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?

5 Weekly Action Items for Entrepreneurs

As the startup grows and raises a financing round or achieves product/market, it’s time to add more structure and process. Now, it’s still critical to stay close to the customer and move fast, but it’s also important to start building a foundation for the future.

Here are five weekly action items for entrepreneurs:

  1. Write a weekly team update email
  2. Track the right metrics for the stage of the company
  3. Update the Simplified One Page Strategic Plan
  4. Run the internal meeting rhythm
  5. Review the sales opportunity pipeline

This process seems pretty simple but it’s actually harder than it looks. Issues are always coming up and there’s always something else to work on — figure out a process and stick to it.

What else? What are some additional weekly action items for entrepreneurs?

Impact of a Recession on the Startup World

Last week someone asked me what I thought would happen to the startup world when the next recession comes along. I don’t spend any time worrying about recessions, but I also know that they’re a normal part of the business cycle and will eventually happen. Here are a few thoughts on the impact of a recession on the startup world:

  • Volume of Startups Increase – With large numbers of layoffs comes more people that become entrepreneurs out of necessity. Most will be replicative entrepreneurs but there will still be plenty of innovative entrepreneurs.
  • Valuations Go Down – As public SaaS market multiples go down, so do SaaS valuations. Hot startups will still demand a premium but VCs will be in a stronger position of power as their dollars will be able to buy more equity.
  • Hiring Becomes Easier – Suddenly there are great people on the market actively looking and more people that have jobs are open to talking after their own company just laid off employees. Top talent will still be in high demand but things get slightly easier for finding good people.
  • Angel Funding Goes Down – As the stock market and real estate decline in value, individuals start feeling the wealth effects of a smaller portfolio, and that translates into fewer angel deals. Family offices will be fine but most angels will cut back.
  • More Zombie Startups – Thousands of zombie startups, defined as startups that have enough revenue to stay in business indefinitely but little or no growth, already exist and that number will grow faster when the economy gets tougher.
  • Nice-to-Haves Wash Out – Products that are in the path of revenue thrive and the nice-to-haves suffer. Meaning, products that help companies make more money do much better than ones that are more difficult to quantify value.

Pardot was built during a recession and became stronger because of it. Recessions have a real impact on the startup world, but great companies are started in all business cycles.

What else? What are some more thoughts on the impact of a recession on the startup world?

Customer Churn is Always Higher in the Early Days

At Pardot, in late 2012 at the time of acquisition, our monthly customer churn was 1.4% (meaning, we lost 1.4% of all our customers every month). Why do I still remember that number over four years later? Well, because it was seared into my mind by being one of the top five questions asked by investors. And, we pitched over 35 VCs through the years, making it a popular topic of conversation.

Now, in some SaaS businesses, 1.4% monthly churn isn’t that good, but we were a month-to-month solution for small-to-medium businesses (SMB). In that market, with that type of no-contract situation, that was considered a great churn rate. Only, it wasn’t always that way. In fact, most startups have high customer churn in the early days and then get better with time.

Here are a few reasons why customer churn is higher initially:

  • Customer Consistency – Early on, the ideal customer profile isn’t well defined as the goal is to get early adopter customers in the door and to work towards product/market fit. Inevitably, bad-fit customers get signed and contribute to a higher churn rate.
  • Contracts – Many startups, like Pardot, start with little or no contract, as a way to remove friction to adoption. While it is customer-friendly is some regards, it makes for customers that sign when it’s really a short-term paid trial in their mind, makes for more volatility when customers hit hard times and leave with no notice, etc. Contracts, at least annual deals, help minimize some of the churn potential in the first few months after the sale.
  • Product Maturity – Software products always have bugs. Always. Early on, products aren’t very mature and will have more bugs resulting in greater potential for customers to have a bad experience that increases the risk of churn.

Entrepreneurs would do well to work towards a low a churn rate and keep in mind that it’s always higher in the early days.

What else? What are some more reasons why customer churn is higher early in the life of a startup?

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?


Investing in Idea and Growth Stage Startups, But Not Seed and Early

Yesterday an investor asked why I rarely participate pro rata in subsequent rounds of financing. On a basic level, my strategy is to either invest in opportunities that have a high risk/reward equation, defined as the ability to make a 15x return, or a “safe” investment where the startup is in the growth stage and there’s a clear path to make 3x (with a goal of 5x).

Now, less than 2% of venture-backed startups sell for $100 million or more, so if the startup is pre product/market fit, to make 15x, knowing that the chance of a $100+ million exit is nearly non-existent, the post-money valuation needs to be well under $4 million when accounting for future dilution. By the time the full seed round comes together, and hence the startup is past the idea stage, the valuation has often gotten too high such that I don’t invest or participate pro rata.

The second investment strategy is to participate once the startup is in the growth stage and has north of $3 million in annual recurring revenue (ARR). At this point, the startup has product/market fit, a repeatable customer acquisition model, and is working on scaling all aspects of the business. While it isn’t a “sure thing”, assuming there’s a great team, market, and unit economics, the chance of the business reaching a material size (e.g. $20 million in ARR) is high and an exit at a substantial valuation well above $100 million becomes much more achievable.

So, this approach skips seed stage and early stage investments since they don’t meet the risk/reward profiles. This approach also skips participating pro rata in the seed stage and early stage as the pro rata participation is the same class of money with the same goals. While this is a strange approach for many angel investors, it’s worked well for me.

What else? What are some more thoughts on this investment strategy focused on idea stage and growth stage startups?

Challenges of a Seed Without a Lead

When entrepreneurs set out to raise a seed round, they typically find that it’s hard to get a lead investor. Lead investors are often professional investors and/or institutional investors that commit a significant amount of time and energy to the company, not just money. At the seed stage, there’s no product/market fit or repeatable customer acquisition process (see The Four Stages of a B2B Startup), making the investment more of a belief in the team and market, not the existing momentum or traction in the business.

Here are a few challenges when there isn’t a lead investor:

  • Accountability – The lead investor is the point person for accountability with the entrepreneur, ensuring timely monthly investor updates, annual reviews, etc.
  • Board Meetings – The lead investor requires regular board meetings and helps enforce standard fiduciary responsibilities
  • Follow On Rounds – If the company isn’t hitting its targets, it’s much more likely that the investors will walk away and not do a bridge round or additional financing as everyone has a more limited ownership stake and participation

Another way to put it is that a seed round without a lead usually results in “just money” whereas a lead investor is a real partner for the entrepreneur.

Entrepreneurs raising a seed round would do well to think through the pros and cons of having, or not having, a lead investor.

What else? What are some more thoughts on the challenges of a seed round without a lead investor?