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This presentation by Burkland Associates founder, Jeff Burkland, examines key financial metrics for SaaS startups. These key metrics help ensure success, as a business as well as when raising critical funds from investors.

Guest post written by Sean Jacobsohn
Venture partner at Emergence Capital Partners.
FORBES
I regularly get asked by entrepreneurs about how valuations are derived by venture capitalists for recurring revenue businesses. While many entrepreneurs are seeking a specific formula, in reality, valuations are a mix of art and science.

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.

TOMASZ TUNGUZ

venture capitalist at redpoint

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.

Interesting publications from Fenwick and West LLP. Click Here

Here’s a look inside a typical VC’s pipeline (a must-read for entrepreneurs)

April 19, 2014 4:35 PM
Sean Jacobsohn, Emergence Capital

When I meet with entrepreneurs, I am often asked about the VC “pipeline.”

How many deals do we see? How many meetings? How often do we conduct due diligence? How many of those companies do we invest in?

I thought it would be helpful to provide visibility about the VC pipeline, while also outlining what helps a company move from an intro meeting into a closed investment.

In order to make 10 investments, the average venture capital firm reviews approximately 1,200 companies.

Leads: These 1,200 come from network introductions, conferences, in-bound inquiries, proactive efforts, portfolio company referrals, and seed investors. Of the 1,200, we find that approximately 500 lead to face-to-face meetings with someone on the investment team.
The most important factor in securing a meeting is the background of the founders. Do they have the skills and experience for the opportunity they are pursuing?
Of course, the pitch also matters: Is it concise and compelling?

In addition, most venture firms like to make sure that a company is not competitive with a current portfolio company.

Personally, the primary reason I don’t meet in person with in-bound requests is that the entrepreneur was not vetted by someone I trust.

Meetings: The average venture firm has approximately 500 face-to-face meetings each year, yet only 10 percent progress from that stage. What makes a venture firm want to dig in and spend the time required to do proper due diligence?

First, most early stage VC firms look for demonstrated product/market fit. At Emergence, we also want to confirm that the company is solving a problem that is relevant outside of Silicon Valley. Too often only customers are in the Bay Area, and they are friends of the founders, which means no proof of a real market.

One of the reasons that a meeting doesn’t go well is that the founding team will say they expect $50 million in revenue in 5 years, but they have difficulty articulating how they’ll get to their first $1million.

Due Diligence: Of these 500 meetings, a mid-sized venture firm may perform due diligence on approximately 50 companies in a year.

Due diligence consists of a product review, customer references, executive team references, financial modeling, market analysis and competitive analysis. Passionate customers who are very engaged with the product can really make a difference during due diligence.
Venture firms also look for at least 100 percent annual revenue growth in the first few years. However, often companies don’t meet short-term projections set in earlier meetings, and firms can lose confidence in their future projections.

Venture firms are also wary of high rates of churn and customer concentration.

Investments:  In a typical mid-size venture firm, the 50 companies may generate 10 investments. Why do these companies stand out? A couple items are critical, such as efficient customer acquisition and a magnetic CEO that people follow. It’s a huge red flag if former employees don’t want to work with the CEO again.

With respect to market size, at Emergence, we like to see a reasonable path to $100 million in annualized revenue. For an industry focused solution, a $300 million market size is sufficient since if they become an industry standard they can get 30 to 50 percent of the market. For a horizontal solution that solves pain points across industries, a company needs $1 billion market size, since the market leader may only get 5 to 10 percent of the market.

While it may seem that one percent represents depressing odds for a founder to secure VC funding, in reality, the process tends to help entrepreneurs refine their strategy. If the first meeting didn’t result in moving to the next phase, a good venture firm will provide specific feedback and guidance. Most venture firms stay in touch with founders they have met in the past, and it is exciting when future meetings highlight changes that have led to more traction.

Link to Original Article

Sean Jacobsohn is a venture partner at Emergence Capital Partners. He joined Emergence Capital after being an executive and advisor at portfolio companies Hightail and Doximity, respectively. In addition to being a sales and alliances executive in the technology enabled services space for 13 years, he is cofounder and co-president of the Harvard Business School Alumni Angels, the largest university-affiliated angel group in the world.

Andy Rachleff is President and CEO of Wealthfront, a software-based financial advisor. Prior to Wealthfront, Rachleff co-founded and was general partner of Benchmark Capital. He also teaches courses on technology entrepreneurship at Stanford Graduate School of Business. Follow him on Twitter @arachleff.

“The defining difference between Silicon Valley companies and almost every other industry in the U.S. is the virtually universal practice among tech companies of distributing meaningful equity (usually in the form of stock options) to ordinary employees. Before companies like Fairchild and Hewlett-Packard began the practice fifty years ago, distributing stock options to anyone other than top management was virtually unheard of. But the engineering tradition that spawned Silicon Valley was much more egalitarian than traditional corporate culture.”

The equity culture among young technology companies is almost universal. When implemented properly, broad employee ownership within a company can:
  • Align the risk and reward of employees betting on an unproven company.
  • Reward long-term value creation and thinking by employees.
  • Encourage employees to think about the company’s holistic success.
Unfortunately, despite decades of experience building new hire option plans, many startups still fail to put in place an equity compensation plan that adequately rewards long term employees over time.
When I was a venture capitalist, I noticed companies that seldom lost employees due to recruitment had a lot in common. Sure they offered challenging and inspiring work environments sought by top-tier talent. But you might be surprised to learn they all rewarded outstanding performance through the issuance of additional stock options (or as is now the case, RSUs) in a similar way. 
The Wealthfront Equity Plan
Based on my observations, I created an equity allocation plan that I encouraged all my portfolios to adopt. It worked so well that executives and my fellow board members usually brought my plan with them when they got involved with other companies. Over the years, I am proud to say that hundreds of companies, including Equinix, Juniper Networks and Opsware, adopted this plan because it just made sense.  
Not surprisingly, we’ve put this plan in place at Wealthfront. 
How It Works
The Wealthfront Equity Plan is designed to specifically handle the four most important cases for granting equity to employees. Each year, you create a new option pool that addresses the following needs:
  1. New Hires: These grants are used to hire new employees at market levels.
  2. Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire her at today for her new position.
  3. Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.
  4. Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities. Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.
The Key: Consistent, Early Evergreen Grants
Most companies put considerable effort into the size of their equity grants for new hires. It’s rare these days to find new hires that haven’t used a tool, like the Wealthfront Start-Up Salary & Equity Compensation Tool, to determine the appropriate amount of salary & equity to expect for a given position.
Fewer companies, especially young ones, put significant effort into thinking about follow-on grants. If you tell your employees to “think like an owner,” then you need to consistently align equity with their contribution to the success of the company.
Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.

“The average tenure for most technology employees is two to three years, and waiting until your first employees hit year four is just too late.”

Instead of an ad-hoc process, the Wealthfront Equity Plan offers a transparent, consistent and fair program of equity grants that employees can build into their long-term expectations. As a result, not only do you avoid cliffs, but you also tie both long-term tenure and contribution to their ownership stake. The best part is that, as your company grows, you always grant stock in proportion to what is fair today rather than in proportion to their original grant.
What About Dilution?
Based on our calculations, the Wealthfront Equity Plan should result in approximately 3.5% to 5% annual dilution assuming no executives need to be hired. (Please see our Slideshare presentation for the details of how to allocate stock for a 50-person private company). As a point of reference, most public technology companies increase their option pools by 4% to 5% per year, so the proposed dilution is well within the reasonable range.

The Wealthfront Equity Plan might result in 0.5% to 1% extra annual dilution relative to less generous plans. One way to think about the trade-off is to ask yourself, if you’re a stockholder, would you rather be assured of retaining a much higher percentage of your key employees and own 97% of what you would have owned without the Wealthfront plan over your four-year vesting period (4x the mid-point of 0.5% to 1%), or deal with the risk of losing valued team members and not suffer the additional dilution? I would take the extra dilution 11 times out of 10.
That being said, there are a number of board directors who think that is too much dilution for a company to absorb. A few months ago, a fellow I recruited as CEO to two of my Benchmark portfolio companies told me he never appreciated the value of the Wealthfront Equity Plan until he joined a board where the board members were too cheap to do the right thing for their employees. Needless to say, he implemented the Wealthfront Equity Plan when he started his own company.
Investors and employees make much more money by increasing the size of the pie rather than their share of the pie. The only reason not to implement the Wealthfront Equity Plan is greed, and greed seldom leads to a good outcome.
An Equity Plan that Works for Employers & Employees
One final observation about companies that successfully retain employees: They usually create a culture that treats options as something dear that aren’t offered as an alternative to a cash bonus. They encourage employees to think about increasing the value of their options through accomplishment rather than asking for more upon completion of a task. It has been my experience that companies granting options for completion of milestones seldom build a culture that values equity — and therefore suffer greater turnover. 
A well-designed equity allocation plan works for both the employer and the employees. The Wealthfront Equity Plan creates a tremendous incentive for people to stay at a company without costing the employer too much. That’s the kind of win-win to which we should all aspire.

Read more: http://firstround.com/article/The-Right-Way-to-Grant-Equity-to-Your-Employees#ixzz2qJ7BLaAA

By
Summary: For a place that prides itself on disrupting tradition, Silicon Valley is still using a pretty traditional method for compensating startup hires and employees with stock. Here’s another idea.

Change is the only constant in life and this is especially true in Silicon Valley. We live in a time of constant change and rebirth, which we optimists think is for the better. One thing hasn’t changed: How Silicon Valley companies — especially startups — use stock to compensate and incentivize their employees.

Traditional stock options are failing to create the ownership culture we want from employees and it’s killing our ability to build companies for long-term success.

For employees, a one-year term ending on the vesting cliff date is increasingly common. This leaves a big hole in the team and the cost to hire a replacement is significant. We all want to eliminate bad matches sooner, but it’s no surprise so many employees wait for the equity. Having more non-employee equity holders causes resentment among current employees doing the hard work to create stock value.
On the other side of the equation, founders and investors are increasingly tight-fisted with company ownership, allocating smaller stock pools to employees — most of which are eaten up by very early hires, rock stars or senior execs — leaving very small amounts for later hires, which does little to nurture their commitment to the company.

I’ve been involved with startups for a long time and have seen these patterns over and over. After working at a number of startups, I co-founded Equinix in 1998, Revision3 in 2005 and was the chief executive of Digg, Revision3 and SimpleGeo. I’ve also been an active advisor to several early-stage startups. After nearly twenty years of using the same recipe for employee equity, I’m taking a new approach at my new startup, Opsmatic. We are sharing equity in a new way, one we believe builds a true ownership culture that will be a key to our success.

I’ll explain more later, but in addition to a traditional stock option grant, we’re offering our first fifteen employees, or however fewer it takes to get to the next financing, an equal share of 15 percent of the company, which they will receive if they stay with the company through a liquidity event.
Why do this? We are focused on attracting and retaining the best possible team over the long term. Our employees are key to our success, and we are determined to change their (and our) behavior to avoid the downsides of the traditional approach to stock allocation. As I talk to CEOs, I’ve uncovered some of the causes of these patterns.

Employee behavior

Burned by booms and busts, employees often look to maximize their compensation up front, hopping from company to company in an attempt to scale compensation or title. Most stock options have a one-year cliff; if they leave at that point, they can purchase 25 percent of their equity with no further commitment to the company, giving them the ability to diversify their equity portfolio and reduce risk.

The rise of secondary markets has complicated matters and created a pervasive myth that employees can sell their stock early. While private stock sales are available to a minority of high-value, successful companies that support these transactions, it’s not an option for most early companies. According to SecondMarket’s 2012 data, the median number of employees for companies with private stock transactions was 347 with an age of seven years and a market cap of $569.5M, and 66 percent of transactions were made by existing employees, not former employees.

Founder behavior

Founders and CEOs typically distribute equity in a long tail, most of which goes to very early employees after a first financing, leaving increasingly smaller amounts for later hires. This does not build a sense of shared ownership.

The rationale I hear is that early employees take more risk around an uncertain future, so they should get higher compensation. Lately, in conversations, I surprisingly found that people joining later often feel they are taking a larger risk around getting paid!

This may seem backward, but upon reflection, there’s always the non-trivial chance of the next round not happening or revenue not coming in before cash is burned away. A fresh, recently funded startup has more money in the bank and has made fewer execution errors, so risk is a matter of perspective.
To make matters worse, I’ve talked to dozens of founders who confirmed that in retrospect, there was little correlation between the distribution of stock options and the actual value the employee brought to the company. Independent of contribution, the larger option packages are dolled out to super early employees (or co-founders) and rock stars.

A rock star hire is a hire in which founders and CEOs pay above market rates for someone they deem super-critical. Maybe you’re developing software and would benefit from someone who is famous for inventing the concept. Perhaps you need to build a new sales force, so you go after a famously successful head of sales veteran from another company. Maybe you want to recruit new talent, so you hire someone that new employees would kill to work with.

Rock stars are typically fought over, so equity distribution increases due to competition, giving these employees a larger share. Nevertheless, years later, post exit, often the unsung heroes — like employee number fifteen — weren’t benefiting in a way that reflected their contribution. As far as I’m concerned, when combined with the long-tail distribution, this is not the best way to motivate employees or engender team loyalty.

The details of our approach

To address these issues, we’ve created a new approach to equity called the Dynamic Stock Pool (DSP).
This pool is designed to be a long-term incentive, encouraging loyalty and reinforcing that we will win or lose as a team. While each of our employees will get a traditional stock option grant, the majority of Opsmatic’s employee stock — 15 percent of the company — is allocated to the DSP.

The DSP pool is egalitarian, shared equally amongst the first fifteen employees we hire. So it’s a rich incentive at 1 percent of the company (before any future dilution). Typically, equity numbers of that level are reserved for VPs, CxOs and rock stars, so this is a significantly more generous offer than most early hires receive, particularly outside of management or founders.

However, here’s the catch: The stock in this pool is only distributed to employees who remain at the company through a liquidity event, such as an IPO or acquisition. If you leave before then, you don’t get any of your DSP shares — so this is truly an incentive to play for the long-term. In fact, the employees who stay through the liquidity event continue to share equally in the pool. For example, if only five of the first fifteen employees remain, each would receive 3 percent (pre-dilution).

What about…

Clearly this is different from how things have been done since companies started handing out stock options, so of course it raises a few questions.

Some feel that varying skills and experience merit differential grants. Beyond accompanying salary differences, we also have a traditional option pool to address a legitimate reason to give one employee more than another. Another challenge involves the perception of the ‘value’ of different kinds of employees. For example, some people have asked, “What if you hire a receptionist or a janitor? Should they have as much value as a developer?” Because each employee is equally diluted in the DSP, this model creates a strong incentive to only hire critical employees. This means hiring fewer non-essential personnel and prioritizing the hiring of great, mission-critical people first. If your team truly needs a receptionist to succeed, the equity is justified. As for early departures, employees who unexpectedly leave would still have their traditional vested options, and measures are in place to prevent a manager from firing someone at the end, like a game of Survivor.

There are other edge cases we have thought of and resolved, and probably complications that arise out of the longer-term nature of this incentive. However, I spent the greater part of two years working with great attorneys closing all the legal loopholes that may arise, and I’m confident enough that I’m using Opsmatic as the first test bed for the DSP.

Of course, I welcome feedback, and I’ll definitely share what I learn as we put this new approach to work.

Jay Adelson is a serial entrepreneur, having built companies such as Equinix, Digg, Revision3 and SimpleGeo. Jay founded Opsmatic in early 2013, and currently serves as Chairman and Founder.
Featured photo courtesy Shutterstock user Shutterstock user AnatolyM

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