Now a critical concept for founders and entrepreneurs…
Recently I read this tweet from a great entrepreneur Danielle Morrill.
It was the straw that broke the camel’s back for me after months of gyrating markets and dozens of similar questions from founders. I was compelled to write. It’s not that Danielle’s question isn’t a great one. It’s just that upon reading the answers to this and other similar questions all over the web, it’s clear that populist answers are all over the map, often conflicting each other and mostly only reflecting a tiny piece of the much bigger picture.
Again, not picking on this answer which may be perfectly reasonable, but generalizations like xx in revenue and breakeven are tough. And what has valuation got to do with it anyway? Yes, I know that’s provocative to entrepreneurs – it’s intentional :-0
Every business is different and key factors like the potential size and emergence of the market, your own readiness to address it and the like could make the tweet above absolutely right or completely wrong.
As per usual, I don’t have an answer, just a point of view with a framework for you to evaluate your decision making. If all you want is the Twitter version, here it is:
If you want more, here’s the thinking behind it.
Funding Cycles vs Market Opportunity
First of all, you can’t control the funding climate you have to work with. So instead, focus on what you can control – the timing and amount of your cash raise and your spend to intercept the market you’re going after.
The key mandate as an entrepreneur is to track how the market itself is emerging and understand how your prospects and customers are responding to your offerings. Armed with that data, pace your go-to-market spend according to your customer acquisition metrics. Look at both how long and how much it takes to acquire and, where possible, expand customers. Don’t overspend if time and cost to acquire are not becoming more repeatable and declining. And never ignore churn. If you pace well, you’ll intercept the evolving need of the market with just the right amount of investment to capture an early leadership position.
Easier said than done, and of course it still requires cash.
On the subject of how to much to raise, I’ve written about that here. On the subject of timing your raise, as I recently wrote, “cash has become king again.” So plan your funding to both raise in advance of when you’ll actually need the cash, but also in the context of key milestones you’ll need to show to raise again successfully. For example: show you’re meeting a real market need, prove repeatability with your product offering, and then think at least one round of funding ahead to what it will take to prove as many major milestones as will justify your next funding round. As you think about your vector to get funded again, get more specific than populist expressions like Minimum Viable Product (MVP) and Product Market Fit. Get granular and think of things like your Minimum Viable Segment (MVS – see definition here) and show how you can show tangible progress, prove value, lead or even dominate in your tightly defined early market engagements.
Introducing Funding-Market Fit
If you do this right and fund yourself at the right pace to capture your market leadership, then you have what I call Funding-Market Fit.
Here’s a simple framework for Funding-Market Fit.
Figure 1: Intersecting the market – just right!
It’s tough to find the “goldilocks” just-right formula, and some of it is personal to your profile. In this case think about the four quadrants that may guide you as follows:
It’s probably better not to raise too much until you both understand product-market fit, and your own propensity for risk.
Raising too much too early can be good if you’re risk averse, but it requires real discipline not to overspend as you figure out the right way to pace your spend to the emergence of the market.
Muscling your way into a market with more cash than anyone else can work, but it’s risky and expensive. Some VCs even try to scare competitors off by choosing to use exclamative funding to aggressively possess a space. Again, it can work, but don’t bluff if you’ve not got the strong overall company-market-fit hand!
Too little, too late and you guessed it, you’re just going to miss the market opportunity 🙁
Think about how you can move away from bottom left in the diagram, to the center, by defining tight iterations of customer and market learning. Like most things in the startup world it will be an iterative learning process that also includes, and is specific to, you, your team, your value proposition, your go-to-market strategies, and your business model. Don’t try to prove too much in each step. Reduce execution variables. Then recognize:
You can execute flawlessly, but if the market isn’t evolving, pace it. Don’t force it or overfund it.
Funding-Market Fit will give you the ability to not only capture a market and lead it, but do so in a capital-efficient manner. It’s not easy, so let’s review a couple of scenarios at each extreme, so you can think about how to target your Funding-Market Fit (FMF).
Oh dear, did I just give you another TLA?! Ignore the Three Letter Acronym if you like but please don’t ignore the concept, it will be at your peril.
If you are too early, you’ll burn cash trying to turn a latent, aspirational need into a blatant, critical need, and that’s expensive. Worse still, as the market pioneer with arrows in your back, you may well get run over by a better-funded competitor who comes in later than you and can ride the trail you’ve blazed more cash-efficiently, capturing the pull of the market as it comes to life.
Then of course if you’re too late, well, you’re too late! And of course, someone else will have captured the market ahead of you and begun building the customer relationships that you’ll have to win back in order to gain market share.
And even if you then “Muscle” your way into the market late, with a big fundraise, you’ll probably have to play by the early market leader’s rules, have to contend with disappointed customers on rebound sales cycles or worse still replacement sales, which are often even harder and more expensive.
Sometimes it may appear too late to enter an existing market but if you’ve got a breakthrough value proposition or disruptive business model such as Google had vs. incumbent search engines, that can be a fine way to blaze along the trail of already defined need laid by early market entrants.
Think 60-30-10. Leaders get to play for 60% of the market, Fast followers fight for the the 30% and the rest just fight over the scrappy 10% that’s left. Then think of the ratios between these. The leaders are often twice as valuable as the followers and 6x as valuable as the laggards who rarely survive anyway.
Talking of valuations, I’ve skipped the other top reason why trying to time your funding to optimize valuation rather than Funding-Market Fit is just plain foolhardy. Maybe you tell yourself you can co-exist or settle for a fast follower position? It could be your only choice at that point, but lest you forget it, market leaders gain a disproportionately high valuation compared to their followers. They get the higher valuation for many good reasons. Their marginal cost of customer acquisition is often lower, they have a larger installed base to offer upgrades and new products to, and are therefore more attractive for partners to work with. I could go on. But the point is all of this feeds a virtuous cycle that is self reinforcing of their market leadership and makes it much more difficult to unseat them in the market ecosystem.
So when you put all that together, it doesn’t make sense to try to optimize the timing of your financing according to the timing of macroeconomic conditions and relative cost of capital. You can’t control those cycles anyway, the best you can do is simply acknowledge them and work with them.
The second key reason that timing your funding according to Valuation is just foolhardy is that it’s not just about the “entry” valuation, it’s just as much if not more about your “exit” valuation. And of course exit valuations are driven by timing themselves. To some extent you might be able to time your exit or IPO, but not always, as IPO windows come and go in macroeconomic cycles and if you’re going to be acquired or worse still, have to sell, it may be out of your control.
So how impactful can exit timing be? (click to tweet) Well you only have to look at the first few months of 2016 to realize how dramatically valuations can fluctuate. For example, in the public market, many SaaS companies are trading at half their average multiples, even after a recent rebound. And they are way off their peak multiples in some cases by nearly an order of magnitude!
All this is to say trying to time your funding to optimize valuation is crazy making stuff. Even if you can do it on “entry” realize you’ll also have to do it on “exit.” In-between is the real determinant of value – whether you can find a large market and capture leadership in it. That’s why Funding-Market Fit is such a powerful and critical concept for founders to grasp.
Those of us who’ve watched the movie over and over again know the plot and the main characters to look for. Ensure you manage what is in your control and raise the capital you need to capture your market window and market leadership and pace your investing / execution accordingly.
If you do that right, even if you took more dilution because you had to raise money in a tough financing environment and owned less of your business early on, the ultimate value of your business has the potential to way more than compensate.
Bottom line: Great entrepreneurs don’t over optimize valuation. They prioritize value creation through market leadership. Great investors don’t optimize short term financings, they prioritize large outcomes. And finally, great partnerships between entrepreneurs and investors are formed when we get in sync on what matters for the long term.
As always we welcome your comments and look forward to hearing what matters most to you in the comments below…
1. Capital IQ and IBES
Note: Large Cap includes: Salesforce.com, Workday, Palo Alto Networks and ServiceNow. Small-to-Mid Cap includes: Demandware, FireEye, Marketo, Veeva, Tableau, Splunk and NetSuite. Multiples for FireEye and Veeva shown after estimates became available post-IPO. IPOs for these companies priced on 9/20/2013 and 10/16/2013, respectively. Revenue estimates per IBES. Estimates were calendarized for companies with non-December fiscal year ends. Enterprise values based on diluted shares outstanding. For table at upper right, 1 year forward multiple defined as current calendar year if before May, otherwise following calendar year metric utilized. Current multiples as of 7-Mar-2016.
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