Category Archives: Startups

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.

 

The Market Leader Play: How to Run It, How to Respond

Business-to-business (B2B) high technology markets are all about the market and only less so about the technology.  This is primarily driven by corporate buyer conservatism — corporate buyers hate to make mistakes in purchasing technology and, if you’re going to make one, it’s far better to be in the herd with everyone else, collectively fooled, than to be out on your own having picked a runner-up or obscure vendor because you thought they were “better.”  Hence, high-technology markets have strong increasing returns on market leadership.  I learned this live, in the trenches, way back in the day at Ingres.

Uh, Dave, please stop for a second.  Thank you.  Thanks so much for coming out to visit us here at BigCo today.  Before you begin your presentation, we wanted you to know that if you simply convince us that Ingres is as good as Oracle that we’re going to chose Oracle.  In fact, I think you’re going to need to convince us that Ingres is 30% to 40% better than Oracle before we’d realistically consider buying from your company.  You may now go ahead with your presentation.

Much as I hated it on that day, what a great position for Oracle to be in!  Somehow, before the product evaluation cage-fight had even begun, Oracle walked into the cage with a 40% advantage — brought to them by their corporate marketing department, and which was all about market leadership.

Why do corporate buyers care so much about buying from market leaders?

  • Less project risk.  If everyone else is buying X, it must be good enough, certainly, to get the job done.
  • Less embarrassment risk.  If the project does fail and you’re using the leading vendor, it’s much less embarrassing than if you’re on an obscure runner-up.  (“Well, I guess they fooled us all.”) [1]
  • Bigger technology ecosystem.  In theory, market leaders have the most connectors to other systems and the most pre-integrated complementary technologies.
  • Bigger skillset ecosystem.  Trying to find someone with 2+ years of experience with, e.g., Host Analytics or Adaptive Insights is way easier than trying to find someone with 2+ years of experience with Budgeta or Jedox.  More market share means more users means you can find more skilled employees and more skilled partners.
  • Potential to go faster.  Particularly for systems with low purchase and low switching costs, there’s a temptation to bypass an evaluation altogether and just get going.  Think:  “it’s the leader, it’s $35K/year, and it’s not that hard to change — heck, let’s just try it.”

Thus, relatively small differences in perceived or actual market leadership early on can generate a series of increasing returns through which the leading vendor wins more deals because it’s the leader, becomes relatively larger and thus an even more clear leader, then wins yet a higher percentage of deals, and so on.  Life for the leader is good, as the rich get richer.  For the others, life is a series of deals fighting from behind and, as they said in Glenngarry Glenn Ross, second prize really is a set of steak knives.

This is why smart vendors in greenfield markets fight for the market leadership position as if their corporate lives depended on it.  Sometimes, in this game of high-stakes, winner-takes-all poker companies cross boundaries to create a perception of success and leadership that isn’t there. [2]

When run correctly — and legally — the goal of the market leader play (MLP) is to create a halo effect around the company.  So how do you run the market leader play?  It comes down to four areas:

  • Fundraising.  Get the biggest name investors [3], raise the most capital, make the most noise about the capital you’ve raised, and use the money to make a few big-name hires, all in an effort to make it clear that Sand Hill Road has thoroughly evaluated the company and its technology and chosen you to be the leader.
  • Public relations and corporate awareness. Spend a nice chunk of that capital on public relations [4].  Have the CEO speak at the conferences and be quoted or by-line articles in the right tech blogs.  Better yet, hire a ghost-writer to author a book for the CEO as part of positioning him/her as a thought leader in the space.  If applicable, market your company’s culture (which is hopefully already documented in a one-hundred slide deck).  Spend big bucks to hold the biggest user conference in the space (which of course cannot be labeled as a user conferenced but instead an industry event with its own branding).  Use billboards to make sure the Digerati and other, lesser denizens of Silicon Valley know your company’s name.  Think:  shock and awe for any lesser competitor.
  • Growth.  Spend a ton of that capital to hire the biggest sales force, wisely first building out a world-class onboarding and enablement program, and then scaling as aggressively as you can.  In enterprise software new sales = number of reps * some-constant, so let’s make sure the number of reps is growing as fast, and perhaps a little faster, than it wisely should be.  Build out channels to increase the reach of your fast-growing sales force and don’t be cheap, during a market-share grab, about how you pay them.  In the end, Rule of 40 aside, hotness in Silicon Valley is really about one thing:  growth.  So get hot by buying the most customers most quickly. [5]
  • Strategic relationships.  Develop strategic relationships with other leading and/or cool companies on the theory that leaders work with leaders.  These relationships can vary from a simple co-marketing arrangement (e.g., Host Analytics and Floqast) to strategic investments (e.g., Salesforce Ventures invests in Alation) to white label re-sale deals (e.g., NetSuite’s resales of Adaptive Insights as NetSuite Planning), and many others.  But the key is to have the most and best strategic relationships in the category.
  • Denial of differentiation.  While you should always look forward [6] when it comes to external communications, when it comes to competitive analysis keep a keen eye looking backward at your smaller competitors.  When they see you running the market leader play, they will try various moves to differentiate themselves and you must immediately deny all such attempts at differentiation by immediately blocking them.  Back in the day, Oracle did this spectacularly well — Ingres would exhaust itself pumping out new/differentiated product (e.g., Ingres/Star) only to have Oracle immediately announce a blocking product either as a pure futures announcement (e.g., Oracle 8 object handling) or a current product launch with only the thinnest technical support (e.g., Oracle/Star).  Either way, the goal is for the mind of the buyer to think “well the leading vendor now does that (or shortly will), too.”  Denying differentiation gives the customer no compelling reason to buy from a non-leader and exhausts the runners-up in increasing futile and esoteric attempts at differentiation.

So that, in a nutshell, is how creating a leader is done.  But what if, in a five-vendor race, you’re not teed up to be the leader.  You haven’t raised the most capital.  You’re not the biggest or growing the fastest.  Then what are you supposed to do to combat this seemingly air-tight play?

Responding to the Market Leadership Play
I think there are three primary strategic responses to the market leadership play.

  • Out-do.  If you are in the position to simply out-do the flashy competitor, then do it.  Enter the VC arms raise — but like any arms race you must play to win. [7]  Raise more capital than they do, build your sales force faster, get even better strategic relationships and simply out-do them.  Think:  “yes, they were on a roll for a while but we are clearly the leader now.”  Cloudera did this to Hortonworks.
  • Two-horse race.  If you can’t win via out-do, but have a strong ability to keep up [8], then reframe the situation into a two-horse race.  Think:  “no, vendor X is not the leader, this market is clearly a two-horse race.”  While most B2B technology markets converge to one leader, sometimes they converge to two (e.g., Business Objects and Cognos).  Much as in a two-rider breakaway from the peloton, number 1 and 2 can actually work together to distance themselves from the rest.  It requires a certain cooperation (or acceptance) from both vendors to do this strategy, but if you’re chasing someone playing the leadership play you can exhaust their attempts to exhaust you by keeping up at every breakaway attempt.
  • Segment leadership.  If you can’t out-do and you can’t keep up (making the market a two-horse race) then have two options:  be a runner-up in the mainstream market or a be a leader in a segment of it.  If you stay a runner-up in the mainstream market you have the chance of being acquired if the leader rebuffs acquisition attempts.  However, more often than not, when it comes to strategic M&A leaders like to acquire leaders — so a runner-up-but-get-acquired strategy is likely to backfire as you watch the leader, after rebuffing a few takeover attempts, get acquired at a 10x+ multiple.  You might argue that the acquisition of the leader creates a hole in the market which you can then fill (as acquired companies certainly do often disappear within larger acquirers), but (unless you get lucky) that process is likely to take years to unfold.  The other choice is to do an audit of your customers, your product usage, and your skills and focus back on a product or vertical segment to build sustainable leadership there.  While this doesn’t preserve horizontal M&A optionality as well as being a runner-up, it does allow you to build sustained differentiation against the leader in your wheelhouse.

# # #

Notes

[1] Or, more tritely, “no one ever got fired for buying IBM” back in the day (communicated indirectly via ads like this), which might easily translate to “no one ever got fired for buying Oracle” today.

[2] Personally, I feel that companies that I’ve competed against such as MicroStrategy, FAST Search & Transfer, and Autonomy at various points in their history all pushed too hard in order to create an aura of success and leadership.  In all three cases, litigation followed and, in a few cases, C-level executives even went to jail.

[3] Who sometimes have in-house marketing departments to help you run the play.

[4] In accordance with my rule that behind every “marketing genius” is a big marketing budget.  You might argue, in fact, that allocating such a budget the first step of the genius.

[5] And build a strong customer success and professional services team to get those customers happy so they renew.  Ending ARR growth is not just about adding new sales to the bucket, it’s about keeping what’s in the bucket renewing.

[6] That is, never “look back” by mentioning the name of a smaller competitor — as with Lot’s Wife, you might well end up a pillar of salt.

[7] If you’re not committed to raising a $100M round after they raise a $75M round in response to your $50M round, then you shouldn’t be in an arms race.  Quoting The Verdict, “we’re not paid to do our best, we’re paid to win.”  So don’t a pick fight where you can’t.

[8] This could be signalled by responding to the archrival’s $50M round with a $50M round, as opposed to a $75M.

The Rule of 40 — Down, But Not Out!

Neeraj Agrawal and Logan Bartlett of Battery Ventures recently published the 2019 version of its outstanding annual software round-up report.  I highly recommend this report — it’s 78-pages chock full of great data about topics like:

  • Why Battery is long software overall
  • The four eras of software evolution
  • The five forces driving software’s accelerating growth
  • Key trends in 2018, including setting records in three areas:  (1) public company revenue multiples, (2) IPO volume (by over 2x), and (3) M&A volume (by over 2x).
  • Key trends from their 2017 report that are still alive, well, and driving software businesses.

But, most of all, it has some great charts on the Rule of 40 [1] that I want to present and discuss here.  Before doing that, I must note that I drank today’s morning coffee reading Alex Clayton’s CloudStrike IPO breakdown, a great post about a cloud security company with absolutely stunning growth at scale — 121% growth to $312M in Ending ARR in FY19.  And, despite my headline, well in compliance with the Rule of 40.  110% revenue growth + -26% free cashflow margin = 84%, one of the highest Rule of 40 scores that I’ve ever seen [2].  Keep an eye on this company, I expect it should have a strong IPO [3].

However, finding one superstar neither proves nor disproves the rule.  Let’s turn to the Battery data to do that.

When discussing the Rule of 40, most financial analysts make one of two plots.

  • They do a scatter plot with revenue growth on the X-axis and FCF margin on the Y-axis.  The Rule of 40 then becomes a line that separates the chart into two zones (compliant and non-compliant).  Note that a minority of public companies actually comply suggesting the rule of 40 is a pretty high bar [4].
  • Or, more interestingly, they do a linear regression of Rule of 40 score vs. enterprise-value/revenue (EV) multiple.  This puts focus on the question:  what’s the relationship between Rule of 40 score and company value? [5]

But that thing has always bugged me is that nobody does the linear regression against both the Rule of 40 score and revenue growth.  Nobody, until Battery.  Here’s what it shows.

First, let’s look at the classic Rule of 40 regression.  Recall that R-squared is a statistical measure that explains the dependence of the dependent variable (in this case, EV multiple) on the independent variable (Rule of 40 score).  Here you can see that about 58% of the variation in enterprise value multiple is explained by Rule of 40 score.  You can intuit that by looking at the dots relative to the line — while there is clearly some linear correlation between the data, it’s a long way from perfect (i.e., lots of dots are pretty far from the line).  [6]

rule of 40-4

Now, the fun part.  Let’s see the same regression against revenue growth alone.  R-squared here is 51%.  So the explanatory power of the Rule of 40 is only 7% higher than revenue growth alone.  Probably still worth looking at, but it sure gets a lot of PR for explaining only an incremental 7%.  It could be worse, I suppose.  Rule of 40 could have a lower R-squared than revenue growth alone — in fact, it did back in 2008 and in 2012.

rule of 40-3

In the vein, for some real fun let’s look at how this relationship has changed over time.  The first thing you’ll notice is that pre-2012 both last twelve month (LTM) revenue growth and the Rule of 40 had far weaker explanatory power, I suspect because profitability played a more important role in the equation.  In 2012, the explanatory power of both metrics doubled.  In 2015 and 2016 the Rule of 40 explained nearly 20% more than revenue growth alone.  In 2017 and 2018, however, that’s dropped to 7 to 8%.

rule of 40-2

I still think the Rule of 40 is a nice way to think about balancing growth vs. profit and Rule of 40 compliant companies still command a disproportionate share of market value.  But remember, its explanatory power has dropped in recent years and, if you’re running an early or mid-stage startup, there is very little comparative data available on the Rule of 40 scores of today’s giants when they were at early- or mid-stage scale.  That’s why I think early- and mid-stage startups need to think about the Rule of 40 in terms of glideslope planning.

Thanks to the folks at Battery for producing and sharing this great report. [7]

# # #

Notes
[1] Rule of 40 score = typically calculated as revenue growth + free cashflow (FCF) margin.  When FCF margin is not available, I typically use operating margin.   Using GAAP operating margin here would result in 110% + -55% = 55%, much lower, but still in rule of 40 compliance.

[2] If calculated using subscription revenue growth, it’s 137% + -26% = 111%, even more amazing.  One thing I don’t like about the fluidity of Rule of 40 calculations, as you can see here, is that depending what might seem small nuances in calculations, you can produce a very broad range of scores.   Here, from 55% to 137%.

[3] To me, this means ending day 1 with a strong valuation.  The degree to which that is up or down from the opening price is really about how the bankers priced the offer.  I am not a financial analyst and do not make buy or sell recommendations.  See my disclaimers, here.

[4] In fact, it’s actually a double bar — first you need to have been successful enough to go public, and second you need to clear the Rule of 40.  Despite a minority of public companies actually clearing this bar, financial analysts are quick to point out the minority who do command a disproportionate share of market cap.

[5] And via the resultant R-squared score, to what extent does the Rule of 40 score explain (or drive) the EV/R multiple?

[6] If R-squared were 1.0 all the dots would fall on the least-squares fit line.

[7] Which continues with further analysis, breaking the Rule of 40 into 4 zones.

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 than a norm will be established.

Reacting to Feedback as CEO

The other day I saw this tweet from my friend Nick Mehta, CEO of GainSight, and it got me thinking.

feedback

It turns out that in addition to making fun music videos for company events, that Nick and I have another thing in common:  we both wrestle with finding the right balance in listening to feedback.  Since this is a topic I’ve pondered quite a bit over my 12+ years as a startup CEO, I thought I’d share those thoughts in this post.

First, you don’t get to be CEO of a startup by not caring.  You want your company to be great, you want your customers to be delighted, and you want your employees to be happy working at your company.  So I think most CEOs will have that same natural tendency towards immediate action that Nick mentions.

But CEOs who overreact both irritate employees (“so you’ve heard one side of this and it sounds like you’ve already made up your mind”) and, more dangerously, are easily manipulated.  If you find 3 people outside your office before a big meeting, each hoping to the last one to talk to you before it begins, then I’d view that as flashing yellow sign that you might be an overreactor.

On the flip side, there is some chance that the feedback is an outlier, and that reacting to it would be a mistake, particularly in terms of the opportunity cost of not having focused on something more generally important.

Finding that balance in the middle is indeed the hard part.  On one hand, CEOs are action-oriented and if they hear something plausible, they want to immediately dispatch someone to fix it.  On the other, CEOs get lots of feedback and it’s a little too easy to create a platitude shield around yourself that rationalizes feedback before it gets through — e.g., salespeople are never happy with their comp plans, employees generally don’t like their bosses, and customers always want more for their services dollar.  If you gave me 30 minutes I think I could generate about ten platitudes that would screen out 90% of feedback.  And that’s not good either.

So what should you do to find this balance?  Here are some tips:

  • Listen to everyone, all the time.  Ask open-ended questions.  For example:  “how’s your experience been working here”, “what are we like to work with as a customer”,  or “what do you think we can do better.”  Rule 1 is you’re not listening if you’re talking, so speak little and listen a lot.  Try to set up meetings as listening or feedback sessions as opposed to the default that “our CEO wants to come in and talk to you.”  Reframe it:  “our CEO wants to come in and listen to you, hear about your project, etc.”  The more feedback you get the harder it is to overreact to any one piece.
  • Remember that people have good days and bad days so do not overreact to any one incident.  (If someone really unloads on you, listen politely, take notes, and set up a follow-up call in a week or two to check back in.)
  • Listen no matter what you’re hearing.  You might hear things that are factually wrong.  You might hear things you find offensive.  You might hear things you immediately want to explain.  Recognize these as defensive reactions (even if they are appropriate defensive reactions) and remember Rule 2:  defensiveness kills communications.  Shut up, let the other person keep talking, take notes about any points you want to clarify, and discuss them at the end of the conversation.
  • Ask the “dead moose” question.  Is there any issue so big and glaring that we’re afraid to talk about and it’s like a giant dead moose in the middle of the conference room table that we’re all ignoring as we converse?  This gives people permission to put the big, often obvious, but potentially dangerous issues on the table — and get the moose off it)
  • Remember that people sometimes have agendas that shape their feedback.  Not all feedback is “pure” or unbiased in the sense that it’s a neutral voice wanting what it perceives as best for the company.  Maybe a customer is in the middle of negotiating a big contract.  Maybe an employee is angry about having missed a promotion.  Maybe a manager is trying to reorganize a department.  There’s nothing wrong with having an agenda, but it helps to know what it is when processing feedback.  Ask:  is there any bigger picture item that’s shaping this feedback overall?
  • When it comes to employee incidents, remember there are three sides to every story:  yours, mine, and what actually happened.  If you react to the first person you hear, then you’ll be teeing up a race to your office after every dispute because (as with patents) the first one to the office wins.  When faced with interpersonal disputes, remember my friend Martin Cooke’s favorite question:  “so what did Joe say when you spoke to him about this?”  If they’ve not spoken yet, then send them off to do so.
  • Beware hearsay.  It’s not allowed in court, so perhaps it shouldn’t be allowed in your office.  I don’t want to spend time with Pete saying he heard Paula say something offensive to Joe.  Tell Joe to come see me.  Or go find Joe yourself.  But we’ve all played the telephone game and know what happens to messages as they told and re-told through layers of people.
  • Remember that “not reacting now” is not the same as “not reacting.”  This is very important because “not reacting now” is probably the right answer 90% of the time.  Write it down.  Think about it.  Schedule a meeting.  But resist — and I know it’s hard — any action-oriented tendency to “do something” right now.  Once you get a reputation for going off half-cocked it’s pretty hard to shake — and very easy to get manipulated.  Time is usually your friend.
  • Remember, the plural of anecdote is not data.  Hearing the same story or opinion two to three times doesn’t automatically turn it into data.  Use surveys to gather data and use all your feedback conversations to guide topical questioning in those surveys.
  • Go get data.  You should already be running quarterly customer surveys and bi-annual or quarterly employee surveys.  Study the data in them.  Use what you’ve heard listening to people to drive special, topical lines of questioning within them.  Or, if indicated, do a special topic survey.  Once you’ve done the survey, call an optional Town Hall meeting to discuss the results.
  • Remember that 80% of an employee’s experience at your company is shaped by their manager (and, as a corollary that 80% of a customer’s experience is shaped by their account manager).  Ask specific questions about both in your surveys and when hot spots light up, go dig into them (i.e, why are so many of Joe’s employees rating him poorly on management).  Most companies are small enough that the digging can be done by live 1-1 meetings or phone calls.
  • View external data with a skeptical eye.  You can’t ignore the fact that product and company review sites exist.  All review sites have limitations — competitors can launch coordinated attacks to decrease your scores while HR can launch proactive programs to increase your scores.  My controversial advice for CEOs is to ignore these sites yourself and put your VP of Marketing in charge of product review sites and your VP of People on company review sites.  If you start to personally and immediately respond to these public posts, you are basically incenting employees to raise gripes in a public forum, as opposed to a private one such as your employee survey or coming to you directly.

Let me thank Nick for putting an important question on the table.  If you have other tips on how to answer it, please share them here.

The Two Dimensions of Startup Performance

When it comes to evaluating a startup’s performance, I think there are two key, orthogonal questions that need to be examined:

  1. Is the company delivering growth?
  2. Is management in control of your business?

Growth is the primary driver of value creation in a software startup.  I’m not going to quantify what is good vs. bad growth here – it’s a function of too many other variables (e.g., state of market, stage of startup).  For a seed stage company 100% growth (e.g., from $200K to $400K in ARR) is not particularly good, whereas 40% growth off $150M is quite strong.  So, the first question is — given the company’s size and situation — is it delivering good growth?

The second question is whether management is in control of the business.  I evaluate that in two ways:  how often does the company miss its quarterly operating plan targets and how often does the company miss its early-quarter (e.g., week 3) forecast for sales, expenses, and cash burn?

You can combine these two dimensions into a quadrant.

startup perf quadrant

Let’s take a look at companies in each of these quadrants, describe the situation they’re in, and offer some thoughts on what to do.

Moribund Startups
Companies that are moribund are literally on death’s door because they are not creating value through growth and, worse yet, not even in control of their business.  They make annual plans that are too aggressive and continually miss the targets set within them.  Worse yet, they also miss quarterly forecasts, forecasting sales of 100 units in week 3, 80 units in week 12, and delivering sales of only 50 units when the quarter is done.  This erodes the board’s faith in management’s execution and makes it impossible for the company to manage expenses and cash.  Remember Sequoia founder Don Valentine’s famous quote:

“All companies go out of business for the same reason.  They run out of money.” — Don Valentine, Sequoia Capital

While there may be many reasons why a moribund company is not growing, the first priority needs to getting back in control of the business:  setting realistic annual operating plans, achieving them, and having reliable early-quarter (e.g., week 3) forecasts for sales, expense, and cash burn.  I think in their desperation to grow too many moribund startups fail to realize that getting back in control should be done before trying to rejuvenate growth and thus die doing neither.

Put differently, if you’re going to end up delivering sub-par growth, at least forecast it realistically so you will still be in control of your business and thus in a far better position to either turnaround operations or pivot to a better strategic place.  Without control you have nothing, which is what your business will soon be worth if you don’t regain it.

Stuck Startups
Stuck companies face a different set of problems.  The good news is that they are in control of the business:  they make and hit their plans, they come in at or above their forecasts.  Thus, they can manage their business without the risk of suddenly running out of cash.  The bad news is that they’re not delivering sufficient growth and ergo not creating value for the shareholders (e.g., investors, founders, and employees).  Stuck companies need to figure out, quickly, why they’re not growing and how to re-ignite growth.

Possible reasons for stalled growth include:

  • Lack of product-market fit. The company has never established that it solves a problem in the market that people are willing to pay (an amount compatible with your business model) to solve. You may have built something that nobody wants at all, or something that people are not simply willing to pay for.  This situation might call for a “pivot” to an adjacent market.
  • Poor sales & marketing (S&M) execution. While plenty of startups have weak S&M organizations, a lot of deeper problems get blamed by startup boards on S&M.  Why?  Because most boards/investors want to believe that S&M is to blame for company performance problems because S&M issues are easier to fix than the alternatives:  just fire the VP of Sales and/or Marketing and try again.  After all, which would you rather be told by doctor?  That your low-grade fever and weakness is due to the flu or leukemia?  The risk is that through willful misdiagnosis you keep churning S&M executives without fixing (or even focusing on) a deeper underlying problem. [1]
  • Weak competitive positioning. Through some combination of your product and product marketing, customers routinely short-list you as a contender, but buy from someone else.  Think: “we seem to be everyone’s favorite second choice.”  This can be driven by anything from poor product marketing to genuine product shortcomings to purely corporate factors (e.g., such as believing you have a fine product, but that your company will not be a winner in the market).

Stuck companies need to figure out, with as much honesty as possible with themselves, their customers, and their prospects, why they are stuck and then take appropriate steps to fix the underlying causes.  In my opinion, the hard part isn’t the fixes – they’re pretty obvious once you admit the problems.  The hard part is getting to the unpleasant truth of why the company is stuck in the first place. [2]

Unbridled Startups
Like Phaeton driving his father’s chariot [3], the unbridled startup is growing fast, but out of control, and thus risks getting too close to the Sun and burning up or simply smashing into the ground.  Unbridled startups typically are delivering big growth numbers – but often those big numbers are below the even bigger numbers in their aggressive annual operating plan.  The execs dismiss the plan as irrelevant and tell the board to look at growth and market share.  The board looks at the cash burn, noting that the management team — despite delivering amazing growth — is often still under plan on sales and over plan on expenses, generating cash burn that’s much larger than planned.

If the growth stops, these companies burn up, because they are addicted to high cash burn and can suddenly find themselves in the position of not being able to raise money.  So to keep the perpetual motion machine going, they’ll do almost anything to keep growing.  That might include:

  • Raising money on an unattainable plan
  • Raising money on undesirable terms [4] that hurt earlier investors and potentially really hurt the common stock
  • Spending heavily on customer acquisition and potentially hiding that in other areas (e.g., big professional services losses)

Remember that once the Halo is lost, it’s virtually impossible to get back so companies and executives will do almost anything to keep it going.  In some cases, they end up crossing lines that get the business in potentially serious trouble.  [5]

Unbridled companies need to bring in “adult supervision,” but fear doing so because they worry that the professional managers they’ll bring in from larger companies may kill the growth, driven by the company’s aggressive, entrepreneurial founders.  Thus, the board ends up in something of a waiting game:  how long do we bet on the founding/early team to keep driving crazy growth – even if it’s unbridled – before we bring in more seasoned and professional managers?  The smart part about this is realizing the odds of replacing the early team without hurting growth are low, so sometimes waiting really is the best strategy.  In this case, the board is thinking, “OK let’s give this [crazy] CEO one more year” but poised to terminate him/her if growth slows.

The transition can be successfully pulled off – it’s just hard and risky.  I’d argue MongoDB did this well in 2014.  But I’d argue that Anaplan did it not-so-well in 2016, with a fairly painful transition after parting ways with a very growth-oriented CEO, leaving the top job open for nearly 9 months [6].

So, the real question for unbridled companies is when to bridle them and how to do so without killing the golden goose of growth.

Star Startups
There’s not much to say about star startups other than if you’re working at one, don’t quit.  They’re hard to find.  They’re great places to learn.  And it’s sometimes easy to forget you’re working at a star.  I remember when I joined Business Objects.  The company had just gone public the prior year [7], so I had the chance to really dig into their situation by reading the S-1.  “This place is perfect,” I thought, “20-something consecutive quarters of profitable growth, something like only $4M in VC raised, market share leadership, a fundamental patented technology, and a great team — I’m critical as heck and I can’t find a single thing wrong with this place.  This is going to be my first job at a perfect company.”

That’s when I learned that while Business Objects was indeed a star, it was far from a perfect company.  It’s where I learned that there are no perfect companies.  There are always problems.  The difference between great and average companies is not that great companies have fewer problems:  it’s that great companies get what matters right.  Which then begs the question:  what matters?

(Which is an excellent topic for any startup strategy offsite.)

# # #

Notes
[1] One trick I use is to assume that, by default, we’re average in all regards.  If we’re hiring the same profiles, using the same comp plans, setting the same quotas, doing the same onboarding, providing the same kit, then we really should be average:  it’s the most likely outcome.  Then, I look for evidence to find areas where we might be above or below.  This is quite different from a vigilante board deciding “we have a bad sales organization” because of a few misses (or a personal style mismatch) and wanting to immediately replace the VP of sales.  I try to slow the mob by pointing out all the ways in which we are normal and then ask for evidence of areas where we are not.  This helps reduce the chance of firing a perfectly good VP of sales when the underlying problem is product, pricing, or competition.

[2] And that’s why they make high-priced consultants – a shameless plug for my new Dave Kellogg Consulting business.

[3] See Ovid’s version, the one I was raised on.

[4] For example, multiple liquidation preferences.

[5] I seem to have a knack to end up competing with companies who do – e.g., Oracle back in the late 1980s did some pretty dubious stuff but survived its comeuppance with $200M in financing from Nippon Steel (which was a lot of money, back in the day), MicroStrategy in 2000 got itself into trouble with reports of inflated earnings and had to pay nearly $100M in settlements (along with other constraints), Fast Search and Transfer managed to get acquired by Microsoft for $1.2B in the middle of an accounting scandal (and were even referred to by some as the “Enron of Norway”) and after its $11B acquisition by HP, Autonomy was charged with allegations of fraud, some of which are still being litigated.

[6] Yes, you can argue it’s been a successful IPO since then, so the transition didn’t hurt things and perhaps eventually had to happen.  But I’m also pretty sure if you asked the insiders, they would have preferred that the transition went down differently and more smoothly.

[7] I was employee number 266 and the company was already public.  My, how times were different back then.

Are You Counting Payments as Renewals?

Enterprise SaaS has drifted to a model where many, if not most, companies do multi-year contracts on annual payment terms.  How did we get here?

  • Most enterprise SaaS products are high-consideration purchases. Buyers typically perform a thorough evaluation process before purchasing and are quite sure that the software will meet their needs when they deploy.  These are not try-and-buy or wing-it purchases.
  • Most SaaS vendors will jump at the opportunity to lock in a longer subscription term. For example, with an 85% gross retention rate you can offer a 5% discount for a two-year contract and end up mathematically ahead [1].  Moreover, with a default annual increase of 5 to 10% built into your standard contact, you can offer a “price lock” without any discount at all (i.e., the customer locks in the price for two years in exchange for a two-year commitment).

When you combine the vendor’s desire to lock in the longer term with the customer’s belief that the solution is going work, you find a fertile ground for doing two- or three-year contracts.  But these multi-year deals are almost always done on annual payment terms.

Most SaaS vendors don’t want to take the next step and ask for a multi-year prepayment.  The upside for the vendor would be to eliminate the need for collections in years 2 and 3, and eliminate the chance that the customer — even if unhappy — won’t make the out-year payments.  But most vendors refrain from this because:

  • It’s seen as an unusual practice that’s frowned upon by investors
  • Most investors believe you could better maximize ARR by simply raising more capital and sticking with annual payments
  • It can lead to lumpy renewals and cash flows that are both hard to manage and understand
  • It can lead to large long-term deferred revenues which can hinder certain M&A discussions.  (Think:  large balance of cashless revenue from suitor’s perspective.)
  • It complicates the calculation of SaaS metrics, sometimes confusing investors into believing that good metrics are bad ones. (I think I am literally the only person in Silicon Valley who is quick to point out that a 75% three-year retention rate is better than a 90% one-year one [2].)

Thus, we end up in a situation where the norm has become a two- or three-year contract with annual payments.  This begs a seemingly simple “if a tree falls in the forest and no one hears it, did it make any noise” kind of question:

Quick, what’s the difference between a one-year contract that’s renewing for the first time and a three-year contract that’s coming up for its first downstream annual payment?

I’ve often quipped that they’re both “renewals,” but in the former case they’re handled Customer Success and in the latter they’re handled by Legal. [3]

But let’s be clear, regardless of the process you use to manage them [4], they are not the same, and should not automatically be treated as such for the purposes of calculating SaaS metrics. One is the voluntary renewal of a subscription contract; the other is the payment of a contractual commitment.

If you don’t want to renew your subscription, there’s nothing I can do to force you.  If you don’t want to make a contractually committed payment I can sue you.

Let’s consider an example.  We have six customers, Alpha through Foxtrot.  The first three did one-year deals, the second three did three-years deals.  The simple question is:  what’s your gross dollar retention?  A merely acceptable 83% or a very healthy 95%?

payment renewal

If you calculate on an available-to-renew (ATR) basis, the rate is 83%.  There were 300 units up for renewal and you renewed 250 of them.  If you include the payments, the rate is 95%.  1,050 units were up for renewal or payment, and you invoiced 1,000.

This is a case that feels a little bit wrong both ways.  Including the payments uplifts the rate by mixing involuntary payments with voluntary renewals; to the extent you want to use the rate as a satisfaction indicator, it will be over-stated [5].  However, excluding the payments seems to fail to credit the company with the auto-renewing nature of multi-year deals.

One thing is clear:  payments certainly cannot be included in any ATR-based rate.  You cannot view making a contractually required payment as the same thing as voluntarily renewing a contract. 

Because of prepaid multi-year deals, I have always calculated retention rates two ways:  ATR-based and ARR-based.  The former is supposed to give you an idea of how often, given the chance, people want to renew their contacts.  The latter is supposed to show you, mathematically, what’s happening to your ARR pool [6].

I have an issue, which is highly subjective, when it comes to out-payments on non-prepaid, multi-year deals:

  • On one hand, I can argue they are contractual commitments that the vast majority of customers will honor and thus are effectively – save for a few rare cases – identical to prepaid multi-year deals. Think:  the money’s good as in the bank.
  • On the other hand, I can argue that a dissatisfied customer – particularly one who blames the vendor and/or the software for their failure – will not want to pay, even if the contract says they’re supposed to. Think:  it’s a toothless contract that the vendor will not likely not enforce against an angry customer.

Philosophically, I can argue that these out-year payments are either “good as in the bank” or I can argue that they’re “basically renewals that will ‘churn’ if the customer is not happy.”  The first argument says to treat them like prepaid multi-year deals and put them in ARR-based retention rates.  The second argument says they’re effectively voluntary renewals and should be counted as such.

In reality, you need to know what happens at your business.

I believe for the vast majority of businesses, customers honor the contracts and we should treat them like prepaid, multi-year deals in ARR-based rates — and you should always publish in parallel ATR-based rates, so people can see both.  However, if your company is an outlier and 10% of those payments are never collected, you’re going to need to look at them differently – perhaps like renewals because that’s how they’re behaving.  Or get better lawyers.  Or stop doing non-prepaid, multi-year deals because, for whatever reason, your customers are not honoring the commitment they made in exchange for you to give them a price lock.

# # #

Notes

[1] Over 2 years you get 190 units versus an expected 185.  (Not counting any expansion.)

[2] 0.75 > 0.9^3 = 0.73 – you need to compound annual rates to compare them to multi-year ones.

[3] Or, really, Accounts Receivable but that doesn’t sound as funny.

[4] I’d argue that when you define your customer success process that you should treat these two customers identically.  Whether it’s a payment or a renewal, in a good customer success process you should constantly monitor customer progress with the hope that the renewal (or the payment) is not some big decision, but merely incidental.  (“Yes, of course, we want to keep using the software – is it just a payment year or do we need to renew the contract?”)  This might increase your cost to renew a bit – because you’ll be paying CSMs or renewals reps to do collection work that could theoretically have been done by Accounts Receivable – but it’s still the right answer if you want to maximize ARR.

[5] While payment does not necessarily indicate satisfaction, it probably does indicate the absence of intense dissatisfaction.

[6] e.g., I’d use the the churn rate (1 minus the retention rate) as the discount rate in a present value calculation.