Category Archives: Financing

Ten Questions Founder CEOs Should Always Be Able to Answer About Their Startups

I’m working with more early-stage companies these days (e.g., pre-seed, seed, seed-plus [1]) and one of the things I’ve noticed is that many founders cannot clearly, succinctly, and confidently answer some basic questions about their businesses.  I decided to write this post to help entrepreneurs ensure they have their bases are covered when speaking to angel investors, seed firms, or venture capitalists.

Note that Silicon Valley is the land of strong convictions, weakly held so it’s better in most cases to be clear, confident, and wrong than it is to waffle, equivocate, and be right.  I often have to remind people of this — particularly founders recently out of PhD programs — because Sand Hill Road is about the dead opposite of graduate school when it comes to this philosophy [2].

Here are ten questions that early-stage founder/CEOs should be able to answer clearly, succinctly, and confidently — along with a few tips on how to best answer them.

1. Who is the target customer?  Be precise, ideally right down to a specific job title in an organization.  It’s great if the answer will broaden over time as the company grows and its strategy naturally expands, but up-front I’d name the people you are targeting today.  Wrong:  “The Office of the CIO in IT organizations in F5000 enterprises around the world.”  Right:  “VPs of financial planning and analysis in 250-1000 employee Services firms in North America.” 

I’m admittedly fanatical about this, but I want to know what it says on the target buyer’s business card [3] .  I can’t tell you the number of times that I’ve heard “we sell to the CIO,” only to be introduced to someone whose business card said “director of data warehousing.”  If you don’t know who you’re selling to, you’re going to have trouble targeting them.

2. What problem do you solve for them?  When you meet one of these people, what do you tell them?  Right:  “We sell a solution that prevents spear phishing.”  Wrong:  “We sell a way to improve security culture at your organization” [4]. The latter answer is wrong because while an improvement in security culture may be a by-product of using your solution, it is not the primary benefit

First-order benefit:  our solution stops spear phishing.  Second-order benefit:  that means you avoid data breaches and/or save millions in ransomware and other breach-related costs.  Third-order benefit:  that means you protect your company’s reputation and your valuable brand.  Fourth-order benefit:  using our solution ends up increasing security culture and awareness.  People generally go shopping for the first-order benefit — they may buy into higher-order benefits, they may say they like your company’s approach and/or vision — but budgets and shopping lists get made on the first-order.  Don’t be selling security culture when customers are buying anti-spear-phishing.

3. How do they solve that problem today?  The majority of startups solve a problem that is already being solved in some way today.  Be realistic about this. Unless you are solving a brand-new problem (e.g., orchestrating containers at the dawn of the container revolution), then somehow the problem is either being solved today (e.g., in Excel, a legacy app, a homegrown system) or the buyer has deliberately decided not to solve it, likely because they think it’s unsolvable (e.g., baldness cures [5]).

If they are already solving the problem in some way, your new solution more likely represents an optimization than a breakthrough.  And even breakthrough companies, such as VMware [6], solved very practical problems early on (e.g., providing multiple environments on a laptop without having to physically change hard drives). 

As another example: even if you’re using advanced machine learning technology to automate trouble ticket resolution and — technically speaking, customers aren’t doing that today — they certainly are handling trouble tickets and the alternative to automatic resolution is generally a combination of human work and case deflection.

4. Why is your solution superior to the status quoOnce you can clearly describe how customers solve the problem today, then you should be able to clearly answer why your solution is superior to the status quo.  Note that I’m not asking how your technology works or why it’s superior — I’m asking why it provides a better solution for the customer. Sticking with the trouble ticket example:  “our solution is superior to human resolution because it’s faster (often by days if not hours), cuts ticket resolution cost by 90%, and results in greatly superior end-user satisfaction ratings.”  That’s a benefits-driven explanation of why it’s superior. 

5. Why is your technology different from that offered by other suppliers? Marketers call this differentiation and it’s not really just about why your technology is different from alternatives, it’s about why it’s better. The important part here is not to deep dive into how the technology works. That’s not the question; the question is why is your technology is better than the alternatives. The most common incorrect answer to this question is a long speech about how the technology works. (See this post for tips on how to build a feature, function, benefit marketing message.)

Example 1: traditional databases were built for and work well at storing structured data, but they have little or no capability for handling unstructured data. Unlike traditional databases, our technology is built using a hybrid of database and search engine technology and thus provides excellent capabilities for storing, indexing, and rapidly querying both structured and unstructured data.

Example 2: many planning systems require you to throw out the tool that most people use for planning today — Excel. Unlike those systems, our product integrates and leverages Excel as part of the solution; we use Excel formula language, Excel formatting conventions, and provide an Excel add-in interface that preserves and leverages your existing Excel knowledge. We don’t throw the baby out with the bathwater.

6. How many target customers have you spoken to — and what was their reaction to your presentation?  First, you means you, the founder/CEO.  It doesn’t mean your salesperson or co-founder.  The answer to the first part of the question is best measured in scores; investors want to know that you are in the market, talking with customers, and listening to their feedback.  They assume that you can sell the technology [7], the strategic question for later is the transferability of that skill.  They also want to know how target customers react to your presentation and how many of them convert into trials or purchases. 

7. Who’s using your product and why did they select it? It’s not hard to sell government labs and commercial advanced research divisions one of pretty much anything. It’s also not hard, in brand new categories, to sell your software to people who probably shouldn’t have purchased it — i.e., people not knowing all their options in the nascent market picked the wrong one. And that’s not to mention the other customers you can get for the wrong reason — because a board member had a friend on the executive staff, because someone was a big donor, etc. Customers “buy” (and I use air quotes become sometimes these early “customers” didn’t pay anything at all) the wrong software all the time, particularly in the early days of a market.

So the question isn’t who downloaded or tried your product, the question is who’s using it — and when they selected it did they know all their options and still choose you? Put differently, the question is “who’s not an accidental customer” and why did that set of non-accidental customers pick you over the alternative? So don’t give a list of company brand names who may or may not be active users. Instead tell a few deep stories of active customers (who they could ask to call), why they picked the software, and how it’s benefiting them.

8.  What is the TAM for solving this problem?   There are a lot of great posts about how to build a total available market (TAM) analysis, so I won’t explain how to do it here. I will say you should have a model that calculates an answer and be able to explain the hopefully simple assumptions behind that model. While I’m sure in b-school every VC undoubtedly said that “getting 1% of a $10B market is a bad strategy,” when they got into the workplace something changed. They all love big TAMs [8]. Telling a VC you’re aiming for 50% of an $800M TAM will not get you very far. Your TAM better be in the billions if not the tens of them.

9.  Why are you and your team the best people to invest in? Most interesting ideas attract several startups so, odds are, you have fairly direct competitors pretty much from inception. And, particularly if you’re talking with a VC at a larger firm, they have probably researched every company in the nascent space and met most of them [9]. So the question here is: (of all the teams I’ve met in this space) why are you the folks who are going to win?

I’d expect most startups in your space have smart people with strong educations, with great backgrounds at the right companies. That’s become the table stakes. The real question is thus why is your team of smart, well educated, and appropriately experienced people better than the others [10]:

  • A lot of this is confidence: “of course, we’re the right folks, because we’re the ones who are going to win.” Some people feel like they’re doing a homework assignment while others feel like they’re building a winning company. Be the latter. We know the stakes, we know the second prize is a set of steak knives, and we are going to win or die trying. #swagger
  • Drivers vs. passengers. Big successful enterprise software companies have definitionally employed a lot of people. So if you’re doing a sales-related category it’s not hard to companies full of ex-Siebel and ex-Salesforce people. The real question thus becomes: what did your people do at those prior companies? Were they drivers (who drove what) or were they passengers just along for the ride. If they drove, emphasize the amazing things they did, not just the brand names of where they worked.
  • Completeness. Some startups have relatively complete teams while others have only a CEO and CTO and a few functional directors. The best answer is a fairly complete team that’s worked together before. That takes a lot of hiring and on-boarding risk off the table. Think: give us money and we can start executing right away.
  • Prior exactly-relevant experience. Saying Mary was VP of ProductX Sales carrying a $500M number at BigCo is quite different from saying Mary just scaled sales at her last startup from $10M to $100M and is ready to do the exact same thing here. The smaller the gap between what people just did and what you’re asking them to do, the better.
  • Finally, and this is somewhat tongue in cheek, remember my concentric circles of fundraising from this post. How VCs see founders and entrepreneurs:

10.  If I give you money what are going to do with it? The quantitative part of this answer should already be in the three-year financial model you’ve built so don’t be afraid to reference that to remind people that your plan and financial model are aligned [11]. But then drill down and give the detail on where the money is planned to be spent. For extra credit, talk about milestone- or ARR-based spend triggers instead of dates. For example, say once we have 3 sales reps hitting their numbers we will go out and hire two more. The financial plan has that happening in July, but if July comes and we haven’t passed that milestone we won’t pull the trigger. Ditto for most hiring across the company. And ditto for marketing: e.g., we’ve got a big increase in programs budget in the second half of next year but we won’t release that money until we’re sure we’ve correctly identified the right marketing programs in which to invest.

It’s also very important that demonstrate knowledge of a key truth of VC-backed startups: each round is about teeing-up the next one. So the key goal of the Series A round should be to put the company in a position to successfully raise a Series B. And so on. Discuss the milestones you’re aiming to achieve that should support that tee-up process. And don’t forget the SaaStr napkin for getting a rough idea of what typical rounds look like by series.

Bonus: origin story. If I were to add one question it would be: tell me how you came to found your company? Or, using the more modern vernacular: tell me about your origin story? If yours is good and your founders are personable and videogenic, then I’d even make it into a short video, like the founders of Hashicorp did. You’re going to get asked this question a lot, so why not work on building the optimal answer and then videoing it.

# # #

Notes

[1] My, how things have changed.  The net result is that the new choke-point is series A (prediction 9).  Seed and angel money seems pretty easy to raise; A-rounds seem pretty hard — if you’ve already raised and spent $2M in seed capital then you should have something to show for it. 

[2] Most of the graduate student types I meet tend to be quite circumspect in their replies.  “Well, it could be this, but we don’t really know so it could be that.  Here are some arguments in favor of this and some against.”  In business, it’s better to be seen as decisive and take a clear stand.  As long as you are also perceived as open-minded and responsive to data, you can always change your mind later.  But you don’t want to be seen as fence-sitter, endlessly equivocating, and waiting for more data before making a decision.

[3] Or the more modern equivalent: an email footer or LinkedIn profile.

[4] Unless a company is shopping for training to improve security culture.  In which case, it’s a first-order benefit.

[5] Reminder that I have moral authority to talk about this :-). This type of problem is often called “latent pain” in sales, because it’s a pain the buyer is unaware they have because they don’t believe there is a solution. Ergo, they just get used to it. Thus, the first job of sales and marketing is to awaken the buyer to this latent pain.

[6] Yes, I know that virtual machines predate VMware considerably, particularly IBM’s VM/CMS operating system, so it wasn’t the creation of the virtual machine that I’d call a breakthrough, but using it to virtualize Microsoft and later Linux servers.

[7] If you can’t, it’s hard to assume that someone else will be able to.  Perhaps you’re not a natural-born seller, but if you were passionate enough about your idea to quit your job and found a company that should generally compensate.  Authenticity works.

[8] Most probably on the logic that they don’t want 1% of a $5B market, they want 40%. That is, they want both: big share and big TAM. And, if you mess up, there’s probably a safer landing net in the $5B market than the $500M one. Quoting the VC adage: great markets make great companies.

[9] This is the big difference between angels and funds. Angels typically meet one team with one idea, evaluate both and make a decision. Early-stage funds meet a company then research every company in the space and then pick a winner.

[10] I’m doing this in the abstract; it’s much easier in the concrete if you make a table and line up some key attributes of your team members vs. those of the competition. You use that table to come up with the arguments, but you don’t ever use that table externally with investors and others.

[11] I’m surprised how many folks dive into answer this question completely ignoring the fact that you’ve likely already put a three-year financial model in front of them that provides the high-level allocation of spend already. While it doesn’t seem to slow down some entrepreneurs, I think it far better to be a founder who refers to his plan a bit too much than a founder acts as if the financial plan doesn’t even exist.

Appearance on the Twenty Minute VC: Financing Thoughts, The Private Equity Sales Process, and More

Today famed venture capital podcaster and now venture capitalist at StrideVC, Harry Stebbings, released a new episode of the Twenty Minute VC podcast with me as his guest.  (iTunes version here.)

dk harry 500

Harry’s interview was broad-ranging, covering a number of topics including:

  • Financing lessons I’ve learned during prior bubble periods and, perhaps more importantly, bubble bursts.
  • The three basic types of exits available today:  strategic acquirer, old-school private equity (PE) squeeze play, and new-school PE growth and/or platform play.
  • A process view of exiting a company via a PE-led sales process, including discussion of the confidential information memorandum (CIM), indications of interest (IOIs), management meetings, overlaying strategic acquirers into the process, and the somewhat non-obvious final selection criteria.

The Soundcloud version, available via any browser is here.  The iTunes version is here.  Regardless of whether you are interested in the topics featured in this episode, I highly recommend Harry’s podcast and listen to it myself during my walking and/or driving time.

Oh, and if you like the content in this episode, don’t miss my first appearance on the show.

 

My Final Verdict on Multi-Year, Prepaid Deals

(Revised 5/4/19, 10:41 AM.)

After years of experience with and thinking about multi-year, prepaid SaaS deals, my mental jury is back in the box and the verdict is in:  if you’re a startup that is within my assumption set below, don’t do them.

Before jumping in, let me first define precisely what I mean by multi-year, prepaid deals and second, detail the assumptions behind my logic in response to some Twitter conversations I’ve had this morning about this post.

What do I Mean by Multi-Year Prepaid Deals?
While there are many forms of “multi-year prepaid deals,” when I use the term I am thinking primarily of a three-year agreement that is fully prepaid.  For example, if a customer’s ARR cost is 100 units for a one-year deal, you might approach them saying something akin to:

By default, our annual contracts have a 10% annual increase built in [1].  If you sign and prepay a three-year agreement, i.e., pay me 300 units within 60 days, then I will lock you in at the 100 units per year price.

Some people didn’t know these kinds of deals were possible — they are.  In my experience, particularly for high-consideration purchases (where the customer has completed a thorough evaluation and is quite sure the system will work), a fairly high percentage of buyers will engage in this conversation.  (In a world where companies have a lot of cash, a 10% return is a lot better than bank interest.)

Multi-year prepaid deals can take other forms as well:

  • The duration can vary:  I’ve seen anything from 2 to 7 years.
  • The contract duration and the prepaid duration can decouple:  e.g., a five-year deal where the first three years are prepaid.

But, to make it simple, just think of a three-year fully prepaid deal as the canonical example.

What are My Underlying Assumptions?
As several readers pointed out, there are some very good reasons to do multi-year prepaid deals [11].  Most of all, they’re a financial win/win for both vendor and customer:  the customer earns a higher rate of return than bank interest and the vendor gets access to capital at a modest cost.

If you’re bootstrapping a company with your own money, have no intention to raise venture capital, and aren’t concerned about complicating an eventual exit to a private equity (PE) or strategic acquirer, then I’d say go ahead and do them if you want to and your customers are game.

However, if you are venture-backed, intend to raise one or more additional rounds before an exit, and anticipate selling to either a strategic or private equity acquirer, then I’d say you should make yourself quite familiar with the following list of disadvantages before building multi-year prepaid deals into your business model.

Why do I Recommend Avoiding Multi-Year Prepaid Deals?
In a phrase, it’s because they’re not the norm.  If you want to raise money from (and eventually sell to) people who are used to SaaS businesses that look a certain way — unless you are specifically trying to disrupt the business model — then you should generally do things that certain way.  Multi-year prepaid deals complicate numerous things and each of those complications will be seen not as endemic to the space, but as idiosyncratic to your company.

Here’s the list of reasons why you should watch out.  Multi-year prepaid deals:

  • Are not the norm, so they raise eyebrows among investors and can backfire with customers [2].
  • Complexify SaaS metrics.  SaaS businesses are hard enough to understand already.  Multi-year deals make metrics calculation and interpretation even more complicated.  For example, do you want to argue with investors that your CAC payback period is not 18 months, but one day?  You can, but you’ll face a great risk of “dying right” in so doing. (And I have done so on more than one occasion [3]).
  • Amplify churn rates. An annual renewal rate [4] of 90% is equivalent to a three-year renewal rate of 72%.  But do you want to argue that, say, 79% is better than 90% [5] or that you should take the Nth root of N-year renewal rates to properly compare them to one-year rates?  You can, but real math is all too often seen as company spin, especially once eyebrows are already raised.
  • Turn your renewals rate into a renewals matrix.  Technically speaking, if you’re doing a mix of one, two, and three-year deals, then your renewal rate isn’t a single rate at all, but a matrix.  Do you want to explain that to investors?

renewals matrix

  • Tee you up for price knock-off at sales time.  Some buyers, particularly those in private equity (PE), will look at the relatively large long-term deferred revenue balance as “cashless revenue” and try to deduct the cost of it from an acquisition price [6].  Moreover, if not discussed up front, someone might try to knock it off what you thought was a final number.
  • Can reduce value for strategic acquirers.  Under today’s rules, for reasons that I don’t entirely understand, deferred revenue seems to get written off (and thus never recognized) in a SaaS acquisition.  So, ceteris paribus, an acquirer would greatly prefer non-prepaid TCV (which it will get to recognize over time) to deferred revenues (which it won’t) [7].
  • Can give pause to strategic acquirers.  Anything that might cause the acquirer to need to start release pro forma financials has the potential to scare them off, particularly one with otherwise pristine financial statements.  For example, having to explain why revenue from a recently acquired startup is shrinking year-over-year might do precisely that [8].
  • Can “inflate” revenues.  Under ASC 606, multi-year, prepaid deals are seen as significant financing events, so — if I have this correct — revenue will exceed the cash received [9] from the customer as interest expense will be recorded and increase the amount of revenue.  Some buyers, particularly PE ones, will see this as another form of cashless revenue and want to deflate your financials to account for it since they are not primarily concerned with GAAP financials, but are more cash-focused.
  • Will similarly inflate remaining performance obligation (RPO).  SaaS companies are increasingly releasing a metric called RPO which I believe is supposed to be a more rigorous form of what one might call “remaining TCV (total contract value)” — i.e., whether prepaid or not, the value of remaining obligations undertaken in the company’s current set of contracts.  If this is calculated on a GAAP basis, you’re going to have the same inflation issue as with revenues when multi-year, prepaid deals are involved.   For example, I think a three-year 100-unit deal done with annual payments will show up as 200 units of RPO but the same deal done a prepaid basis will show up as 200-something (e.g., 210, 220) due to imputed interest.
  • Impede analysis of billings. If you want to go public or get acquired by a public company, financial analysts are going to focus on a metric called calculated billings [10] which is equal to revenue plus the change in deferred revenue for a given time period.  For SaaS purist companies (i.e., those that do only annual contracts with one-year prepays), calculated billings is actually a pretty good measure of new sales.  Multi-year prepays impede analysis of billings because deferred revenue ends up a mishmash of deals of varying lengths and is thus basically impossible to interpret [11].  This could preclude an acquisition by a SaaS purist company [12].

More than anything, I think when you take these factors together, you can end up with complexity fatigue which ultimately takes you back to whether it’s a normal industry practice.  If it were, people would just think, “that’s the complexity endemic in the space.” If it’s not, people think, “gosh, it’s just too darn hard to normalize this company to the ones in our portfolio [13] and my head hurts.”

Yes, there are a few very good reasons to do multi-year, prepaid deals [14], but overall, I’d say most investors and acquirers would prefer if you just raised a bit more capital and didn’t try to finance your growth using customer prepayments.  In my experience, the norm in enterprise software is increasingly converging to three-year deals with annual payments which provide many of the advantages of multi-year deals without a lot of the added complexity [15].

# # #

Notes

[1] While 10% is indeed high, it makes the math easier for the example (i.e., the three-year cost is 331 vs. 300).  In reality, I think 5-6% is more reasonable, though it’s always easier to reduce something than increase it in a negotiation.

[2] Especially if your competition primes them by saying — “those guys are in financial trouble, they need cash, so they’re going to ask you for a multi-year, prepaid deal.  Mark my words!”

[3] Think:  “I know the formula you’re using says ’18 months’ but I’m holding an invoice (or, if you wait 30 days, check) in my hand for more than the customer acquisition cost.”  Or, “remember from b-school that payback periods are supposed to measure risk, no return, and to do so by measuring how long your money is on the table.”  Or, “the problem with your formula is you’re producing a continuous result in a world where you actually only collect modulo 12 months — isn’t that a problem for a would-be ‘payback’ metric?”

[4] Renewal rate = 1 – churn rate

[5] That is, that a 79% three-year rate is ergo better than a one-year 90% renewal rate.

[6] Arguing that while the buyer will get to recognize the deferred revenue over time that the cash has already been collected, and ergo that the purchase price should be reduced by the cost of delivering that revenue, i.e., (COGS %) * (long-term deferred revenue).

[7] Happily, the deferred revenue write-down approach seems to be in the midst of re-evaluation.

[8] If the acquired company does a high percentage of multi-year, prepaid deals and you write off its deferred revenue, it will certainly reduce its apparent growth rate and possibly cause it to shrink on a year-over-year basis.  What was “in the bag revenue” for the acquired company gets vaporized for the acquirer.

[9] Or our other subsidiaries, for a strategic acquirer.

[10]  Known either as billings or calculated billings.  I prefer the latter because it emphasizes that it’s not a metric that most companies publish, but one commonly derived by financial analysts.

[11] We are testing the limits of my accounting knowledge here, but I suppose if deferred revenue is split into current and long-term you might still be able to get a reasonable guestimate for new ARR sales by calculating billings based only on current, but I’m not sure that’s true and worry that the constant flow from long-term to current deferred revenue will impede that analysis.

[12]  A purist SaaS company — and they do exist — would actually see two problems.  First, potential year-over-year shrinkage due to the write-down discussed in footnote [7].  Second, they’d face a dilemma in choosing between the risk associated with immediately transitioning the acquired company’s business to annual-only and the potential pollution of its otherwise pristine deferred revenue if they don’t.

[13] Minute 1:28 of the same video referenced in the prior link.

[14] Good reasons to do multi-year, prepaid deals include:  (a) they are arguably a clever form of financing using customer money, (b) they tend to buy you a second chance if a customer fails in implementation (e.g., if you’ve failed 9 months into a one-year contract, odds are you won’t try again — with a three-year, prepay you might well), (c) they are usually a financing win/win for both vendor and customer as the discount offered exceeds the time value of money.

[15] You do get one new form of complexity which is whether to count payments as renewals, but if everyone is doing 3-year, annual payment deals then a norm will be established.

Rule of 40 Glideslope Planning

Enterprise SaaS companies need a lot of money to grow. The median company spends $1.32 to acquire $1.00 in annual recurring revenue (ARR) [1].  They need to make that investment for 14 years before getting to an IPO.  It all adds up to a median of $300M in capital raised prior to an IPO.

With such vast amounts of money in play, some say “it’s a growth at all costs” game.  But others hold to the Rule of 40 which attempts to balance growth and profitability with a simple rule:  grow as fast as you want as long as your revenue growth rate + your free cashflow margin >= 40%.

The Rule of 40 gets a lot of attention, but I think that companies are not asking the right question about it.  The right question is not “when should my growing startup be Rule of 40 compliant?” [2]

For more than half of all public SaaS companies, the answer to that question, by the way, is “not yet.”  Per multiple studies I’ve read the median Rule of 40 score for public SaaS companies is ~31%, meaning that more than half of public SaaS companies are not Rule of 40 compliant [3].

So, unless you’re an absolutely amazing company like Elastic (which had a Rule of 40 score of 87% at its IPO), you probably shouldn’t be unrealistically planning to become Rule of 40 compliant three years before your IPO [4].  If you do, especially if you’re well funded and don’t need additional expense constraints, you might well compromise growth with a premature focus on the Rule of 40, which could shoot off your corporate foot in terms of your eventual valuation.

If “when should we be Rule of 40 compliant” is the wrong question, then what’s the right one?

What should my company’s Rule of 40 glideslope be?

That is, over the next several years what is your eventual Rule of 40 score target and how do you want to evolve to it?  The big advantage of this question is that the answer isn’t “a year” and it doesn’t assume Rule of 40 compliance.  But it does get you to start thinking about and tracking your Rule of 40 score.

I built a little model to help do some what-if analysis around this question.  You can download it here.

r40-1

In our example, we’ve got a 5 year-old, $30M ARR SaaS company planning the next five years of its evolution, hopefully with an IPO in year 8 or 9.  The driver cells (orange) define how fast you want to grow and what you want your Rule of 40 glideslope to be.  Everything else is calculated.  At the bottom we have an overall efficiency analysis:  in each year how much more are we spending than the previous year, how much more revenue do we expect to get, and what’s the ratio between the two (i.e., which works like kind of an incremental revenue CAC).  As we improve the Rule of 40 score you can see that we need to improve efficiency by spending less for each incremental dollar of revenue.  You can use this as a sanity check on your results as we’ll see in a minute.

Let me demonstrate why I predict that 9 out 10 ten CFOs will love this modeling approach.  Let’s look at every CFO’s nightmare scenario.  Think:  “we can’t really control revenues but we can control expenses so my wake up in the middle of the night sweating outcome is that we build expenses per the plan and miss the revenues.”

r40-2

In the above (CFO nightmare) scenario, we hold expenses constant with the original plan and come in considerably lighter on revenue.  The drives us miles off our desired Rule of 40 glideslope (see red cells).  We end up needing to fund $42.4M more in operating losses than the original plan, all to generate a company that’s $30.5M smaller in revenue and generating much larger losses.  It’s no wonder why CFOs worry about this.  They should.

What would the CFO really like?  A Rule-of-40-driven autopilot.

As in, let’s agree to a Rule of 40 glideslope and then if revenues come up short, we have all pre-agreed to adjust expenses to fall in line with the new, reduced revenues and the desired Rule of 40 score.

r40-3

That’s what the third block shows above.  We hold to the reduced revenues of the middle scenario but reduce expenses to hold to the planned Rule of 40 glideslope.  Here’s the bad news:  in this scenario (and probably most real-life ones resembling it) you can’t actually do it — the required revenue-gathering efficiency more than doubles (see red cells).  You were spending $1.38 to get an incremental $1 of revenue and, to hold to the glideslope, you need to instantly jump to spending only $0.49.  That’s not going to happen.  While it’s probably impossible to hold to the original {-10%, 0%, 5%} glideslope, if you at least try (and, e.g., don’t build expenses fully to plan when other indicators don’t support it), then you will certainly do a lot better than the {-10%, -32%, -42%} glideslope in the second scenario.

In this post, we’ve talked about the Rule of 40 and why startups should think about it as a glideslope rather than a short- or mid-term destination.  We’ve provided you with a downloadable model where you can play with your Rule of 40 glideslope.  And we’ve shown why CFOs will inherently be drawn to the Rule of 40 as a long-term planning constraint, because in many ways it will help your company act like a self-righting ship.

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Notes

[1] The 75th percentile spends $1.92.  And 25% spend more than that.  Per KeyBanc.

[2] Rule of 40 compliant means a company has an rule of 40 score >= 40%.  See next note.

[3] Rule of 40 score is generally defined as revenue growth rate + free cashflow (FCF) margin.  Sometimes operating margin or EBITDA margin is used instead because FCF margin can be somewhat harder to find.

[4] I’m trying to find data a good data set of Rule of 40 scores at IPO time but thus far haven’t found one.  Anecdotally, I can say that lots of successful high-growth SaaS IPOs (e.g., MongoDB, Anaplan, and Blackline) were not Rule of 40 compliant at IPO time — nor were they well after, e.g., as of Oct 2018 per JMP’s quarterly software review.  It seems that if growth is sufficiently there, that the profitability constraint can be somewhat deferred in the mind of the market.

Highlights from the Fenwick & West 3Q18 Venture Capital Survey

It’s been a few years since I wrote about this survey, which I post about less to communicate recent highlights and more to generate awareness of its existence.  The Fenwick & West Venture Capital Survey is must-read material for any entrepreneur or startup CEO because it not only makes you aware of trends in financing, but also provides an excellent overview of venture capital terminology as well as answering the important question of “what’s normal” in today’s venture funding environment (also known as “what’s market.”)

So if you’re not yet subscribed to it, you can sign up here.

3Q18 F&W Venture Capital Survey Highlights

  • 215 VC financing rounds were closed by companies with headquarters in Silicon Valley
  • Up rounds beat down rounds 78% to 9%
  • The average price increase (from the prior round) was 71%
  • 24% of rounds had a senior liquidation preference
  • 8% of rounds had multiple liquidation preferences
  • 11% of rounds has participation
  • 6% of rounds had cumulative dividends
  • 98% of rounds had weighted-average anti-dilution provisions
  • 2% of rounds had pay-to-play provisions
  • 6% of rounds had redemption rights

In summary, terms remained pretty friendly and valuations high.  Below is Fenwick’s venture capital barometer which focuses on price changes from the prior financing round.  It’s a little tricky to interpret because the amount of time between rounds varies by company, but it does show in any given quarter what the price difference is, on average, across all the financings closed in that quarter.  In 3Q18, it was 71%, slightly down from the prior quarters, but well above the average of 57%.

vc barometer

 

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