What’s the “Cause of Death” in Your Churn Reporting?

In looking at this issue across several companies, I’ve noticed a disturbing trend / missed opportunity in how many SaaS companies classify the reason for customer churn.  Roughly speaking, if companies were hospitals, they’d too frequently be reporting the cause of death as “stopped breathing.”

Yes, the patient who died stopped breathing; the question is why did they stop breathing.  In churn-speak, “yes, the customer who churned issued a churn notice and chose not to renew.”  The question is why did they choose not to renew?

Many people have written great posts on reasons customers churn and how to prevent them.  These reasons often look like hierarchies:

Uncontrollable:

  • Got acquired
  • Went bankrupt
  • Corporate edict
  • New sponsor

Controllable:

  • Failed implementation
  • Product functionality
  • Product ease of use
  • Oversold  / poor fit

These hierarchies aren’t a bad start, but they aren’t good enough, either.  A new sponsor isn’t an automatic death sentence for a SaaS product.  He or she might be, however, if the team using it had a rough implementation and was only half-satisfied with the product.  Similarly, a failed implementation will certainly reduce the odds of renewal, but sometimes people do have the will to start over — and why did the implementation fail in the first place?

Physicians have been in the “churn” business much longer than SaaS companies and I think they’ve arrived at a superior system.  Here’s an excerpt from the CDC’s Physicians’ Handbook on Medical Certification of Death — not a publication, I’d add, linked to by most SaaS bloggers:

chain of death

For example, when my dear father passed away from a stroke several years ago, I remember the form said:

example cod

(And, at the time, literally observing that it was a better way to classify churn.)

The rule above spells it out quite clearly  — “DO NOT enter terminal events such as respiratory arrest […] without showing the etiology.”  That is, “stopped breathing” by itself isn’t good enough.  Just like “sent churn notice” or “decided not to renew.”

I have not built out a full taxonomy here; classifying churn in this way remained a future item on my to-do list at the time we sold my last company.  Nevertheless, while I know it’s not easy, I believe that companies should start trying to find a way to richly encode churn reasons using this “chain” concept so as to not lose critical information in encoding their data.  Otherwise, we risk believing that all our customers churned because they sent us a churn notice (or some easily blamed “uncontrollable” event).

As one example:

  • Churned, due to
  • New sponsor, due to
  • Failed implementation, due to
  • Partner problem, due to
  • Partner training

Or, another:

  • Churned, due to
  • Corporate edict, due to
  • M&A, due to
  • Product dissatisfaction, due to
  • Oversold, due to
  • Sales training

These aren’t perfect, but I’m trying quickly demonstrate the real complexity behind why customers churn.  For example, happy customers might challenge a corporate edict issued after an acquisition — so you can’t just blame the edict.  You have to look more deeply.  If you knew that the customer fought the edict and failed, you might stop the chain there.  But if you knew they were never terribly happy with the system because they were overpromised capabilities at the start, then you should code that into the chain, too.

# # #

For more information on the warning signs and symptoms of a stroke, go here.

 

Highlights from the 1Q19 Fenwick & West Venture Capital Survey

(Revised 5/9/19, 3:30 PM to add chart from SVVCCI survey at the bottom.)

Every so often I post highlights from the quarterly Fenwick & West Venture Capital Survey, as much to share knowledge about the existence of the survey [1] as to share its current-quarter data.

This survey is important for two reasons.  First, it shows trends in price changes over time across various VC rounds.  This is useful information to see what’s happening in the market, and I suppose semi-useful information in perhaps timing your venture rounds (subject to Kellblog Rules 1 and 2 of Financing [2]).

But the really important of this survey is it tells you about terms.  Raising $20M with a 1x, non-participating preference is very, very different from raising $20M with an 8% accumulating dividend, a multiple, participating liquidation preference that ratchets from 1.5x to 1.75x to 2.0x over three years, and includes redemption rights [3].  If you’re a CEO or founder of a startup and don’t understand the prior sentence, you need to.  A good glossary, plus the F&W Survey, will help.

Let’s look at the survey highlights, starting with pricing and moving into terms.  81% of companies had financings that were “up rounds” (i.e., the share price was higher in the round last than the previous one).   On average this runs nearly 70%.

price change history

The chart shows the Fenwick & West (F&W) Venture Capital Barometer (TM), which measures the magnitude of the price change since the prior round.  In 1Q19, prices averaged 75% up since the company’s prior round, running high, but certainly not near historical highs of well over 100%

barometer history

The report does a lot of nice segmentation.  Here is direction and magnitude price change data by sector.

by industry

Now we move onto financing terms.  For definitions, see the glossary F&W publishes along with the survey.  Better yet, read the Ultimate Guide to Liquidation Preferences by Charles Yu.

Senior liquidation preferences were used in 27% of rounds [4].

senior liquidation

Of those rounds with senior liquidation preferences, 9% had multiple liquidation preferences [5].

multiple liquidation pref

Participation means that the investor doesn’t have to choose between getting their money back and getting their pro rata share of the company.  Participating preferred shares first get their money back and then get their pro rata share of what’s remaining.  That’s why they’re sometimes called “double dip” preferred.  12% of rounds in 1Q19 had participation.  While F&W doesn’t break out the data geographically, I’ve always considered participation an “East Coast” VC term.  It’s also common in Europe as well.

participation

One way to limit the effects of participation is to cap it.  However, 65% of time participation is used, it is uncapped.  35% of the time, it is capped, which sounds like an improvement, but has the perverse consequence of creating a zone of indifference for the investor.cap

There’s lots more in the F&W survey which you can find here.

Before signing off, let me highlight one other interesting survey, the University of San Francisco Venture Capital Confidence Index (SVVCCI), which in February 2019 fell to its lowest value in the past 10 years — 3.20 out of 5.00, down from 3.52 in the prior quarter.

VVCI

Unfortunately, they no longer make the full report instantly downloadable (you need to mail someone on the survey page to get a copy of it).  Nevertheless, it’s another interesting quarterly survey and I always try to read the two together.

# # #

Notes

[1] Much as I periodically post about the Bessemer Nasdaq Emerging Cloud Index for the same reason.

[2] Kellblog Rule 1 of Financing:  the best time to raise money is now.  Kellblog Rule 2 of Financing:  the best amount of money to raise is as much as you can (provided it’s at a good price).  Why?  In my opinion, too many startups press their luck, trying to delay financing in favor of hitting a few more consecutive quarters to limit dilution.  That works great — until it doesn’t — e.g., if you miss one of those quarters or if the markets turn on you.  As an example, there were two kinds of startups in 2002:  those that raised large amounts of money at crazy valuations in 2001 and dead.

[3] Terms generally do one of three things:  (a) reallocate the pie towards the investors in bad scenarios, i.e., “downside protection,” (b) provide minimum returns before others get their money, or (c) provide other rights (e.g., the right to sell the stock back to the company after N years) that can be used as forcing functions to get liquidity or control.

[4] Note that VCs buy preferred stock which is always senior to the common typically held by founders and employees. In this case, senior means senior to the other/earlier classes of preferred.  For example, if the series C gets all of its money back before the series B, then that would be a senior liquidation preference.  If series A, B, and C all got their money back on an pari passu basis, there would be no senior liquidation preference in this context.

[5] Meaning the investor gets not only his/her money back first, but some multiple (e.g., 1.5x) of it.  You can see how an investor might yield to an investor on a certain “vanity valuation” in exchange for a multiple liquidation preference, which ends up being close to a guaranteed return — e.g., if it’s on the last round, you’re first in line behind the debt with a guaranteed multiple (and maybe even more if you have participation).

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.

Is Another SaaSacre In The Offing?

I’m not a financial analyst and I don’t make stock recommendations [1], but as a participant and observer in the software investing ecosystem, I do keep an eye on macro market parameters and I read a fair bit of financial analyst research.  Once in an while, I comment on what I’m seeing.

In February 2016, I wrote two posts (SaaS Stocks:  How Much Punishment is in Store and The SaaSacre Part II:  Time for the Rebound?).  To remind you how depressed SaaS stocks were back then:

  • Workday was $49/share, now at $192
  • Zendesk was $15/share, now at $85
  • ServiceNow was $47/share, now at $247
  • Salesforce was $56/share, now at $160

Those four stocks are up 342% over the past 3 years and two months.  More broadly, the Bessemer Emerging Cloud Index is up 385% over the same period.  Given the increase, a seemingly frothy market for stocks (P/E of the S&P 500 at ~21), and plenty of global geopolitical and economic uncertainty, the question is whether there is another SaaSacre (rhymes with massacre) in the not-too-distant future?

Based just on gut feel, I would say yes.  (Hence my Kellblog prediction that markets would be choppy in 2019.)  But this morning, I saw a chart in a Cowen report that helped bring some data to the question:

cowen

I wish we had a longer time period to look at, but the data is still interesting.  The chart plots enterprise value (EV) divided by next twelve month (NTM) sales.  As a forward multiple, it’s already more aggressive than a trailing twelve month (TTM) multiple because revenue is growing (let’s guess 25% to 30% across the coverage universe), thus the multiple gets deflated when looking forward as opposed to back.

That said, let’s look at the shape of the curve.  When I draw a line through 7x, it appears to me that about half the chart is above the line and half below, so let’s guesstimate that median multiple during the period is 7x.  If you believe in regression to the mean, you should theoretically be a bearish when stocks are trading above the median and bullish when they’re below.

Because the average multiple line is pretty thick, it’s hard to see where exactly it ends, but it looks like 8.25x to me.  That means today’s multiples are “only” 18% above the median [2].  That’s good news, in one sense, as my gut was that it would be higher.  The bad news is:  (1) when things correct they often don’t simply drop to the line but well through it and (2) if anything happens to hurt the anticipated sales growth, the EV/NTM-sales multiple goes up at constant EV because  NTM-sales goes down.  Thus there’s kind of a double whammy effect because lower future anticipated growth increases multiples at a time when the multiples themselves want to be decreasing.

This is a long way of saying, in my opinion, as a chartist [3] using this chart, I would conclude that multiples are somewhat frothy, about 20% above the median, with a lot predicated on future growth.

This exercise shows that looking only at price appreciation presents a more dangerous-looking picture than looking at prices as related to revenues:  looking across the whole chart, prices are up a lot since April 2014 but so are forward-looking revenues, and the multiple is roughly the same at the start as at the end:  8x. [4]  Looking at things differently, of the ~350% gain since April 2016, half is due to multiple expansion (from a way-below-median ~4x to an above-median ~8x), and half is to stock revenue growth.

For me, when I look at overall markets (e.g., PE of the S&P), geopolitical uncertainty, price appreciation, and SaaS multiples, I still feel like taking a conservative position.  But somewhat less than so than before I saw this chart.  While it’s totally subjective:  SaaS is less frothy than I thought when looking only at price appreciation.

Switching gears, the same Cowen report had a nice rule of 40 chart that I thought I’d share as well:

r40 cowen

Since the R^2 is only 0.32, I continue to wonder if you’d get a higher R^2 using only revenue growth as opposed to rule of 40 score on the X axis.  For more on this topic, see my other Rule of 40 posts here.

# # #

Notes
[1] See disclaimers in my FAQ and terms of use in the blog license agreement.

[2] Nevertheless, 18% is a lot to lose if multiples instantly reset to the median.  (And they often don’t just drop to the median, but break well through it — e.g., in Jan 2016, they were as low as 4x.)

[3] And chartism doesn’t work.

[4] If you ignore most of the first month where it appeared to be falling from 10x to 8x.

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.

The Introvert’s Guide to Glad-Handing

One day back at MarkLogic, we invited our local congresswoman, Jackie Speier, to visit our offices.  Regardless of what you may think of her politics, she’s an impressive person with an fascinating background including, for those with long memories, that she was the congressional aide shot five times and left for dead on the runway in Guyana when Congressman Leo Ryan went to investigate Jonestown.  I was looking forward to meeting her.

She arrived — early of course — with a few handlers.  We exchanged the usual greetings and took a few pictures.  Then, she said, “would you mind if I went around and met a few people before the presentation?”  “No, no — not at all,” I said.  Leaving the handlers behind, off she went into the sea of cubicles.

Affordable Care Act

What I saw next blew me away.

Cube by cube she proceeded, “Hi, I’m Jackie — what’s your name?”  “Great, what do you do here?”  “Oh, I see [from the picture on your desk] you have a son, what’s his name?’  “How old is he?”  “Oh, [insert something in common here].”  More chatter.  A few laughs.  “Are there any questions I can answer for you today?”

There are extroverted people.  There are gregarious people.  There are charismatic people.  And then there are politicians.  She was the best room-worker I had ever seen in my life and she did it as effortlessly as she did naturally.

“This,” I thought, ” is why you’re not a politician, Dave. You have no skills.”

But leading the troops is a key part of the job of a startup CEO.  While such glad-handing often comes naturally to sales-oriented CEOs, it usually does not for more product-oriented ones.  A sales-oriented CEO is typically an extrovert; a product-oriented one an introvert.  So what’s a poor introvert to do?

First, Run A Normal Communications Program
All CEOs should run some sort of baseline company communications program.  This could look something like:

  • Bi-annual kickoffs where the company is brought together to hear about progress, learn about new initiatives, and recognize achievement.  Think:  educate, decorate, inebriate.
  • Post-quarter all hands calls/meetings after the off-quarters to discuss company performance, progress on quarterly goals, and go-forward priorities.
  • Topical all-hands emails and follow-up live calls/meeting to announce breaking news and provide commentary.
  • Separate and/or built-in “town hall” sessions with open employee Q&A to the CEO and the exec team.

This is baseline.  If you’re not doing this and you’re over about 20 people you need to start doing aspects of it.  If you’re over 150-200 people you should be doing all of this and quite possibly more.

For most CEOs — even the introverts — this isn’t hard.  It’s structured.  There are presentations.  Most of the questions in Q&A can be anticipated, if not solicited in advance.

Management by Walking Around
Let’s say you’ve set up such a program and are getting good feedback on it.  But nevertheless you’re still getting feedback like:

“You’re in your office and in meetings too much.  People want to see more of you.  The answer isn’t more all hands meetings.  Those are fine.  But people want to see you in a more informal and/or 1-1 way.  I know, you need to do more MBWA — management by walking around.  You’ll be great at it!”

“No, I won’t,” thinks the highly self-aware introvert CEO, imaging a nightmare that goes something like this:

CEO:  “Hey, Bro-dy!” [Struggling to choose between Bro and Buddy.]
Employee:  “Did you just call me grody?  What the –“
CEO:  “No, Buddy, no,  I called you Bro, Pal.”
CEO:  “So, how’s my Buddy doing?”  [Slaps his back.]
Employee:  “Ow!  I just had shoulder surgery.”
CEO:  “Whoops, sorry about that.”
Employee:  “No problem.”
CEO:  [Notices wedding picture on desk.]  “Hey, how’s that lovely wife?”
Employee:  “We split up three months ago.”
CEO:  [Thinking: “I bet this never happens to Jackie Speier, I bet this never happens to … “]

Sure, the CEO thinks, let’s try some more MBWA.  Or maybe not.

Find Your Way
The problem here is simple — it’s a classic, in this case “reverse,” delegation mistake.  The well-intentioned feedback-giver isn’t just telling you what needs to be done (i.e., help people get to know you better through more individualized interaction),  they’re telling you how to do it (i.e., management by walking around).  So the solution is simple:  listen to the what and find your own way of how.  If you’re not a natural grip-and-grin type, them MBWA isn’t going to work for you.  What might?  Here are some ideas:

  • Every Friday morning do three, half-hour 1-1s with employees across the organization.  This will play to your introvert strength in 1-1 meetings and and your desire to have substantial, not superficial, interactions with people.  If you’re disciplined, you’ll get to know 156 people/year this year.
  • Management by sitting in the way (MBSITW).  Pick a busy spot — e.g., the coffee room or the cafeteria — and camp out there for a few hours every week.  Work on your laptop when no one’s around but when someone walks in, say hi, and engage in a 1-1 chat.
  • Small-group town hall Q&A sessions.  Attend one department’s group meeting and do a one-hour town hall Q&A.  It’s not quite 1-1, but it’s definitionally a smaller forum which will provide more intimacy.
  • Thursday lunches.  Every Thursday have lunch with 3-4 people chosen at semi-random so as to help you build relationships across the organisation.

So, the next time someone tells you that you need to do more MBWA, thank them for input, and then go find your way of solving the underlying problem.