Blog

Continuing from last week’s post on the Rule of 50, I received several comments and questions. The biggest and most important question concerns whether a Rule of 50 score equates to viability for funding. From a funding perspective for seed-stage and early-stage companies, founders looking to raise venture capital need to understand that a score of 50 in the Rule of 50 is typically not enough to raise money.

Let’s look at three examples:

Example 1: The startup is growing super fast with a 100% year-over-year growth rate and has -50% free cash flow margins. If you take the 100% growth rate and multiply it by 2, you get 200. Add the -50% margin for a score of 150. A score of 150 will often be sufficient to raise venture capital, assuming other expected elements like margins, market size, team, etc.

Example 2: The startup has a 30% year-over-year growth rate and is breakeven. At a 30% year-over-year growth rate times two, you get 60. Subtract 0 because there is no burn, resulting in a score of 60. A 30% growth rate with no burn is enough to raise funding but likely not enough for a typical venture round. In this case, funding could come from growth equity, a family office, or venture debt.

Example 3: The startup has a 10% growth rate and a 10% free cash flow margin. In this example, the 10% growth rate times two equals 20, plus your 10% free cash margin gets you to 30. So, in the Rule of 50, your score is 30. In this case, the business likely isn’t fundable and won’t be able to raise another round.

In the context of raising money, it’s important to know that a score of 50 on the Rule of 50 is good, but you often need to be exceptional to raise venture capital. The big idea of the Rule of 50 score is that there are many startups still finding their way and need a target to achieve a healthy baseline of general viability for the business—not necessarily to raise a nice up round.

The Rule of 50 score of 50 is a solid target representing a variety of businesses like high growth with lots of losses, medium growth with modest profitability, or something with low growth and tremendous profitability. Most of the 2020 and 2021 heavily funded startups should aim for medium growth plus limited burn in the near term to achieve a level of viability. From there, the belief is that as spending on software and investment in tools increases, they will be in a good position to accelerate their growth rate.

The Rule of 50 and a score at or better than that number is a good target for entrepreneurs who want a sustainable, healthy business. However, a score of 50 is not high enough to raise venture capital. Entrepreneurs should think through their goals and aspirations and target their Rule of 50 score accordingly.

With the shift from growth at all costs to a heavier emphasis on profitability, the traditional Rule of 40 has become more popular over the last two and a half years. Put simply, the Rule of 40 is a combination of growth rate and profitability (free cash flow margin) with a target score of 40 or higher. Some hypergrowth startups achieve a score of 100 or more for an extended period, while many venture-backed startups struggle to reach 40 due to a high burn rate. For example, if a startup is growing 60% per year and has negative 20% free cash flow margins, adding 60 and -20 results in a score of 40, indicating a good position. Even during pre-boom times, the Rule of 40 was used to justify aggressive spending to achieve growth (e.g., growing 200% with negative 100% free cash flow margins).

Reflexively, this is a simple metric, but there’s one element that isn’t quite right: growth and profitability can’t be equal. While the focus on growth fluctuates based on market conditions and investors, adding an extra dollar of growth for high-margin recurring revenue SaaS startups is clearly better than adding a dollar of one-time profit. Thankfully, Bessemer conducted an analysis of publicly traded SaaS companies over an extended period and showed that a multiplier on the growth rate, combined with a free cash flow profitability measure, more accurately predicted valuations compared to the traditional Rule of 40 score. Their finding: 1% more growth is roughly twice as valuable as 1% more profitability (see The Rule of X). The growth multiplier fluctuates over time and reached as high as 9x during the early COVID years.

Intuitively, growth being twice as valuable as profitability makes sense. Investing in growth and reducing profitability can potentially make the company more valuable by buying a recurring revenue stream, with the expectation that the revenue will add to the current revenue, making the business larger indefinitely.

Now, with growth being twice as valuable as profitability, the Rule of 40 target of 40 needs to be adjusted upwards to reflect a new, higher target in line with historic public company data. Bessemer did this work as well, and the resulting target is 50. Let’s look at an example: a startup growing 10% due to the downturn combined with 20% free cash flow margins. Under the Rule of 50 scoring, that’s a score of 40 (10 * 2 plus 20), which is below the 50 target. Not good. Now, for a second example: a startup growing 100% with free cash flow margins of negative 100% gets a score of 100 (100 * 2 plus -100), which is excellent. Both examples pass the gut check, assuming they have millions in revenue (e.g., not seed stage).

My recommendation is to use the naming convention Rule of 40 when discussing the traditional growth plus profitability score, and use the naming convention Rule of 50 when discussing growth plus profitability where growth is doubled to represent its greater weighting. Startups should use the Rule of 50, representing growth rate multiplied by two plus free cash flow margins when assessing their performance. Growth is more valuable than profitability.

Last week, I was catching up with an entrepreneur, and his story was one I’ve heard many times before. He has always enjoyed technology. He started in the tech world, decided to go out on his own to do software consulting, and then one of his clients requested a solution that turned into a product.

I’ve heard this general consulting-to-specific-product story so many times that it strikes me as the ideal path for someone passionate about technology and software development but who doesn’t have a specific product idea yet. While software development might seem straightforward with the advent of low-code, no-code, AI copilot tools, and offshore development, it remains incredibly difficult for companies to build software products and get them to market.

My own journey took this path. I started consulting with small businesses as a web designer during the Dot Com days. That lead to more complex web apps followed by my first product company (web content management) and then my second (marketing automation). Consulting helped me develop my software engineering and sales skills.

For entrepreneurs, going the consulting route is one of the lowest-friction, least capital-intensive ways to start a new business and quickly get to market with customers directly telling you what they want. This approach doesn’t guarantee that a product idea will emerge, but I’ve seen many technologists become entrepreneurs and stumble into a product idea, eventually building an incredible product business.

For tech entrepreneurs who don’t have an idea but want to build software, my recommendation is to start a consulting company, build software for clients, and listen to feedback and market trends. Look for opportunities. One of the best ways to become a software entrepreneur is to start as a software consulting entrepreneur.

Last week, I caught up with an entrepreneur who has a great business. He’s built an incredibly compelling product, is targeting a huge market, and has raised a tremendous amount of money. Within our local startup community, his type of startup is in an underserved segment. We discussed how hard it was to find other like-minded entrepreneurs working in similar areas, how difficult it was to raise money (most of which had to come from outside the region), and how challenging it was to find team members with the specialized skills needed to build and innovate around the product.

Thinking back on the conversation with him, I was reminded of our B2B SaaS community 15+ years ago. At that time, we had a handful of entrepreneurs working on their ideas. It was clear that it was going to be a big opportunity, but it was still very small. Some of the things we tried to jumpstart the community included regular meetups facilitated by Twitter and casual email lists. We also tried a collaborative blog where people cross-posted ideas related to B2B SaaS. We organized different events in the community, including an annual get-together that doubled as a pitch competition. Additionally, we attended various regional and national events together to learn new ideas and bring them back to the community. We also informally got together once a quarter for dinner to share ideas, best practices, and updates on our respective businesses.

Looking back, we now have a strong B2B SaaS community in town after many years of working on it. My hope for this entrepreneur and his community is for a similar outcome: more startups, more success stories, and more people reinvesting in the community. Developing a nascent segment of the startup ecosystem takes many years and lots of trial and error, but the outcome, especially from our own experiences, can be incredible. Start now—it’s worth the effort.

As economic cycles go, I was hoping that by now, nearly 2 1/2 years into the software downturn, we’d be seeing more green shoots and signs of recovery. While there are some small pockets of growth, especially around AI investment, the software market is still in a recession. I’ve been reflecting on this over the past few months, talking to entrepreneurs, getting feedback, and trying to find reasons and insights. On valuations, they are still down dramatically from 2020 and 2021, and rightfully so. The valuations got so far ahead of themselves and were so distorted based on the accelerated demand for products from COVID and the zero interest rate environment. After valuations peaked towards the end of 2021, they started to fall dramatically and have since fluctuated in a more sustainable, long-term average range.

From a software perspective, for sales, churn, and renewal rates, this downturn has highlighted just how often software companies sell to other software companies. Much like in the dot-com heyday, high flyers with fast growth sold their products, ads, and solutions to other tech companies. As long as money was flowing on the investment side, those dollars helped the whole ecosystem, and everything looked good. Once the new investment stopped, most of the ecosystem fell apart. Today, we’re in a similar situation outside of the AI investments.

In other words, software companies are the early adopters for other software companies. When software companies stop receiving large amounts of venture capital at favorable valuations, they become much more cost-conscious. They let go of employees, cut back on their own spending, and stop buying software from other software companies. This presents challenges for the software industry.

Of course, plenty of software companies sell to non-software companies. By and large, the economy is doing fine but not growing fast adjusted for inflation, so the sales from software companies to non-software companies have been slow and steady. Sales from software companies to other software companies have been nonexistent, resulting in an overall malaise in the software business. When does it all end? I don’t know. We’re still bouncing along the bottom. At some point, things will pick up, and we’ll get back to a more aggressive growth orientation as a software industry. Hopefully, that’s in 2025, but you never know. The lack of investment by software companies and software companies selling to other software companies has been eye-opening to me and is one of the important reasons why the software industry has struggled for nearly 2 1/2 years.

Last week, I caught up with an entrepreneur who shared insights on the importance of connecting with the local startup community and fellow founders. Having experienced the ups and downs of business, they now find themselves in a position to network and build an entrepreneurial network as things are on the upswing. This conversation reminded me of my own experiences when I moved to Atlanta over 20 years ago and the effort it took to meet local entrepreneurs. At that time, the startup community was fragmented, spread out across the region, and primarily linked to a couple of local universities and a few networking groups.

Reflecting on the importance of the startup community and the outcomes from many years of participation, I can unequivocally say that the value derived has far exceeded the effort invested. One example that comes to mind is from 2006 when I attended a local networking event for interactive marketers. While standing in line to check in and pick up my name badge, I ran into my college classmate, Adam Blitzer. We hadn’t seen each other in a few years, and reconnecting at that random event led us to start Pardot together. A similar instance occurred in 2012 at a startup event, where I shared my experiences. After the meeting, Rob Forman approached me looking for his next opportunity. I connected him with Kyle Porter, and together they did amazing things as the co-founders of Salesloft. In both cases, it was regular community-building events that facilitated networking and led to great outcomes.

Today, there are many more programs, events, and organizations that bring the community together, uniting different verticals and stages of entrepreneurship into a robust environment for networking and support. Reflecting on my journey, my main recommendation for entrepreneurs is to find and build their own community. If there’s a gap in the market, address it by building your community. I believe that the human element of the entrepreneurial journey is often underestimated by first-time entrepreneurs. By neglecting this aspect, they miss out on valuable opportunities. Entrepreneurs would do well to engage with their local startup community and build relationships with fellow founders.

Last week, I caught up with an entrepreneur, and we discussed milestones for his startup. In this case, they had raised a seed round, and have been building the product for several months. The big question we discussed was: What does it take to raise the next round of financing, and what milestones should we be aiming for? We talked about the pros and cons of aiming for a recurring revenue target or a certain type of customer profile target. But ultimately, at this stage of the journey with no revenue and no paying customers, the most important thing is to sign 10 unaffiliated customers who pay something as the next milestone.

The reason this is so important is that right now, there’s a belief from market trends and some customer discovery that there’s a need for the product and solution. With no paying customers, it’s difficult to prove credibly that there is, in fact, this market opportunity. Instead of aiming for $1 million of revenue or some larger aspiration, it’s more important to get 10 unaffiliated customers that love the product. They will be a testimonial for the product and willingness to pay, even if it’s far below what the market will eventually command.

With these paying customers, it’s easy to extrapolate out how a small but fast-growing market achieves scale in the next 5 to 10 years. Ideally, there will be a huge number of potential customers. By having the customers pay at least something, even if it’s a beta, it demonstrates that there’s real skin in the game and a meaningful problem being solved.

Too often, entrepreneurs try to sign free “customers” in an effort to get the product used, and that usually doesn’t work. It’s much better to have the customers pay at least something so that they’re bought in and provide honest feedback. As an entrepreneur in the early days, it’s easy to get caught up in fundraising and selling a vision. But the first huge milestone is signing up 10 unaffiliated customers who love the product. It sounds simple, but it’s incredibly difficult.

Last week, I was reminded of the importance of believing in others even more than they believe in themselves. I was catching up with an entrepreneur, and we discussed our different projects and what we’re currently working on. He shared how he was assisting another entrepreneur who was early in her journey. Upon digging deeper, it was clear that the entrepreneur was onto something, but market timing and external forces were making the process more challenging. She had been plugging away for a couple of years with little progress, but in the last 12 months, she had made tremendous strides. My friend’s belief in the entrepreneur, serving as a regular sounding board and confidant, had made a real difference.

I was reminded of my early years as a software entrepreneur when I truly thought building a great product was all that it took. I had no concept or understanding of the role that sales, marketing, and distribution play in the success of a product. Fortunately, I was connected with a much later-stage entrepreneur who took me under his wing and believed in me. We talked about the entrepreneurial journey, the highs and lows, what works and what doesn’t work through the customer acquisition process—what it took to find potential prospects, nurture those relationships, turn them into customers, and finally help them become raving fans. At the time, I was so myopically focused on product development I didn’t see or understand the bigger picture of what it took to succeed. His mentorship and belief in me was life-changing.

In hindsight, I believe one of the best things an entrepreneur can do is to find a mentor, coach, or friend who believes in them even more than they believe in themselves. Of course, entrepreneurs are often confident and visionary, but even with that, there is always a need for help and mentorship. Finding a person who genuinely cares and believes makes all the difference.

Last week, I connected with an entrepreneur and we dove into a common scenario that occurs when a startup is doing well. The founder, skilled at selling, had signed up dozens of customers over the years. The business was thriving, so the founder decided to hire an outside head of sales to help grow the business. However, this new hire, who came from a large company, failed at the startup. At his previous company, the sales leader had an existing process, team, and brand. Despite having significant industry and sales experience, transitioning to a startup resulted in a failure.

Hire a Process-Oriented Sales Assistant and Document the Current Sales Process

My recommendation is to hire a process-oriented sales assistant as a first step. This assistant would help the founder make founder-led sales more efficient and productive, and most importantly, codify what works and what doesn’t. Essentially, the sales assistant would act like a product manager for the sales motion, helping the founder alleviate some of the manual work he was performing. This person would also document the sales process and start building the framework of a sales playbook, translating what the founder has been doing for years into written form. As a precursor to hiring a dedicated sales team, much of what already works in founder-led selling would be translated and documented.

Hire a Sales Leader to Build a Team

After the sales assistant has shadowed the entrepreneur for some time and codified the sales playbook, it’s time to bring on a sales leader. The sales leader should focus on building a repeatable, scalable process, whereby the different milestones in a sales process are defined, and the inputs, like cold calls, emails, trade shows, and marketing qualified leads, turn into scheduled demos that then progress into proof of concepts or proposals, and so on. The sales leader is part sales coach and part process manager. Often, entrepreneurs seek to hire a unicorn that not only does the process but also sells and is a product expert. It’s much easier and more successful to find a sales leader that’s focused on building and running a process, not being able to do everything.

Conclusion

Transitioning from founder-led sales to a hired sales team is often a difficult process. Failure rates are high with new sales hires, and many of the lessons have to be learned over and over again. Once product-market fit is achieved and the business is working, the next step is to hire a process-oriented sales assistant to take all the lessons learned, document them, and start mapping out the sales process. With this in place, then it’s time to hire a sales leader to build a team focused on running a scalable process and delivering results.

Last week, I was catching up with an entrepreneur who is in the middle of a fundraising process. He has received a couple of verbal offers and a few outlines of potential term sheets. One of the obvious differences between the investors he’s been talking to are how the investors operate. Generally, I like to think of it in two broad categories. 

The first category includes investors who focus on the upside, what could be, and how big the opportunity is. In the first bucket of investors, it’s easy to hear in their commentary and see in their term sheets that the terms are very clean and simple. The idea is that we’re in it together, and if it goes great, everybody wins; if it doesn’t work out as expected, then that’s just how the cookie crumbles. Typically, the most famous investors in venture, the ones that have had the biggest wins, operate in this manner.

The second set of investors focuses on achieving some minimum threshold return with significant downside protection. In the second bucket, the focus is more on generating 3-5x their money in 3-5 years with solid downside protection. Downside protection is typically revealed in term sheets through things like participating preferred preferences, cumulative dividends, minimum returns, and funding tranches based on milestones. There’s nothing wrong with these other than they have to be accounted for when thinking through the different scenarios of potential outcomes of the business as well as the type of financial sponsor desired.

The key is that there are two major categories of investors, whereby one is focused on unlimited upside, and the other is focused on a minimum return combined with downside protection. When fundraising, entrepreneurs should understand the two categories of investors and think through the pros and cons of being upside-focused or minimum return-focused.