What I love about my job is getting to see teams of super-early-stage companies develop ideas that while raw have potential to make an impact on the market. I love the enthusiasm, the boundless energy and the sense of possibility that comes from having an idea that hasn’t yet been beat up in the marketplace of competing ideas, customer contracts, VC skepticism, jaded journalists or fickle consumers who are on to the (continue here)
Zenefits – Provides benfits and some HR support.
Bay Point Benefits – For potentially greater and more hands-on HR support.
Based on my experience as both an entrepreneur and investor, there are six primary components that impact the venture capital valuation of an early stage technology company: market dynamics, company metrics, future funding needs, team, comparable transactions, and VC ownership targets. I will provide some detail on each in this article, though the relative importance of each category will vary by deal.
Market dynamics: Factors that impact valuation include the size of the total addressable market (TAM) and a company’s potential to become the market leader. Industry focused solutions should be pursuing at least a $300 million market size, while horizontal solutions that solve pain points across industries, need a $1 billion market size. Investors also want to think that if the company executes well that the upside scenario in each company has the potential to return 50-100% of the entire fund. Companies get a valuation bump for market leadership: the #1 player tends to get at least a 1.5 multiple premium over the #2 player in the space.
Company Metrics: VCs like to invest in companies that have a chance to go public. Today the minimum bar for a business cloud company to go public is $50 million in revenue growing at 50% a year. In the early stages (Series A & Series B), a company should demonstrate an ability to achieve 2-3x annual growth consistently. Valuations are most generous when enterprise companies can keep churn under 10% a year, otherwise growth can be constrained by just trying to replace lost customers. In addition, VCs look for unique leverage in the sales model allowing for capital efficient customer acquisition. This will impact the need to raise more capital in the future, often leading to a higher valuation today.
Future Funding Needs: Virtually every company will need to raise another round. A key aspect of the valuation is whether it is reasonable to believe the valuation of the next round will be at least 1.5-2X the current value. Founders never want to tell their teams that all the hard work they’ve done between rounds isn’t worth a higher valuation. Thus, does the executive team have the money it needs to meet key milestones before the next round of funding? If the answer is no, then the VC will likely discount the current valuation. Although most investors allocate 50%+ of their funds for follow-on, investors need to believe the company will be relatively capital efficient so their ownership stakes aren’t diluted significantly by the time of an exit.
Team: Investors tend to pay a premium for repeat entrepreneurs or super-star entrepreneurs who are motivated for a big outcome. Most VCs expect to find holes on the executive team – the question is whether the initial team can recruit the best people in the world for this opportunity.
Comparable Transactions: In order to settle on a valuation, investors look at comparable public companies as well as the revenue multiples of recent acquisitions. Most venture investors focus on comparable transactions above $100 million as those transactions are more likely based on business fundamentals than those below $50 million. Other key data points include the revenue multiples the potential acquirers are trading at and the revenue multiples paid on prior acquisitions.
VC Ownership Targets: Series A and B investors often have a desired ownership target of 20-25% after the funding round, which can impact valuations. For example, if a Series A company wants to raise $7 million, and the VC wants to own 25%, it would be difficult to settle on a post-money valuation of more than $28 million without raising more money or reducing the percent ownership for the VC.
These six categories are meant to be a guide, but in reality there are often other factors that come into play. For example, in competitive situations, a venture firm might stretch on valuation to “win” a strategic deal. In addition, venture valuations are cyclical, and they often track behind public market valuations. Two companies with similar metrics might end up with very different valuations based on market timing.
Finally, valuation isn’t everything when selecting a venture firm. Entrepreneurs and investors are building a long term relationship, and entrepreneurs who are fortunate to have multiple term sheets may opt for a lower valuation if it means having a certain partner on board. The key is starting the relationship with a valuation that feels fair to both parties, and sets the company up for long term success.
Several weeks ago, I wrote a post about the Optimal Contract Value for a SaaS company. I wondered whether startups serving enterprises might be more or less valuable than those serving small-to-medium businesses (SMBs). Interestingly, the data showed there was no optimal customer value to build a publicly traded SaaS company.
Having written that post, I began to wonder about other differences between different types of SaaS companies. In particular, do SaaS startups serving SMBs spend more or less than their counterparts in the mid-market and enterprise? And which type of SaaS startup grows the fastest?
To answer those questions, I’ve pulled together data from a basket of 46 publicly traded SaaS/Cloud companies and segmented them based on their average annual customer value (ACV) into three buckets: SMB (<$10k), Midmarket, (>=$10k to < $100k) and Enterprise (>$100k).
Below I’ve charted the median trends of these companies as they progress from their founding over the next ten years. These four charts contrast sales & marketing investments and revenue growth trends across the three different SaaS startup segments.
The chart above depicts the Sales & Marketing (S&M) spend across the three segments. The median SMB SaaS startup spends significantly less on sales and marketing through year 4 of their lives. Presumably, these startups are driven to find more cost-effective means of customer acquisition, like freemium, because the smaller ACVs can’t accommodate larger cost-of-customer acquisition.
As the company’s revenue grows, however, SMB companies’ S&M expenditure converges with Midmarket and Enterprise companies.
The mid-market and enterprise companies can afford to hire large sales and marketing teams to acquire customers and spend statistically identical amounts on sales and marketing throughout.
The next most important question, of course, is how those sales & marketing investments translate into revenue growth. The chart above shows that despite the important differences in sales and marketing spend, the SMB companies in the dataset (who have been successful enough to IPO), have sustained equivalent revenue growth rates to their sales-team-driven brethren.
Presumably, these SMBs SaaS startups found a scalable customer acquisition channel that either complemented or wholly replaced the sales and marketing teams in the early days.
If you’re curious about the median gross S&M spend by segment, the chart above shows that. And the chart below plots the median revenue by segment. These two charts do show one counterintuitive trend: Midmarket SaaS startups tend to generate more revenue than either SMBs or Enterprise.
In Segmenting the SaaS Market for Sales Success, we showed that the number of employees in very small, medium and very large companies is roughly equal. So, for a startup pricing per seat, the market opportunity is equivalent. But the substantially larger revenues of Midmarket companies shows that these companies are able to penetrate their market more deeply and ultimately capture more revenue.
Perhaps these companies strike the best balance between large enough ACVs to justify sales investment and minimize the customization often required of large enterprise software: this powerful combination minimizes sales costs while accelerating sales velocity. Or so the data suggests.
It’s important to note that the dataset I’ve used is quite small and the number of data points on any given year for a given segment number no more than 10. This means that for most of the comparisons, there is no statistically significant difference between the data of SMB, Midmarket and Enterprise companies’ sales & marketing investments or revenue growth, which is itself an interesting conclusion. There is only one exception to this: the S&M expenditure of SMB SaaS companies is significantly lower in their early years than in other segments.
Also, these benchmarks are medians and they mask the variance across companies. Each of these companies pursued unique approaches in the market that enabled them to become leaders in their field and the aggregate statistics will never be able to communicate those unique stories.
Thanks to Dan Siroker who inspired this post.