A big reason early stage companies fail is because they ran out of cash. A key job of the CEO is to understand how much cash is left and whether that will carry the company to a milestone that can lead to a successful financing, or to cash flow positive.
Milestones for Raising Cash
The valuations of a startup don't change in a linear fashion over time. Simply because it was twelve months since you raised your Series A round, does not mean that you are now worth more money.
To reach an increase in valuation, a company must achieve certain key milestones. For a software company, these might look something like the following:
Progress from Seed round valuation: goal is to remove some major element of risk. That could be hiring a key team member, proving that some technical obstacle can be overcome, or building a prototype and getting some customer reaction.
Product in Beta test, and have customer validation. Note that if the product is finished, but there is not yet any customer validation, valuation will not likely increase much. The customer validation part is far more important.
Product is shipping, and some early customers have paid for it, and are using it in production, and reporting positive feedback.
Product/Market fit issues that are normal with a first release (some features are missing that prove to be required in most sales situations, etc.) have been mostly eliminated. There are early indications of the business starting to ramp.
Business model is proven. It is now known how to acquire customers, and it has been proven that this process can be scaled. The cost of acquiring customers is acceptably low, and it is clear that the business can be profitable, as monetization from each customer exceeds this cost.
Business has scaled well, but needs additional funding to further accelerate expansion. This capital might be to expand internationally, or to accelerate expansion in a land grab market situation, or could be to fund working capital needs as the business grows.
What goes wrong
What frequently goes wrong, and leads to a company running out of cash, and unable to raise more, is that management failed to achieve the next milestone before cash ran out. Many times it is still possible to raise cash, but the valuation will be significantly lower.
When to put the gas pedal to the floor
One of a CEO’s most important jobs is knowing how to regulate the cash gas pedal. In the early stages of a business, while the product is being developed, and the business model refined, the pedal needs to be set very lightly to conserve cash. There is no point hiring lots of sales and marketing people if the company is still in the process of finishing the product to the point where it really meets the market need. This is a really common mistake, and will just result in a fast burn, and lots of frustration.
However there comes a time when it finally becomes apparent that the business model has been proven, and that is the time when the gas pedal should be pressed down hard. As hard as the capital resources available to the company permit.
Why? Because the single most important factor in determining the valuation of a software company is the revenue growth rate. You've got to hit the gas pedal and drive revenues up. I wrote about this in another post, The Value of Revenue Growth
Dave Kellogg summarized the correlation between valuation and growth rates for SaaS companies in his blog post, with much of it restated here:
Basically (growth rate % / 10) + 1 = forward revenue multiple.
Proven Business Model
By “business model has been proven”, I mean that the data is available that conclusively shows the cost to acquire a customer, (and that this cost can be maintained as you scale), and that you are able to monetize those customers at a rate which is significantly higher than CAC (as a rough starting point, three times higher). And that CAC can be recovered in under 12 months. I wrote about this in a previous post, Avoiding Business Model Failure.
For first time CEOs, knowing how to react when they reach this point can be tough. Up until now they have maniacally guarded every penny of the company’s cash, and held back spending. Suddenly they need to throw a switch, and start investing aggressively ahead of revenue. This may involve hiring multiple sales people per month, or spending considerable sums on SEM. That switch can be very counterintuitive.
You'll drive flat out for as long a possible at this point. You'll have another milestone you need to hit on a timeline you've created. Hyper-growth creates multiple opportunities; opportunities to continue to grow and expand the company. You can raise more money at even higher valuations, acquire other companies to expand into new markets or enhance the solution offering, or look for a very lucrative liquidity event (sale or IPO).
For guidance on how hard you should press on the gas pedal, contact me at email@example.com
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