The Science of Financing a Software Startup (Part 1 of 2)
"If you buy things you do not need, soon you will have to sell things you need" —Warren Buffet
There are now almost 440 European VCs (more than 2x the number a few years ago) which can make it tricky and time consuming to differentiate the best from the rest. Most founders I have spoken with indicated that they met with 50 to 150 investors in the past year in preparation for their upcoming fundraise.
Is that the best use of time when there are only 20 to 30 VCs that are really relevant for the business today?
Last time I wrote about how to evaluate VC funds from the perspective of their investors (a.k.a Limited Partners or “LPs”). In the next two articles, I will address the same topic in a more practical way for software founders who are looking to fundraise this year.
The articles provide a framework for the following two key questions:
How much money should a startup raise?
Who should a startup raise from?
In order to answer these questions, software startups need to understand the purpose behind what the money is used for and what expectations they have from their investors.
These would include evaluating the business and prospective VCs in terms of:
Business maturity: Scale vs. Predictability
Purpose of money: Cash Flow vs. Growth
Business objective: Flexibility vs. Cost
Fund strategy: Fund Size vs. Growth Acceleration
Let’s dive into the first two topics in more detail.
How much money should a startup raise?
In March 2017, I had an one-hour meeting with a founder who told me his thriving startup was a “lean and mean army ready to strategically attack the old kingdom that had become complacent & entitled and was sitting on a throne of riches”. He had tracked the efficiency of every individual within his 50-person team down to each phone call and minute working inside the business. I thought he was completely bonkers and (possibly) brilliant. I walked away from the conversation with high conviction that the business had measured, analyzed, and took action on all employee engagements and customer interactions in order to scale towards a predictable commercial engine and navigate a very complex, regulated market. (The company has since gone on to raise over $120MM in funding.)
The amount of external capital a company should fundraise depends on:
Maturity of the business
Purpose of raising money
1. Business maturity: Scale vs. Predictability
Mercedes Petronas is known as the most successful Formula 1 team in history. They have won every single championship since 2014 following a shift in strategy in 2013 which included the recruitment of late legendary driver Niki Lauda (red cap) and current racing star Lewis Hamilton (black cap).
In today’s market, there is a discrepancy between amount of money raised, classification of the funding round, and business maturity, so it is better to categorize where a company is in its lifecycle based on the key strategic objective at each stage.
The below graph breaks down the maturity of a high growth software business based on scale (measured based on Annual Recurring Revenue or “ARR” and headcount) and predictability (as a function of time to market).
*Note: Scale is measured based on ARR and employee headcount. As previously mentioned, a healthy benchmark for mid/enterprise software businesses at scale (i.e. 100–250 FTEs or $10–30MM ARR) is $100–150K ARR per full-time employee (“FTE”).
Point Nine, a leading European software seed investor, conducts an annual survey of what a software business looks like when it fundraises in relation to ARR, growth, valuation, round size, go-to market and organization set-up. See their SaaS Funding Napkins for 2019 and 2018.
2. Purpose of money: Cash Flow vs. Growth
Is the financing for race car fuel, engine & parts, or the drivers?
The second and equally important consideration is figuring out what the money is being used for —whether it is spent on:
Working capital — operating cash flow, and/or
Growth — experimental or proven marketing and sales
Working capital is the difference between when money is actually paid and received within the business— the delta between customers payments and employee compensation. The beauty of modern day B2B software businesses (often SaaS) is they have negative working capital — the customers are partially funding the business and its talent before they have experienced all the benefits of the products and services the company offers.
Growth is a mixture between experimental and proven commercial distribution. In the early days, it means achieving product-market fit by acquiring paying customers for a new and proven solution. As the business scales to 100–250 FTEs, it translates to a predictable growth engine— with clear revenue & cost attribution and predictable forecasting behind marketing & sales as well as business cash needs.
The below chart shows a simplified overview of the type of venture funding available to software startups based on the purpose and related implications of raising that capital.
Note: The above excludes financial capital received from R&D grants, government, and private individuals.
Before raising a Series A round (let’s say it’s $5–15MM+ of funding), it is important to start tracking & measuring each customer interaction and employee engagement in order to understand the revenue & cost structure (i.e. variable, fixed) and cash needs (i.e. working capital, growth) of the business.
Understanding unit economics is super important because the majority of venture funding should be invested in growing the commercial engine (i.e. marketing and sales).
Where & how are customers and employees investing their time? What is the outcome?
For customer interactions, this means understanding:
Sales conversion funnel — Marketing Qualified Lead (“MQL”), Sales Qualified Lead (“SQL”), verbal commitment, contract signing
After sales process — contract signing, going live, onboarding & customer support, expansion & contraction
Time associated with each interaction across each function within the business
For employee engagements, the business should seek to have a clear view of:
Time to hire
Time to onboard and ramp
Performance — quota attainment, mishires
Compensation — salaries, commissions
Oktoberfest spend will vary by tent, table, week, day of week, time spent, gluten and meat tolerance, and emotional sentiment.
Before embarking on a fundraise, a software startup should always seek to understand what is achievable and sustainable in terms of growth and cash needs based on:
In the next post, I will provide a practical framework for software startups and their founders to use when evaluating VC funds.