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Praying for Growth & Exits
How to achieve the best possible financial outcome
Founder/CEOs never want to give up on the IPO dream. VCs are outlier oriented (need home runs to make money) and they want to maintain a positive reputation so they will almost never tell CEOs to give up on their dream. This dynamic can create suboptimal outcomes…
This issue is amplified by the fact that many of these companies raised tons of money at insane valuations in the 2021 era. In many of these cases the company’s current valuation is less than the total cash raised — so no one is making any money unless they shoot for the stars before running out of cash.
Exec teams are looking at options and are considering the sage advice of 50 Cent: “Get rich or die tryin’”. The mindset is to either grow revenue fast or die trying because if high growth doesn’t come then either no one is making any money or we “fail” and have to sell the company.
A lot of companies today have <2 years of cash runway left. Admist an environment of continued deceleration of revenue growth for software companies, companies are looking at the next year as their last chance to really reaccelerate growth to prove to VCs that they are fundable. It’s go big or go home time!
This might be logical, but there is a way to approach it that will maximize the potential outcome in any scenario. Keep reading…
Teams are trying to figure out what to do right now. These companies have a finite amount of cash, the VC fundraising market is still really tough, and there is a limited time to prove their company is investable.
The general scenarios being discussed:
Do we plan for an aggressive sales scenario and pray that the sales come? If the stars align then we are investable!
Do we significantly cut cash burn so we can extend our runway (or become profitable)? But we potentially kill our chances of meaningfully reaccelerating growth, becoming investable, and having an amazing financial outcome.
Do we do something in between #1 and #2?
The pressure to do #1 is strong. The logic is as follows:
If we aren’t growing [X]% then it doesn’t really matter anyways. We won’t get another round of VC funding so the company will either die or be sold. And in either case we won’t make much, if any, money…Let’s plan for the ideal case regardless of likelihood and if we fail then we just kill the company a little bit faster.
Raising another VC round of financing isn’t the only option, but given the desire to continue toward IPO dreams and the prior insane fundraising rounds it may feel like the only one that makes sense.
Once a software company reaches a certain revenue scale it is almost impossible to kill, but it may be dead from a financial return perspective given prior fundraising and current economics.
Multiple Potential Outcomes
Being acquired can be a very lucrative exit outcome. But there are different types of acquisitions with a wide range of potential outcomes.
I am confident that the employees and investors of MosaicML were pretty excited about last month’s announcement of their $1.3B acquisition by Databricks with only $20M in revenue (65x revenue multiple). They were last valued at $222M.
But strategic acquisitions (particularly in the increasingly hot AI space) are much different than an acquisition by private equity. While private equity acquisitions can be a great outcome, they are almost never thought of as the goal. And they are a very difficult option for companies that previously raised at crazy valuations.
Here are some options to be considered:
Become default investable
Become default alive
Become Default Investable
As mentioned above, becoming "default investable" is generally the focus of most VC-backed software companies.
Default Investable: a company's metrics are good enough to raise another financing round even in the current environment. -- concept from David Sacks
Revenue growth is one of the core pillars to being default investable. The level of growth required is dependent on company stage and a bit of a moving target right now as growth has stalled for mostly everyone but hopefully it starts to come back soon.
And as we all hopefully know by now, investors want growth AND efficiency. Efficiency does not mean cash flow positive, but rather favorable software unit economics.
Become Default Alive
The concept of "default alive" was coined by Paul Graham. It refers to a company's ability to not require outside capital to run the business. This does not mean they are currently profitable but that they have a path to cash flow positive before current cash runs out.
As I alluded to above, the problem for a lot of earlier-stage companies that raised money in 2020-2021 is that becoming "default-alive" might be synonymous with "zombiecorn" because not heavily investing and burning cash might result in slow growth. And slow growth means small valuations.
Zombiecorn - a company with a unicorn valuation that is still running but it is dead from an investment and employee equity return standpoint. Growth is too slow and/or cash burn is to high to be investable.
If a company is shooting for default alive and they raised a ton of money at high valuations then there likely isn’t much value to the stock. It is now a lifestyle business for the CEO and team.
The exception are the companies that are cash flow positive while growing quickly. These are rare and are both “default alive” and *very* “default investable”.
Strategic acquirers are companies that are competitors (direct or indirect), in close adjacencies, looking to expand in new directions, etc. They try to identify companies with products that can synergistically integrate with their existing business to create more value then if the entities had not combined.
They try to make 1 + 1 = 3. Or in some cases it is just to defend their current position.
An example of a strategic acquisition is Databricks acquiring MosaicML
Private Equity Acquisition
Private equity (PE) firms love software companies given their recurring revenue, scalability, and potentially high profit margins. Typically when a PE firm acquires a software company they want to be able to exit within 5-ish years (+/- 2 years).
An acquisition by PE can be a great outcome but they target specific company profiles where they think they can 2-3x their money in a few years — stable revenue (low churn), high gross margins, moderate/low revenue growth (otherwise they would go to VCs), operating leverage that enables them to move to profitability, etc.
The valuation multiples paid by PE firms are relatively low though given the profile of companies they target. So companies that raised lots of money at huge valuations will almost always have a bad financial outcome if they are considering an exit to PE.
Below are the revenue multiples by stage for PE deals. It’s interesting to see the large multiple spread based on deal size. Tech company PE multiples are better with a median of 4.9x.
Efficient Revenue Growth Cures All
Companies should aim to grow as fast as possible while remaining as efficient as possible.
Seems obvious but many repeatedly get this wrong. Companies create Microsoft Excel-induced hallucinations — "in order to be default investable then we need to grow by X% and be X% more efficient so let's go do that."
They end up missing those unrealistic sales targets, costs are the same, so cash burn skyrockets and efficiency plummets.
You just successfully ruined any chance of a good outcome. You are default dead.
How do we balance the goal of maxmizing growth while ensuring a minimum level of efficiency?
The beauty of software companies is there are endless metrics to help determine the durability and efficiency of your revenue growth. Every company's answer to this question will be slightly different depending on their stage, GTM motion, industry, etc.
Finding the answer to this question is critical. The answer to this question, will maximize the value under each of the above outcome options.
A quote that I think about often is from famed VC, Paul Graham:
Large staffs of successful startups are probably more the effect of growth than the cause.
Throwing more bodies and money at the problem in the hopes you can grow faster likely doesn’t have the result you expect. If you do grow faster, it probably is only marginally related to the more bodies/money. If growth continues to be slow, then your cash runway shrinks, efficiency plummets, and….you are now default dead.
If properly balanced then revenue might be slightly less, but efficiency is magnitudes higher. This should result in the best possible outcome in whatever scenario the company is headed towards.
US PE Breakdown - Pitchbook on the recent PE trends with 2Q23 data
Become Efficient or Die - related reading