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.

Over the last two weeks the book The Five Dysfunctions of a Team by Patrick Lencioni has come up multiple times. If you haven’t read it, it’s one of the all-time great leadership books, and especially applicable to entrepreneurs. In classic Lencioni style, it starts with a parable of a team making common mistakes followed by a journey of reflection and teamwork improvement.

From the listing:

Like it or not, all teams are potentially dysfunctional. This is inevitable because they are made up of fallible, imperfect human beings. From the basketball coach to the executive suite, politics and confusion are more the rule than the exception. However, facing dysfunction and focusing on teamwork is particularly critical at the top of an organization because the executive team sets the tone for how all employees work with one another. Fortunately, there is hope. Counter to conventional wisdom, the causes of dysfunction are both identifiable and curable. The first step toward reducing politics and confusion within your team is to understand that there are five dysfunctions to contend with, and address each that applies, one by one.

DYSFUNCTION #1: ABSENCE OF TRUST

The fear of being vulnerable with team members prevents building of trust within the team.

DYSFUNCTION #2: FEAR OF CONFLICT

The desire to preserve artificial harmony stifles the occurrence of productive, ideological conflict.

DYSFUNCTION #3: LACK OF COMMITMENT

The lack of clarity or buy-in prevents team members from making decisions they will stick to.

DYSFUNCTION #4: AVOIDANCE OF ACCOUNTABILITY

The need to avoid interpersonal discomfort prevents team members from holding one another accountable for their behaviors and performance.

DYSFUNCTION #5: INATTENTION TO RESULTS

The pursuit of individual goals and personal status erodes the focus on collective success.

While it might sound like commonsense, there’s a large gap between knowing something can be better and knowing the best practices to make it excel. Every entrepreneur should read The Five Dysfunctions of a Team individually and as a team with their employees.

Last week I was talking to a growth stage software investor. We were discussing a recent round they lead and I asked how they thought about the revenue multiple for this SaaS business. Revenue multiple? I was quickly corrected that they didn’t underwrite it as a Rule of 40 multiple of recurring revenue, growth rate, and gross margin (see Rule of 40 Valuations). Rather, they made the investment based on an estimated EBITDA, and EBITDA multiple, five years from now.

Coming from the grow-at-all-costs for several years to the current grow-reasonably-efficient times, making the leap to EBITDA multiples isn’t as dramatic, but it’s still problematic with so many software companies burning cash. EBITDA (earnings before interest, taxes, depreciation, and amortization) is form of profitability calculation made popular by the Cable Cowboy John Malone many years ago. In rough numbers, a smaller business is worth 4-6x EBITDA, a mid-sized business is 6-8x EBITDA, and a large business or one with an exceptional business model is 10-15x+ EBITDA (also varies dramatically by industry, growth rate, etc.).

SaaS companies, due to characteristics like the stickiness of the product, high gross margins, revenue predictability, and more make for an exceptional business model. Let’s do some basic math to see how a growth stage investor might underwrite a SaaS company at scale to make 3-5x the investment in five years.

Initial Deal
$20M Revenue
$0 EBITDA
$80M pre-money valuation
$20M investment for 20% ($100M post-money valuation)

End of Year 1
$27M Revenue
$0 EBITDA

End of Year 2
$34M Revenue
$5M EBITDA

End of Year 3
$41M Revenue
$10M EBITDA

End of Year 4
$48M Revenue
$15M EBITDA

End of Year 5
$55M Revenue
$20M EBITDA

This is a fairly basic example with a static $7M revenue growth per year (meaning the growth rate slows each year with scale) and tremendous EBITDA growth in the later years due to economies of scale and a higher base of recurring revenue.

Here with a $50M revenue software business, $20M of EBITDA, and a 15x EBITDA multiple, you arrive at a valuation of $300M. A sale of $300M returns 3x the original investment, assuming no further dilution along the way, and the investors achieved their goal.

Theoretically, businesses should always have a floor valuation that’s based on the expected value of the future cash flows. For SaaS and other SaaS-like business models, this is a good exercise to think through potential valuations from a cash flow multiple perspective.

Last week I had the opportunity to walk the floor of a massive trade show for the first time since before the pandemic. There’s a real energy and buzz when hundreds of vendors mix with tens of thousands of attendees. The usual amalgamation of multi-story professional booths combined with homemade single-stall stations give it an air of upstarts and incumbents all vying for the time and attention of customers, potential customers, media, vendors, and partners. I imagine the first trade show was simply taking the format and style of a street market from thousands of years ago and organizing it for a specific industry. Humans proactively trading with each other is one of our biggest innovations as a species.

When I was growing up, my dad would go to a big trade show every summer for his industry and several times I was able to tag along. We went to places like Toronto, St. Louis, and Seattle for four or five days and did a mix of trade show and tourist activities. As a kid in middle school, I’d be on my own while he’d go to continuing education sessions. My favorite activity? Walking the trade show floor, of course, and collecting as many free goodies as I could. Pens and candies were my treasure. At the end of each day I’d show off my spoils and regale him with stories of cool products and booths. I distinctly remember sitting in a car on the show floor — a Lincoln Mark VIII coupe — and thinking how amazing it was to be in a fancy car with the latest high tech gadgets. Freedom to roam and trade show energy make for an incredible combination.

As an entrepreneur looking to break into a new industry, the first thing I’d do is find the biggest gathering, research the players, make a huge list of questions, and walk the trade show floor asking the best questions to anyone that’d listen. I’d go from booth to booth in the relevant areas and eavesdrop on conversations, observe which vendors have the biggest crowds, and seek out insights on the latest trends and growth areas. While not easy, the value and knowledge per hour spent should be as good as it gets.

Entrepreneurs should experience a large trade show at least once and learn how to get value from them.

Almost four months ago I highlighted how the economic downturn was going to seriously hurt renewal rates for SaaS companies.

SaaS Renewal Rate Reduction with the Economic Downturn

Unfortunately, it’s proving correct. Daily, big tech companies are announcing layoffs from Salesforce.com to Google to Microsoft. While the big brands make the headlines, for every major company that announces layoffs, there are hundreds of startups doing the same thing.

Startups often sell to other startups and tech companies.

Startups and tech companies are early adopters. When they do layoffs, through no fault of the SaaS vendor, the number of seats and/or usage volume goes down. This hurts the renewal rates. Lower renewal rates make it harder to grow as there’s a mountain to climb just to get back to the same size as the previous year, let alone grow fast.

Startup valuations are heavily dependent on the growth rate, especially using the Rule of 40 methodology. With growth rate down due to higher churn from layoffs and fewer new customers due to the slowing economy, the Rule of 40 score goes way down. A lower Rule of 40 score makes for a much lower valuation come fundraising time, which increases the chance of a down round or no round. It’s a vicious cycle.

For entrepreneurs, it’s a real balancing act. Here’s an opportunity to keep pushing hard to build out the platform and gain marketshare while everyone else is challenged. Only, push too hard without enough progress and the chance of not being able to raise another round on favorable terms dramatically increases.

For many entrepreneurs, the solution is to push hard while attaining some form of default alive. Becoming profitable or breakeven, so as to be default alive, results in tremendous flexibility — there’s no ticking clock requiring another funding round. Even if it’s too dramatic to immediately get to default alive, another variation is to have a plan in place, often involving cutting costs and team members, to make the change, if things don’t progress the desired way. More flexibility also provides an invaluable benefit — helping entrepreneurs sleep better at night.

It’s a tough time in startup land. For the entrepreneurs that can make it through the next 12-24 months in a position of strength, renewal rate improvements and stronger new customer growth will be the reward.

One of the hottest topics lately is valuations. With the public equities down dramatically over the last year and most startups deferring as long as possible to raise another round, it’s hard to know what’s market out there. Of course, some deals are getting done and the startup funding world is still turning, albeit at a slower, more jerky pace. 

On the public market front, the BVP Cloud Index shows cloud stocks trading at an average revenue multiple of 6.3x with an average growth rate of 29%. The median forward revenue multiple is 4.82x (using the expected revenue for the next twelve months). At the peak of the market on February 10, 2021, the median forward revenue multiple was 15.95x. Thus, we’ve seen a 70% drop in valuations.

On the private market front, I’ve heard of deals all over the place from 2x to 10x+ revenue run rate, often driven by how desperate the startup is to raise money to how desperate an investor is to put money into a startup. The days of 50x or 100x run rate valuations are long gone (ignoring outliers like Figma or OpenAI). 

So, what’s a generic valuation formula in today’s market? Absent more data, here’s a formula to ballpark a number:

Revenue Run Rate (most commonly annual recurring revenue)

Multiplied by

Rule of 40 Score

Multiplied by

.2 (market sentiment, in this case 20%)

Some examples:

• $20M ARR x 50 Rule of 40 Score x .2 = $200M
  Because of the high Rule of 40 Score, the startup gets a valuation of 10x run rate
  
• $10M ARR x 20 Rule of 40 Score x .2 = $40M
  Because of the normal Rule of 40 Score, the startup gets a valuation of 4x run rate
  
• $5M ARR x 10 Rule of 40 Score x .2 = $10M
  Because of the low Rule of 40 Score, the startup gets a valuation of 2x run rate

Rule of 40 Score is basically growth rate plus profit margin as numeric values. The easiest way to get profit margin up (or less negative) is through layoffs, and we’ve seen huge numbers of them lately.

Much like “animal spirits” from John Maynard Keynes, market sentiment here is subjectively and fluctuates regularly. While this formula isn’t perfect, it’s directionally useful in today’s market.