech Village. The idea: let’s get hundreds of people under the same roof building the future while surrounding them with everything we can to increase their chance of success. A byproduct would then be recombinations of entrepreneurs — some entrepreneurs move on from their current venture and start new ventures with other entrepreneurs they’ve met along the way. Now, 10 years later, we’ve seen this happen many times.

To promote relationship building we work on ways to engineer serendipity through programs and events as well as shared resources like kitchens and common spaces. In the world of distributed teams and remote work environments, human relationships are more important than ever, and physical spaces, while not used in the same ways as pre-COVID, are still critical for bringing people together.

The more entrepreneurs spend time with other entrepreneurs, the greater the chance they find a match for a future startup. Entrepreneurs combining on new startups is a strong signal this works and an integral part of startup communities.

Last week I was joking to a group that our approach to startup awards at Pardot was straightforward: no award was beneath us. Want to recognize us as a fast growing company? We’ll take it. Want to recognize us as a great place to work? We’ll take it. Want to recognize us as the coolest company between 50 and 200 employees in the Southeast in the marketing technology category with a six letter dot com domain name? We’ll take it.

Startup awards are plentiful and a popular element of the community. Publications use awards as a way to generate content and put on events. Non-profits and community groups use awards as a way to annually celebrate local startups and entrepreneurs. Recognizing success and accomplishments also acts as inspiration for the next generation that want to see their name in lights.

Only, as an entrepreneur, it’s critical to remember that startup awards don’t equal success. With all the challenges that come with entrepreneurship, there’s a strong desire to seek external validation. By winning this award, I must be doing something right. Only, it’s too easy to internalize awards as a credible sign of progress. We won this award therefore our startup is going to succeed is not true.

Awards are fun and exciting.

Awards are not success.

Startup success is only bestowed by customers — not by mentors, investors or media. Customers decide where to spend their budget and whether or not a product is useful. The market decides, not the media.

Accept startup awards with a smile and stay focused on the customer.

While some of the dust has settled around Silicon Valley Bank’s demise, a number of second and third order effects are still looming. For startup-land, one of the biggest challenges on the horizon is the impending cancellation of startup credit lines. Silicon Valley Bank (SVB) was the largest provider of debt to startups, and still is as the new bank Silicon Valley Bridge Bank (SVBB). So, if the bank still has $6.7 billion dollars of loans out to startups what’s the problem?

The problem is that the majority of deposits have left the bank and aren’t coming back. Without deposits, the bank can’t lend as much. The bank has to maintain certain capital ratios, and with intense scrutiny, will be more conservative with how it uses deposits to make money. Many startups will still be able to keep a credit line, but it’ll likely be much smaller than in the past.

In addition, startups are difficult to underwrite. While the SVBB staff is being paid 50% more than their normal salary to stay on for 45 days, many will inevitably be let go because the bank has many fewer deposits, so it needs many fewer employees. Once a fair number of employees are let go, the volume of underwriting capacity will decrease, and the bank will opt to focus on the higher quality startups. 

Finally, startups have shown they’ll happily move their deposits anywhere, as opposed to a small business owner that wants to work with the bank that’s in their neighborhood. As startups usually don’t have a local connection, there’s less emotional attachment to taking their deposits to other banks or putting money in t-bills and programs that spread deposits across multiple banks to maximize FDIC insurance. With fewer deposits as part of the story, startups are less desirable customers (banks that provide credit lines will still require banking with them, but more cash will be put in money markets that don’t help the bank as much).

How many startups might this apply to? Let’s do some rough math:

• $6.7 billion in loans from SVBB
• Guess of $3M average per startup (credit lines are typically 1/3rd of annual recurring revenue or some percentage of institutional equity in the startup)
• $6.7B divided by $3M results in 2,233 startups

This is only at SVBB. Add in Signature Bank, First Republic, and several others. Many thousands of startups will not have their credit lines renewed.

Another wrinkle is that thousands of startups have been using venture debt to fund the operations of their business. In the past, venture debt was encouraged as a safety net only to be used in times of emergency. With the great resetting of valuations, thousands of startups decided to use venture debt to buy more time and hopefully grow into their last valuation. It was no longer a safety net. Instead, it was a time bomb.

Net net, over the next 12 months as lines of credits come up for renewal, look for hundreds of startups to turn the keys to the business back to the bank. Cap tables are upside down with too much capital and not enough progress. Valuations have reset and in many cases the startup is worth less than the capital invested. All is not lost, but many more challenges lie ahead for the industry.

The last 72 hours has been a whirlwind in startupland. With the collapse of Silicon Valley Bank (SVB), the largest financial institution for startups is no more. SVB worked with half the VC-backed companies in the United States, and according to PitchBook, there are 130,000 such businesses. That’s right, an astounding 65,000 startups are SVB customers. As of Friday morning, the first $250,000 of demand deposits are guaranteed and monies in excess of that are dependent on winding down the bank and not guaranteed. Current rumors range from 50% of deposits will be made available on Monday to takeover by a bigger bank with minimal disruption to deposits. Yet, nothing above the first $250,000 is guaranteed.

Startups that bank with SVB will have a long weekend waiting to see what ultimately is shared on Monday. My guess is that startups will get all their deposits back, but it might take some time to do so depending on whether or not the government steps in.

Now, regardless of being venture backed or an SVB customer, there are a few bank hygiene takeaways for startups:

• Two Bank Relationships – Treasury management is clearly mission critical to the business. By having standard bank accounts with two different banks, a backup is ready to go in case the primary bank struggles. In addition, it’s valuable to negotiate better rates and terms whereby the banks compete against each other. Just like having geographically independent data centers to host your app for redundancy, do the same for your banking. Consider putting your excess cash in a mega bank that’s too big to fail (> $250B in assets). 
• Insured Cash Sweeps – Ask your bank if they offer Insured Cash Sweeps where your balance is split automatically behind the scenes across many banks such that each bank has no more than $250,000 and the entire amount is fully insured by the FDIC.
• Treasury Bills – Park cash that isn’t immediately needed directly with the government via Treasury Bills at TreasuryDirect These are the safest investments possible because the U.S. government prints the actual money, the risk of default is as low as possible (if it defaults, we have bigger problems!).
• Automated Cash Management – Services like Max https://www.maxmyinterest.com/ and Vesto https://www.getvesto.com/ will automatically move money around to get the best interest rates and spread the cash across multiple banks as well as treasury bills based on rules.

The immediate next steps are to have two banking relationships and a strategy to have deposits over the FDIC $250,000 amount either insured across multiple banks and/or in ultra short term government T-bills. Bank failures are extremely rare, but with a little work, the tools and systems are already available to minimize any potential exposure.

Last week I had the opportunity to share my startup story with a group of executives in town. During the Q&A portion at the end, one of the guests asked for entrepreneurial advice regarding idea selection knowing that pivoting is common. My recommendation: fall in love with the market, not the idea.

Think of a market as a big mountain with hints of gold flakes in the surrounding streams. Now, using those context clues, the goal is to mine it and find the best vein of gold. At first, you search for any vein of gold, talking to potential customers, listening to their stories, seeking insights. Then, you pick an idea and start digging. Sometimes it’s easier than expected and you find a vein of gold quickly. Often, that first, second, or third spot you dig in doesn’t work out. More context clues emerge with each attempt. You hear something from a local, you notice a new clue each shovel of dirt. Ideally with enough time, effort, and ingenuity, an incredible vein of gold is found, tapped, and harvested thereby building the foundation for a large business.

Too often, entrepreneurs fall in love with their idea. They believe it’s going to work exactly as imagined then build a product without continuous input from prospects. Rarely does the field of dreams approach work, and many failed startup post mortem cite this lesson learned. The key: embrace the market, go as deep as possible, and iterate to find the best ideas. Think markets, not ideas.

The next time an entrepreneur excitedly shares their idea, ask questions about the market, and encourage them to doggedly pursue customer feedback, while being open to better, adjacent ideas during the process. Pursue great markets and find the best ideas within them.

Last week I was talking to an entrepreneur and I had a hard time understanding the pitch. After a few rounds back and forth, I worked to simplify and repeat the pitch back to him. It was OK but not great. Then, I realized the problem: he was stating the idea based on what he thought I wanted to hear. AI this, cloud that, etc. I wanted to hear the problem being solved, the value derived by the customer, and the prospects for becoming a large business.

My advice to the entrepreneur: go talk to 10 customers. Ask how they describe the solution. Ask what value they receive from the product. Do this in a way that doesn’t lead the witness. Be patient and quiet as they think through their answers. The point of the exercise isn’t to change the vision or mission of the company. Rather, the point is to refine the messaging and pitch to more accurately reflect the market. The market always decides no matter how hard you want it to be a certain way. 

Ultimately, the clearer the message, the better people will understand it and the faster they’ll be able to know if they need it. Messaging and positioning are harder than they appear. Entrepreneurs would do well to lean on customers and better understand the value from their perspective. 

One of the hot topics right now among venture-backed entrepreneurs is the trade-off between growth and cash burn. Growth is being challenged due to higher churn from tech layoffs (startups often sell to other tech companies) and uncertainty in the economy. Views on cash burn have changed dramatically due to much lower public market valuations and a higher cost of capital from alternative sources like venture debt.

In order to balance growth against cash burn (or profitability!), the Rule of 40 was created. The Rule of 40 is a score defined as the growth rate over the last 12 months plus the free cash flow (FCF) margin over the last twelve months. As a simple example, if the business grew 30% and had 10% profit margins, it’d have a score of 40 (30 + 10), and would be considered great. While a basic methodology, it gives the entrepreneur a framework for analyzing trade-offs.

Last week Kyle Porter, founder of Salesloft, shared with me a more nuanced way to think about it. Instead of growth and free cash flow margins being exactly a percentage turned into a score, there should be a multiple modifier that represents market sentiment. Sometimes growth is more highly valued, like the last few years, and sometimes less valued, like today. This can be expressed as a multiplier to the score.

While there’s no exact formula, a multiplier example right now might be 1.25 growth and .75 FCF margins. So, growth is still favored over profitability, but it’s not as dramatic as two years ago when it was closer to 2.0 (or 10.0!) for growth and 0.0 for FCF margins.

Here’s an example:

$10 million SaaS startup

40% growth rate

-10% FCF margin

Basic Rule of 40 score: 30 (40 + -10)

Growth Multiplier Rule of 40 score: 42.5 ((40*1.25) + (-10*.75))

In the basic model, this startup would have a Rule of 40 score of 30, which is good, but not great. With the growth multiplier set to 1.25x to represent growth being somewhat more important than FCF margins, the startup gets a score of 42.5, which is great.

Entrepreneurs with a venture-backed startup should decide on a target Rule of 40 score that’s appropriate for their business and consider incorporating a growth multiplier that reflects the market.