Advice to Entrepreneurs Seeking Capital by Peter Cowen
The Funding Environment
The wave of tech investing during the pandemic has been nothing short of breathtaking. 2020 was a record year and 2021 surpassed that mark many months ago. Not surprisingly valuations are markedly higher. In good growth businesses, the same company now gets a 2-3x higher valuation than pre-Covid. For great companies that delta is even larger. Most of us know this current environment is not sustainable.
A Financing Frenzy
The amount of capital has exploded and come from several sources. New investors, particularly in the seed stage have entered in large numbers. Secondly, the largest and most successful funds such as Tiger Global, Sequoia Capital and Insight Ventures, have made a conscious decision to not miss out on a great deal. As a result, they are investing in earlier rounds than before and doing so VERY frequently. Each of these funds has been investing recently at a clip of more than 1 deal per day.
Not surprisingly, in this funding frenzy, due diligence has been compressed from what was often a couple of months to a couple of weeks, and sometimes even shorter. The initial hesitation about whether to invest solely over Zoom calls has transformed to a wider audience, unconstrained by distance and geography—hence the whole experience for founder/funder is virtual. The initial call, the follow up, the term sheet, the due diligence, the final negotiation are done virtually.
It is critical to note that most of these companies are performing well by key metrics: their growth and retention rates are strong. When looking at companies that reach $5M ARR run rate (recurring revenue of $400k per month in the last month of recurring revenue annualized) and particularly $25M ARR companies, their ability to attract, retain and upsell clients has been notable. A major factor has been strong sales/marketing/customer support/analytics tools (industry leading SaaS companies, such as Salesforce, Twilio, Hubspot, Gainsight,Sprinklr, ServiceNow) are improving performance and helping to optimize pricing. These factors are enabling solution providers to intelligently increase pricing with reduced churn helping to reduce net churn, which is a “golden metric” (net churn is taking clients from 12 months ago looking at what they paid then looking at the most recent month, where some companies have left but the remaining clients are paying more. In many cases they are paying so much more that they offset the churned clients. A negative churn of 100% is good, 120% is fantastic).
Private Valuations of SaaS Companies
Another driver of private valuations is the fact that the public markets in many ways are overvalued. The Bessemer Cloud Index provides a great perspective on SaaS company valuations which looks at 100 leading public SaaS companies. They are growing on average at 30% per year. Their valuations until this last recent Wall Street shakeup were 20x revenue and are now closer to 15x revenue. These companies, while still growing, have actually had slower growth while enjoying increased valuations, which has given them relatively cheap dollars to buy private companies, further increasing the private funding frenzy.
Solid companies where investors throwing money at entrepreneurs—often preemptively at jaw dropping valuations—and at very founder friendly terms. We are seeing valuations at 20x, 40x even 100x current ARR (key criteria are market segment, client type, growth rate, founder experience). So what can go wrong?
Consider this Strategy in Your Funding Approach
The most important thing is to know the carnival will stop sometime in the near future and it is your responsibility as CEO/CFO/Founder to make sure you are well capitalized when that time comes. That also includes your taking some chips off the table to diversify your holdings and be able to operate well without financial stress if and when market conditions change (a subject for another day).
The second point is tougher and counterintuitive. Choose your investment partner thoughtfully and with specific criteria so they can be your best partner. The highest valuation is not the first criteria and the prestige of the firm may not necessarily be in your best interest. Consider the following:
1) If your company is way overvalued and the day of reckoning happens founder’s shares (common stock/options) will plummet in value and investors goals will fall out of alignment with yours. This will prove painful, distracting, demoralizing and not end well.
2) Look more closely at the partner than the firm (and of course their influence within their firm—not all partners are equal) because this is likely to be a critical partner at many levels. We have seen high profile investors be absent or adversarial as over time your Company is not worth their time and/or they are unavailable/disengaged at key times. Do your due diligence on the partner as much as possible before taking $.
Enjoy these unprecedented times—just know they will not last. Don’t think of this as the “new normal”: instead be aggressive as you pursue capital--- and make plans now. Do not have regrets that you could/should have done a couple of rational/sensible things during this period.