BRAD FELD ON PRODUCT MARKET FIT – THIS ONE IS A BITCH

January 20, 2015

The Illusion of Product/Market Fit for SaaS Companies

“We have product/market fit.”

“We are searching for product/market fit.”

“We are raising this financing to find product/market fit.”

“Our customer traction demonstrates product/market fit.”

Product/market fit. It’s a wonderful phrase, thanks to Marc Andreessen, Sean Ellis, Steve Blank, and Eric Ries. But it also one of the most overused, and inappropriately used, phrases that I hear with SaaS companies on a daily basis.

I was in a meeting a month ago with a company I’m on the board of where product/market fit was asserted. I sat quietly for a moment and then stated as clearly as I could that the company didn’t have product/market fit, they had the illusion of product/market fit. A long conversation ensued which resulted in me pondering this illusion and trying to put some parameters around it.

But first, some history.

There’s a fun post from Ben Horowitz in 2010 titled The Revenge of the Fat Guy that weaves in comments from Fred Wilson about product/market fit where Fred argues in his post Being Fat Is Not Healthy. While ostensibly it’s a post about lean vs. fat startups, it really is about discovering product/market fit and it gives a good history lesson on the thinking circa 2010 on this issue. Ben eventually states, and then explains, four product/market fit myths.

  • Myth #1: Product market fit is always a discrete, big bang event
  • Myth #2: It’s patently obvious when you have product market fit
  • Myth #3: Once you achieve product market fit, you can’t lose it.
  • Myth #4: Once you have product-market fit, you don’t have to sweat the competition.

As I rolled this around in my head, I started to realize that part of the illusion of product/market fit is that there’s a belief that once you have it, you never lose it (myth #3). There’s also the belief that there’s a magic moment where you have it and declare it (myth #1). Worse, there’s the belief that it’s obvious when you have it (myth #2). And tragically, a lot of companies believe when they have it, they don’t have to worry about anyone else because they’ve won (myth #4).

I’ve experienced the downside of each of these myths many times. I’ve seen companies have to rediscover product/market fit after getting to a $500k MRR (monthly recurring revenue). I’ve been involved in companies that thought they owned the market at a $2m MRR only to have a new competitor come out of no where and beat the crap out of them. I watched companies at a $4m MRR enter new markets and struggle mightily to discover product/market fit for these new markets. Or worse, I’ve seen a new product release that was late completely toast product/market fit and force a company to hang on to customers any way possible while rushing to fix what was broken.

The illusion of product/market fit pops up at multiple points in time. So I started thinking about heuristics for these points in time and came up with MRR as a parameter to explore. Suddenly, the illusion problem came into focus for me based on MRR, with clear transitions happening up to a $1m MRR. While I’m going to keep exploring this, I have a hypothesis now about the dynamics around product/market fit in SaaS companies that I’m playing around with. Feel free to tear it apart.

When you have $0 of MRR, you have no product/market fit. Ok – that was easy. You are working on a product and searching for your first customer.

From $1 to $10k MRR, you have the illusion of product/market fit. You finally found someone to pay you for your shitty MVP, but you’ve got a long way to go before you truly have product/market fit. Do not pour on the gas at this point. Stay calm and keep doing what you are doing.

$10k to $100k MRR is a super exciting time. You’ve got a semblance of product/market fit. You are starting to learn what your customers will pay you for. You feel like things are actually cranking. You probably have one or two salespeople and one of your founders – maybe your CEO – is still the head of sales. If you try to raise a Series A, the process is straightforward. It’s easy to believe you’ve got it figured it out here. This is the point at which myth’s #1 and #2 usually kick you in the ass. If you aren’t growing a compounded 10% each month, you don’t have product market/fit yet. If you are growing faster than that, you have found something.

Going from $100k to $500k MRR is a product/market fit sweet spot. You are starting to build a sales organization, have visibility in the market in your segment, and might even have customers coming to you on a regular basis. This is where myth #3 bops you on the head. You think you’ve got it and it’ll keep scaling, but you hire the wrong VP Sales, you focus on the wrong metrics, or you end up struggling to renew your customers when the first annual renewal cycle hits. You get confused about negative churn and conflate upsells with growth with churn. Lots of companies stall here – some due to self-inflicted pain; others due to the illusion of product/market fit.

If you can blast through the $500k MRR mark and march to $1m MRR, you’ve found product/market fit. You are now at the magical point some people call “Initial Scale.” Cool – you’ve got a business.

Now, your value is going to be determined by your growth rate. At any point in time, if you are growing > 100% year-over-year you will be highly valued – think at least 10x revenue, but I won’t tell you whether it’s trailing or forward, as that’ll shift around based on the public markets. And, the faster you are growing, the more discontinuous (e.g. higher multiple, but not linear) your valuation will be.

If your growth rate is between 50% and 100% and holding steady, that’s good and you’ll see a nice, big, healthy valuation. But if it’s declining, watch out for that magic 50% year-over-year mark. It’s like a trip wire that will send off all kinds of weird alarm bells. Once you decline below 20%, you better make sure your existing investors are going to be ready to step up to finance you, or else start the rapid march to profitability, which likely generates even slower growth.

Myth #3 and myth #4 show up all the time at MRR’s > $1m. You disrupted someone a few years ago which is what caused you to discover product/market fit. Don’t be confused about the world – someone else is gunning for you now that you are the big player in whatever segment you are in.

Every time you work on something new, whether it’s a new feature, a new product, or a new product line, recognize that you are searching for incremental product/market fit. The search is a continuous and never ending quest. Don’t confuse illusion with reality.

hi, badrish – see this – its kinda interesting

Accel invests $50m in code testing firm BrowserStack

ET Bureau|
Jan 31, 2018, 08.50 AM IST

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Read more at:
//economictimes.indiatimes.com/articleshow/62718792.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

From: Badrish \<badrish.aom>
Date: Wed, Jan 31, 2018 at 11:20 AM
Subject: Re: hi, badrish – see this – its kinda interesting
To: Ajay Mishra <ajayinsead03>

Example of Patience in Venture

https://economictimes.indiatimes.com/small-biz/startups/newsbuzz/accel-invests-50m-in-code-testing-firm-browserstack/articleshow/62718792.cms

On Wed, Jan 31, 2018 at 5:06 AM, Ajay Mishra <ajayinsead03> wrote:

https://en.wikipedia.org/wiki/Typeform.com

WE MAKE THINGS THAT GO INSIDE THE THING THAT GOES INSIDE ANOTHER THING – Thats Mittelstand – and its a very GERMAN thing. Its not an AMERICAN OR ISRAELI OR INDIAN THING

A VC asked me where i see the company in years ahead

he is an american VC

so his question is do u want to be a Billion dollar worth company or do you plan to stick around and grow Myraah to be a Billion dollar sales

here is that post -> http://yoninetanyahu.com/2018/01/31/the-question-are-u-gonna-be-a-billion-dollar-valuation-company-or-do-u-want-ot-be-a-billion-dollar-in-sales-company/

70 % of german employment is through MITTELSTAND companies : these companies are :

[a] SMALL AND MEDIUM BUSINESSES WITH AROUND $50 MILLION IN ANNUAL SALES

[B] TYPICALLY FAMILY OWNED

[C] TYPICALLY IN GERMAN SUBURBS OR AT LEAST FAR FROM THE MAJOR BIG CITIES LIKE BERLIN MUNICH, FRANKFURT ETC

these Mittelstand companies are mostly high tech manufacturing and/or high – end manufacturing – most of them manufacture assembly items that go into the larger assembly items of some end product – a finished good ..

[youtube http://youtube.com/w/?v=1CRDcqkHLE4]

[youtube http://youtube.com/w/?v=eUjqQZLbKgA]

as you can see -this MITTLESTAND is a godo thing

[youtube http://youtube.com/w/?v=ov8i50KEekI]

that said – VC backed companies or our company MYRAAH isn’t like MITTLESTAND model

u can see a good blog post on the differences here -> https://nothingventured.rocks/what-startups-can-learn-from-the-mittelstand-399842086221

here u will hear a word UNICRON – motre on that later

ps: one way to think about growth and unicorns is to ask- CAN this company grow non-linearly ? – SPECIALLY when u want to compare and contrast a company in say technology – which has the potential to grow exponentially – or non linearly – versus – a manufacturing company – which is hard to grow non linearly

THE QUESTION : HEY U MYRAAH FOLKS :ARE U GONNA BE A BILLION DOLLAR VALUATION COMPANY OR DO U WANT TO BE A BILLION DOLLAR IN SALES COMPANY

WITH YOU HE MEANS

THE FOUNDERS OF MYRAAH

 

IE

SAURAV KUMAR

 

AJAY MISHRA

 

GAURAV KUMAR

Gaurav called me today. He said ” sir, whats happening at your end “

 i am mulling over last night’s question from a VC friend from Palo Alto California. I told Gaurav.. and one more question – the backup for the addressable market..size.

 

 

 

For entrepreneurs its an important question.


It has something to do with:

[a]

the VISION

[b]

the AMBITION – U can call it as some others may – the MISSION

[c]

the patience, the perseverance and there is one more word – with p – Yeah the PSYCHOLOGY


because? well because – many entrepreneurs get burned.


They are happy with an early exit .

Dreams of Seychelles, Sicily and Serenity of Goa, Eilat, Hawaii and Bali come to many an entrepreneur’s mind.

 

We just exceeded this month’s sales target. Its always good to have good news.


 

Later in the day: Dad asked me -” SO, how is your company doing?”

I told him : we want to be a BILLION DOLLAR REVENUE COMPANY

:)


we are moving to a new office. starting February 5. Well February 5, is the Havan

what is a Havan? Well, its a Hindu event thing they do when they want to inaugurate a new beginning. Its the Hindu equivalent of a Blue Ribbon cutting ceremony

[youtube http://youtube.com/w/?v=o5tbcKS1pAM]

my mom will do her own Puja { Puja means worship and praying } in Lucknow house.

Gaurav – wrote this cool post.

Gaurav is a nice fella. Very Smart guy.

Gaurav was in London.

He did his Master’s of Finance in London.

And worked in London at Lloyd ‘s .

Gurav then did his MBA from IIM Ahmedabad.

Saurav is the younger brother of Guarav:

Saurav is my junior from IIT Kanpur.

Saurav is our Ramanujam – a MATHS MAJOR FROM IIT.

Go to the profile of Myraah IO
Myraah IOFollow
Oct 1, 2017

Om’s (Shiva) law of Sales

1*qSwBRuJgscWnj5hbLkaGjw.jpeg

To my entrepreneur friends,

So you have figured out a product or service. You and your co-founders worked day and night to create a product or service.

Now, the most important battle begins — To find the product market FIT.

This challenge is enormous and this is why many of start-ups fail. They fail to sell.

I am no start-up guru. But based on my experience of over 10+ years doing start-ups I discovered a common pattern.

This may help other entrepreneurs make their first sales.

OR

even better discover a PROFITABLE AND SCALABLE SALES MODEL.


I call it OM’s law of sales. It sounds like OHM’s law in physics and actually works like that. But I renamed it coz I am a SHIVA follower.

Here it goes:

The idea of sales is to flow the money from customer to your bank account. Think of it like current flowing from point C (Customer) TO your Bank Account (B). WOW- Like C-2-B

0*SGM0HLW9YlA5dL6C.png

OK, this transaction is our goal. To make the current (Money) Flow from customer to your account.

But, you will need to overcome FOUR resistances.

R1 : WHAT ARE THE CHANCES THAT THE PROSPECT IN QUESTION IS LOOKING FOR THE SOLUTION YOU ARE SELLING

Real Estate Example: If you are selling a 1 BHK home. And you come across a prospect. But, She is actually looking to buy a 2 BHK. What are the chance of sale — 0%. No matter how hard you try you won’t be able to do the transaction.

Now the next example entrepreneurs will love. Suppose you are approaching a VC for funding. Suppose you have a services business.

 

BUT the VC invests only in TECH product.

The chances of funding is ZERO coz their money cannot cross the first R.

Simple. When you realize this. move on to the next lead.

 

Lesson: Focus and invest in finding the RIGHT prospect.

R2: WHAT ARE THE CHANCES THAT THE PROSPECT IN QUESTION HAS AN IMMEDIATE NEED TO BUY

Real Estate Example: If your prospect is actually looking for 1BHK home and you are selling 1 BHK home. Great R1 crossed with fair probability. Now suppose prospect says he is looking to buy in 3–4 months of time as he has started looking for a home. Oh, this means the probability of transaction happening is low. These kind of prospects will waste your time. Move on Buddy!

Now the VC example: So the VC invests in the business type you are in. Great. But they don’t are not in a hurry may be they will like to shop around for 6 months or so as they are meeting many start-ups. What are your chances buddy!

This happens a lot in the Angel world.

Lesson: Find prospects , who are hungry and you have the right food for them.

R3: WHAT ARE THE CHANCES THAT THE PROSPECT IN QUESTION HAS AN ABILITY TO PAY

Real Estate Example : Your prospect is looking for 1BHK. He wants to close the deal in next 10 days. How about his ability to pay, that’s R3. You realize his credit rating is bad and no bank will give him loan. FINISHED. He cannot buy. So move on.

Now the VC example: You spoke to an associate at the firm and everything is looking good. They like what you are doing and they like your team. Waiting for the cheque. Actually VC himself is waiting for the Cheque from their General partners. They don’t have the money RIGHT NOW in the bank. As they themselves are raising for the FUND -2. What are your chances of getting funded buddy !

This has happened with me and friends I know. So don’t discard this.

Lesson: Always confirm if the prospect has the money to buy what you are selling.

R4: WHAT ARE THE CHANCES THAT PRICE PROSPECT IS ASKING IS A PRICE YOU WANT

Now Suppose our prospect got the loan and all R1,R2 an R3 are satisfied. Now it’s a deal buddy. NO.

Real Estate Example: The last thing is that prospect may say: I can offer 30 Lakhs for the flat you want to sell at 50 Lakhs. Will the deal happen? NO.

Now the VC Example : All done. Now the VC gives you valuation of $1 M whereas your expectation is $5 M, Will the deal happen. Remember Snapdeal.

Lesson: Always clarify the price early in the sales process.

OK

Here is the summary:

Figure out all these chances (Probability) earlier in the sales process. So that you don’t waste time on wrong leads.

MULTIPLY them and calculate what the chances of sales are. If any one of them is ZERO. Trust me my HERO it’s gonna happen. MOVE ONE.

Here is OM’s law of sales:

CHANCE OF SALES =

(PROBABILITY THAT I AM SELLING THE SAME THING AS PROSPECT IS LOOKING FOR)

X

(PROBABILITY THAT PROSPECT HAS AN IMMEDIATE NEED TO BUY)

X

(PROBABILITY THAT PROSPECT HAS MONEY OR CAPACITY TO DO THIS TRANSACTION)

X

(PROBABILITY THAT PROSPECT HAS SIMILAR EXPECATION OF PRICE THAT I HAVE IN MIND)

Comments pls.

saurav’s paper is below

[slideshare id=74566381&doc=sauravsspainpaperregardsajaymishra324368521-170406171229&type=d]

Mom asked me why i work?

here is why

PS: A BILLION DOLLAR VALUATION COMPANY MEANS $100 MILLION IN SALES – MULTIPLIES BY 10 TIMES THE SALES = A NET WORTH OF ONE BILLION US DOLLAR COMPANY

AND A BILLION DOLLAR IN SALES COMPANY – MEANS  MANY A BILLION DOLLAR NET WORTH COMPANY.

PS: AFTER A FEW MILLION DOLLARS – OK – LETS SAY $100 MILLION – IT DOESN’T REALLY MATTER MUCH – HOW MUCH MATTER ONE. ONE WAY TO EXPLAIN THIS WOULD BE – HOW MY PROFESSOR AT INSEAD SAID – HE SAID – THERE IS A LAW OF DIMINISHING UTILITY –

I WANT TO DO SOMETHING MORE THAN JUST HAVE MORE MONEY. .. SO, WHAT IS IT HONEY? DO U KNOW?

 

 

Regarding PAR Finance :

Hi Saurav and Rohit

[1] Change the NAME of the header – from GALLERY to TEAM

[2] Add a TEAM BLOCK content on Home Page – – position – just right above this section

[3] 4 people team Block in here

OUR TEAM

team.jpg

PAR Financial offers a common integrated platform for all your financial needs, be it budgeting, investment planning, investing and achieving goals.
We provide tools that allow users to create monthly investment plans track their spending pattern and optimize savings.
Whether you opt for long term or short term investment plans, PAR Financial acts as a financial investment advisor and helps you select, compare and keep track of your investment goals.

PAR Financial makes users financially independent by helping them grow and track of their investments

PAR Financial offers savings optimizer to help user optimize savings, which ultimately helps them to achieve their goals.

http://myraah.co/clients/financial/

thnx

ajay

 

Someone just viewed: Fwd: BEACH

HELLO MOSCOW

:)

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eyJlbWFpbF9pZCI6IlpNX3lBUUFCWVVkSVBDSkYyZUZmU2p1VVJEZEsifQ==

the dreaded FUNNEL

Sales Funnel Optimization For SaaS Startups

sales_funnel.png

There’s a magical property to the classic sales funnel SaaS startups use to evaluate the effectiveness of their go-to-market organizations: an increase in effectiveness at any stage of a sales funnel cascades through to the end funnel. But improvements to the early parts of the funnel are more important than those later in the funnel, because they meaningfully improve key SaaS metrics like cost-of-customer acquisition and pay-back period.

Most startups employ a four stage funnel: prospect, lead, opportunity, customer. Typically, a prospect is an email of a potential customer. A Sales Development Rep (SDR) qualifies the prospect to a lead. The lead is then passed to an Account Executive (AE) who qualifies it further into an opportunity and works to close the deal, yielding a customer. The yield from one part of the funnel varies quite a bit depending on the startup’s sector, how the business acquires leads, the competitive dynamics in the sector and the qualification regimen of the company.

Let’s compare three different funnels each starting with 1000 leads and yielding 125 customers. Funnel 1 pushes 50% of leads through each step. In Funnel 2, SDRs filter 70% of prospects up-front. In Funnel 3, Account Executives whittle down the high volume of SDR-qualified leads late in the process.

Funnel

Prospect

Lead

Opportunity

Customer

1

1000

500

250

125

2

1000

300

150

125

3

1000

750

500

125

For each funnel, we’ll improve yield at a different step. In Funnel 1, the prospect-to-lead ratio increases by 10%. Same for Funnel 2’s Lead-to-Opportunity ratio and Funnel 3s Opportunity to Customer Ratio.

Funnel

Prospect

Lead

Opportunity

Customer

1

1000

550

275

137.5

2

1000

300

165

137.5

3

1000

750

500

137.5

No matter where the incremental 10% improvement occurred in the funnel, the business benefits from a 10% growth in customers. This conclusion can be counterintuitive at first, but it works because of the commutative property of multiplication.

For startups, this hypothetical implies that any efficiency or yield improvement in the sales funnel is equally as valuable as another of the same magnitude.

But consider the question of time efficiency for a startup. Let’s assume an SDR requires 5 minutes to evaluate a prospect, an AE needs 30 minutes to qualify a lead to an opportunity and the AE invests 4 hours to convert an opportunity to a customer. The table below shows the total hours required by each step.

Funnel

Lead

Opportunity

Customer

Total

SC CAC ($)

1

83

275

825

1183

403

2

83

150

450

683

229

3

83

375

1125

1583

543

The third funnel is 2x more expensive in time as the second requiring 1583 hours to produce 137.5 customers compared to 683 hours.

The sales-contribution to the cost-of-customer-acquisition which is abbreviated SC CAC in the table above, increases from $228 to $543 for Funnels 3 compared to 2. In other words, this time efficiency doubles how much money the sales team invests to acquire a customer. Keeping the SC CAC low will increase payback periods, sales efficiency and many other go-to-market metrics, enabling your startup to grow faster with less capital required.

This is why investing in improvements at the top of the sales funnel, particularly in early prospect and lead qualification are so valuable: they save the time and energy of a startup’s go to market teams and can meaningfully improve unit economics.

ON PRICE

Ten Year’s Worth Of Learnings About Pricing

bw_cash_register.jpg

Last week, I shared a presentation with an executive team at a large public SaaS company on everything I’ve learned about pricing. Here’s a summary of the frameworks and theory that I’ve aggregated over a decade of investing in startups.

Why do we set prices? Setting aside the important reasons of generating revenue and maintaining solvency for a business, there are many other reasons to set price. Price reinforces brand because price telegraphs whether a product is a premium product or a value product. Price differentiates products in the market and can be used as a go-to-market strategy. Underprice the competition to gain share. There are many others too.

There are four components to pricing: 1. Strategy: what is the goal of the price? 2. Philosophy: how does the company price relative to costs? 3. Structure: what is the pricing rubric? 4. Positioning: how best to communicate the price?

Strategy
There are only 3 pricing strategies: Skimming, Maximization, and Penetration. Skimming means charging the first to buy a product more than the later buyers. Maximization is charging the most you can extract in each sale. Penetration is under-pricing to gain share.

Philosophy
There are two pricing philosophies: cost-based pricing and value-based pricing. Cost-based pricing is common in commodity markets. To price based on cost, you take the cost of the product and then add a margin. If you’re targeting 50% margins, just double your cost and there you are.

Value based pricing means charging the customer what they are willing to pay. This requires understanding their budget and the value of the product to them.

Structure
In software, we typically see three pricing structures. Linear Pricing (LP) – Each analytics event costs $0.10.

2 Part Tariff (2PT) – The analytics software has a base platform fee of $10,000 and each analytics event processed by the system costs $0.10 more.

3 Part Tariff (3PT) – Again, the software has a base platform fee but the fee is $25,000 because it includes the first 150k events are free. Each marginal event costs $0.15.

In academic research and theory, the 3 part tariff is proven to be best. It provides many different ways for the sales team to negotiate on price and captures the most value.

Position
There are three ways to position pricing: per unit of consumption (message, analytics event, telephony minute), per person and ELA (enterprise license agreement), which is a prenegotiated deal for everyone in a business.

To figure out the right pricing strategy, it’s critical to determine what the buyer cares about. Do they care about cost or value? What is their core unit of their world: people, dollars, gigabytes? How predictable is the pricing plan? And can the buyer clearly articulate the pricing, advocate on your behalf and champion the purchase?

It’s also important to understand the seller’s needs. How does the pricing change the market size? The unit economics and cash flows associated with the sale? The competitive positioning?

All of these disciplines fall under product marketing. Well run product marketing teams develop these perspectives before product launch. By combining market research, interviews with prospective customers, conversations with the sales team, the product marketing team can develop a unified pricing strategy that is consistent with the company strategy and the sales tactics.

The challenge with pricing is that it’s never a constant. As an industry evolves, competitive pressures change, a vendor’s positioning changes and the buyer’s needs change, so must pricing.

Thinking through these 4 core parts of pricing is critical to ensuring internal alignment and maximizing success of developing the right pricing plan for your business.

IF PRICE CHANGES BY X % AND QUANTITY CHNAGES BY Y $ – WHAT WOULD BE THE % CHANGE IN THE REVENUE GIVEN THAT R = P * Q – HOW TO GET THIS BY CALCULUS

R = P * Q

% CHANGE IN R = R ( n) – R ( n-1) / R = d (R) /r

dR = P dQ + Q dP

dR/ R = P ( dQ )/ P*Q) + Q DP/(P*Q)

=> d(R) / R = Change in Revenue / Original revenue = percentage change in R –

= d(Q)/ Q + d (P) /P

= % CHANGE IN Q + % CHANGE IN P

Here P stands for Price,

Q for quantity

and

R for Revenue – ie sales

so,

IF PRICE CHANGE BY 3 % AND QUANTITY CHANGES BY 5 % – THEN THE PERCENTAGE CHANGE IN R – THE REVENUE

= % CHANGE IN ( P + THAT IN Q)

= 3 % + 5 %

= 8 %

NOTE – HERE D or d is the standard operator symbol for the DIFFERENTIAL – as in DIFFERENTIAL CALCULUS

YES U CAN DO THE SAME CALCULUS IS THERE IS A RATIO

AS IN IF SOME NUMBER N = A DIVIDED BY B THEN IF A CHANGES BY X % AND B BY Y % THEN N WILL CHANGE BY X MINUS Y PERCENT

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3 MODELS – TO ACHIEVE THE SAME $1 M OR $10 M TARGET : [A] LINEAR – IE AP -GROWTH MODEL [B] EXPONENTIAL IE GP GROWTH MODEL AND [C] A HYBRID – GROWTH MODEL FOR MRR SPECIALLY

AND YES, WE CAN HIT THE SAME – TARGET – SAY $ 1 MILLION REVENUE OR $100 MILLION REVENUE – BY THESE 3 MODELS : BECAUSE CUMULATIVE YEARLY REVENUE = SUM OF ALL THE 12 MONTH REVENUE –

HOW?

FIRST SEE THE DIFFERENT GROWTH MODELS

[a]

Linear Growth model -means ARITHMETIC progression : as in

{\displaystyle \ a_{n}=a_{1}+(n-1)d},

where

– a 1 = the first term – i.e. – the revenue /sales at the beginning of a month

– a n = the revenue in the nth month

– d = the common difference

S (n) = Sum of all the monthly revenue numbers

S_n=\frac{n}{2}( a_1 + a_n).

In this model a CONSTANT number gets added to the number prior to it – ie. this month revenue = previous month revenue PLUS – a Number called – D

 

 

{\displaystyle \ a_{n}=a_{1}+(n-1)d},

 

 

 

so in this case if we want to arrive at the growth rate formula

then G = growth Rate = a(n) / (a(n-1) – 1

where a ( n-1 ) = a 1 + (n-2) d

substitute and get G = { a (1) + (n-1) /d } / { a 1 + ( n-2) d)

which means and implies that G (n) will not be a constant – and would vary each month

ie – there would be a mean value but since each term { each number} would be different – there would be a variation – and here is the

standard deviation –

 

The standard deviation of any arithmetic progression can be calculated as

\sigma = |d|\sqrt{\frac{(n-1)(n+1)}{12}}

where n is the number of terms in the progression and d is the common difference between terms.

so, there would be a MEAN around the Revenue number and the distribution would have a standard deviation – shown above

[b]

EXPONENTIAL GROWTH MODEL – AKA – THE GEOMETRIC PROGRESSION –

This EXPONENTIAL Model is hard to sustain –

– this model assumes – a constant growth rate –

OBVIOUSLY THIS IS ONE WHICH EVERYONE LIKES

a,\ ar,\ ar^{2},\ ar^{3},\ ar^{4},\ \ldots

where r ≠ 0 is the common ratio and a is a scale factor, equal to the sequence’s start value.

BECAUSE IT BLOWS UP TO INFINITY – QUICKLY – BUT THIS IS ALSO A HARD ONE TO SUSTAIN WHEN N – APPROACHED LARGE NUMBERS

The n-th term of a geometric sequence with initial value a and common ratio r is given by

a_{n}=a\,r^{n-1}.

Such a geometric sequence also follows the recursive relation

a_{n}=r\,a_{n-1}

for every integer n\geq 1.

OBVIOUSLY BY DEFINITION

– THE GROWTH RATE IMPLIED IN THIS MODEL IS – CONSTANT –

THIS MONTH SALES NUMBER DIVIDED BY LAST MONTH’S SALES NUMBER

=

A(n) DIVIDED BY A(n-1)

WHICH IS EQUAL TO THE SAME

– IE – THE COMMON RATIO R

SO, MONTHLY GROWTH RATE IN THIS MODEL – REMAINS THE SAME.

[C]

THERE IS A 3RD MODEL

 A HYBRID -MODEL

BETWEEN THE AP AND THE GP – MODELS-

I.E BETWEEN THE LINEAR AND THE EXPONENTIAL MODEL :

WHICH IS MORE REALISTIC

AND WHAT WE SHOULD

OR WOULD BE FORCED TO PLAN FOR

– AS N – THE NUMBER OF MONTHS – IN OPERATION – INCREASES LINEARLY WITH T –

THE TIME – FARTHER AWAY

FROM SEPTEMBER 2017 INCREASES

 

in this model – you take the average of the NET – NEW – MRR – numbers –

{ MRR STANDS FOR MONTHLY RECURRING REVENUE }

BY ADDING THE TWO NEW NEW MRR NUMBERS

FROM THE LINEAR AND THE EXPONENTIAL MODELS ABOVE – MENTIONED IN [A] AND [B] – SECTIONS –

AND THEN DIVIDE THAT BY 2 –

AND THEN ADD TO THE PREVIOUS TERM

TO GET THE NTH TERM

BASICALLY

– IN THE LINEAR MODEL U HAD – A COMMON DIFFERENCE – IE D – ADDED TO EACH TERM

– AND IN THE EXPONENTIAL MODEL U HAD THE COMMON RATIO – R MULTIPLIED TO EACH SUBSEQUENT TERM

– IN THE HYBRID MODEL – YOU TAKE THE AVERAGE OF THE TWO END POINTS –

AND ADD TO EACH SUBSEQUENT TERM

 

 

 

YOU CAN DO THE MATHS – IN EQUATION FORMAT

OR – YOU CAN DO ACTUAL NUMBERS AND MACROS AND FORMULAS IN EXCEL

OR GOOGLE SHEETS

 

HERE IS THE LINK FOR GOOGLE SHEETS ->

https://docs.google.com/spreadsheets/d/1k9BW460b8cTRSTFpl61k47Cg28xo4pOBCAx0V5n3FrM/edit?usp=sharing

yes, you can download in CSV format as well..

If you like to see numbers visually

see this graph

– GRAPH OF GROWTH MODELS –

 

IN SAAS growth MATTERS – AND IT MATTERS – A LOT

OR I GUESS SOME WOULD SAY – IT MATTERS THE MOST

The Increasing Growth Rates Of SaaS Companies

SaaS startups are growing faster than ever before. Publicly-traded SaaS companies founded from 2008 through 2014 needed 50% less time to reach $50M than their counterparts founded between 1998 and 2005. I stumbled across this trend when looking at a different chart used in my S-1 analyses that compares the time to $50M for each of the 51 or so publicly traded SaaS companies.

 

WIX IS SHOWN BELOW -in red

MY EYES AREN’T PERFECT -BUT I EYE BALLED IT – AND IT LOOKS LIKE- IT TOOK WIX – 7 YEARS – APPROX – SEVEN YEARS – TO HIT THE $50 M REVENUE COMPANY – WE R US –

 

colored the companies founded in the last ten years in red.

Newer SaaS companies grow faster.

82% of the companies to achieve $50M in revenue in under 8 years have been founded in the last decade.

Meanwhile, all of the companies requiring longer than 8 years were founded before 2004.

FORWARD MULTIPLES IN THE PUBLIC SAAS MARKET

forward_multiple_2017-08-21.png

We’ve seen quite a bit of volatility in the valuations of publicly traded software companies over the last 5 years. In 2014, the average software company traded at 7.7x forward revenues – the sum of projected revenues over the next 12 months. Two years later, that multiple dropped 57% to 3.3x. Today, we’re exactly where we were in 2013, at 5.4x, which is coincidentally, is the average over this time period.

distribution_forward_multiples_mid_2017.png

The average figure masks the substantial variance in forward muliples. By breaking out the multiples on a stock by stock basis, we expose the true distribution. Veeva (VEEV) tops the list at 11.6x forward while MobileIron plays cleanup at 1.5x.

multiple_change_mid_2017.png

In addition to the broad range of multiples, some of these businesses has seen tremendous volatility. HortonWorks and LivePerson have seen greater than 90% increases in forward multiples, while Zendesk and Twilio observed contractions of 32% and 64%.

forward_multiple_boxplot2017-08-21.png

Last, the box plot demonstrates that the majority of companies fit within a narrow band. But we are starting to see a handful more outliers, whose multiples are two standard deviations above the median. The red box indicates the range of companies between the 25th and 75th percentiles.

Overall, the data suggests that the median forward multiple of 5.5X is a good summary metric for long-term analysis of next generation software companies. But the distribution and the variances year-over-year indicate that there’s quite a bit of movement in forward multiples, depending on the particulars of each business.

This public market data mirrors to some extent of the behavior of the private market. Namely, while the forward multiple for most private SaaS companies has fallen in the last year or so, the most sought after businesses are commanding some of the highest multiples we’ve seen in 24 months.

VOCABULARY

409a valuationA formal report that tells you the fair market value of your company’s common stock prepared in compliance to recommended guidelines issued by regulatory bodies.FURTHER READING

409a valuationA formal report that tells you the fair market value of your company’s common stock prepared in compliance to recommended guidelines issued by regulatory bodies.


83(b) electionA form that tells the IRS that you will be taxed on the value of granted shares today rather than recognizing income on their value as of the date that they vest.


acceleratorA type of business incubator that typically accepts startup teams into a three-month program and may provide capital, basic living expenses, office space and mentorship, often in exchange for equity in the startup.


accountingThe process of contextualizing each transaction in order to present an accurate picture of the company’s financial performance. Accountants go beyond recording a transaction; they interpret how each transaction impacts the financial status of the business.


acqui-hireOne company’s acquisition of another for the primary purpose of hiring its employees, rather than for the intrinsic value of the business itself.


acquisitionA process where a company acquires the controlling interest (more than 50%) of another company.


advisorAn individual providing guidance, connections, advice and support to the entrepreneur, often in return for a small equity stake.


Amazon Web Services (AWS)A service that allows startups to cheaply rent server space and development tools in the cloud and scale up as needed rather than purchasing their own expensive servers.


angel groupA formal or information organization of individual accredited investors who pool their deal flow, resources, expertise and capital in order to make angel investments.


angel investorAn accredited investor who invests his or her personal capital in early stage, potentially high-growth companies.


angel roundA round of investment into a startup company from angel investors not previously affiliated with the founder. Typically the first money invested in a company after the founder’s own money and the founder’s friends and family.


annual recurring revenue (ARR)The subscription-based revenue which software-as-a-service or platform-as-a-service (SaaS/PaaS)-based companies receive each year; also known as the run rate.


Articles of Incorporation (or Certificate of Incorporation)Documents filed with the state’s Secretary of State or Registrar which acts as a charter to document the establishment and existence of a corporation—typically including the business’s name, address, a statement of business purpose, and details related to the types of stock the corporation is entitled to issue.


authorized sharesThe maximum number of shares that a company can issue, as decided by its Board of Directors. For a Delaware C-Corporation, any increases or decreases to this number require amending and restating the Certificate of Incorporation in Delaware. Gust Launch starts each company with 10 million authorized shares—a very common number to begin with.


balance sheetA condensed financial statement showing the nature and total value of a company’s assets, liabilities, and capital on a given date.


BHAGBig Hairy Audacious Goal, the giant sweeping vision of a startup founder to change the world.


Board of DirectorsA group of people elected by a company’s shareholders (often according to the terms of a negotiated shareholders’ agreement) that makes decisions on major company issues, including hiring/firing the CEO.


bookkeepingThe process of recording all of the company’s transactions in a set of books, also known as a ledger. Entries are recorded in accounting software, which will compile reports based on how bookkeepers tag such entries.


bootstrappingFunding a company without external help or capital and reinvesting initial profits.


bridge loanA temporary investment instrument used to cover a company’s operating expenses until a future financing.


business-to-business (B2B)When one business engages in commercial interactions with other businesses (one business is the supplier and the other businesses are the customers).


business-to-consumer (B2C)When a business engages in commercial interactions directly with consumers (the consumer is the end-use customer of the product or services provided).


burn rateThe monthly negative cash flow from a startup.


business model canvasA strategic management template for developing or documenting business models through a visual chart with elements describing a firm’s value proposition, infrastructure, customers and finances.


business plan competitionA program to encourage entrepreneurs to develop plans for new businesses, and sometimes a showcase competition for existing startups seeking financing.


buyoutThe purchase of a company or a controlling interest of a corporation’s shares, product line or business. A leveraged buyout is an acquisition accomplished with borrowed money or by issuing more stock.


cap (on a convertible note)The maximum company valuation at which a convertible note will convert into a company’s stock.


cap table (capitalization table)A record of all securities and their shareholders commonly displayed in a fully diluted view.


cash flow statementReconciles the beginning cash balance to the ending cash balance by illustrating the sources and uses of cash from operations, investing, and financing activities.


common stockA US term for a form of equity ownership of a company, equivalent to the terms “voting share” or “ordinary share” used in other parts of the world. In a liquidity event or a bankruptcy, common stockholders receive all of the net value of a company after paying the fixed amounts due to bondholders, creditors and preferred stockholders. Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors.


convertible noteA type of loan (also known as convertible debt) which provides that the amount of money loaned may (or must, under certain conditions) be converted by the investor into shares of stock in the company at a particular price.


convertible preferred stockPreferred stock in a company that is convertible at the option of the holder into common stock at a predetermined valuation. This provides the priority and security of holding preferred stock, as well as the potential value appreciation of common stock.


corporate ventureAn investment from one corporation in another, typically at an early stage for strategic reasons.


crowdfundingA joint effort by many individuals to support a cause, project or company. Donation-based crowdfunding bears no expectation of returns. In reward-based crowdfunding, contributors are promised rewards (such as the ability to purchase a product) in exchange for their contributions. Equity-based crowdfunding gives funders the ability to purchase equity interests in a company.


customer lifetime value (CLTV or LTV)A forecast of the total net profit related to the entire lifetime of a specific customer relationship.


DBA RegistrationAllows you to conduct business in a name other than your own (or your company’s) legal name, and allows others to identify the person or entity behind the business name you’ve registered.


deal leadThe investor or investment organization taking primary responsibility for organizing an investment round in a company. The deal lead typically finds the company, negotiates the terms of the investment, invests the largest amount and serves as the primary liaison between the company and the other investors.


debtBorrowed money that needs to be paid back. The entrepreneur rents the money for a specific period of time and promises to pay interest on the money for as long as the loan is outstanding.


demo dayA public pitch event or “graduation” day for a group of startups in an accelerator or other program at which each company has 5–15 minutes to present its investment opportunity to potential investors in attendance.


dilutionWhen a company sells additional shares of stock, thereby decreasing the percentage ownership of existing shareholders. Note that if the valuation of the new sale is at a high enough level, the value of stock held by existing investors may increase, even though the percentage ownership may decrease.


discounted convertible noteA loan that converts into the same equity security being purchased in a future investment round, but at a discounted price representing a risk premium for the early investment.


due diligenceThe process of investigation whereby both an investor and an entrepreneur have the opportunity to analyze and assess each other for the potential of an investment opportunity and partnership.


duty of careA fiduciary duty of a board of directors that obligates board members to reasonably avail themselves of all material information before making a business decision.


duty of loyaltyA fiduciary duty of a board of directors that requires a director to put the interests of the stockholders ahead of their own individual interests.


EBITDA“Earnings Before Interest, Taxes, Depreciation, and Amortization.” By not including interest, taxes, depreciation, and amortization, you can clearly see the company’s cash flow.


Employer Identification Number (EIN)A unique, 9-digit identification number utilized by the Internal Revenue Service, (IRS) and assigned to business entities to identify employers as part of the tax reporting process. In order to obtain an EIN, business entities must file or apply to the IRS.

FURTHER READING


entrepreneurA person who organizes and operates a business or businesses, taking on greater than normal financial risks to do so. Entrepreneurs are the founders of startups, and are the people angel investors support.


equityA corporation is divided into shares, which represent a slice of both the company itself and the value the company creates. These shares, once distributed, represent the company ownership (a word commonly interchanged with equity).

FURTHER READING


equity seed roundWhen an entrepreneur first sells a part of his or her business— and therefore a proportional part of the good things (like profits) and the not-so-good things (like losses)—to an investor. Equity investments, unlike loans, do not need to be paid back.


exitWhen a company is either acquired for cash, sold during a public offering, or abandoned as a failed venture.


founders stock (or founder’s equity)The common stock owned by one or more of a company’s founders, typically received when the company was incorporated.

FURTHER READING


franchise taxA yearly tax for conducting business as a separate legal “person” from its owners.


friends & family roundAn investment in a company that often follows the founder’s own investment, from people who are investing primarily because of their relationship with the founder rather than their knowledge of the business.


fully diluted sharesAll stock (common and preferred) and issued options (or warrants) as if converted to common stock. This is less relevant in the early days, but it’s a representation that investors care about as it most accurately reflects preferences, rights, and decisions made during a liquidity event (e.g. an acquisition or IPO).


funding platformAny online website used to facilitate investments in private companies. As a defined term, a specific type of platform defined by the JOBS Act of 2012 that will allow non-accredited investors to invest in private offerings.


grantMoney provided by a government agency or other organization that does not need to be repaid and does not purchase equity.


GustThe global SaaS platform for founding, operating, and investing in scalable, high growth companies. Gust’s online tools support corporate legal and financial formation and operation for entrepreneurs, as well as deal flow and relationship management for investors, from startup through exit.

FURTHER READING


incubatorA program or shared office center designed to support the successful development of companies by offering cost effective resources and support.


independent contractorA specific classification of worker that is not an employee of the company. Usually distinguished by 1) whether the business has a right to direct and control how the worker does the task for which the worker is hired, 2) whether the company has a right to control the business aspects of the worker’s job, and 3) what kind of relationship the worker has to the business.


intellectual property (IP)An intangible asset of value. The protections of IP—trademarks, copyrights and patents—determine if you can prevent other people from copying these creations, and whether or not you yourself can use them freely.


initial public offering (IPO)The first public sale of the stock of a formerly privately held company. After a lockup period, investors are typically able to sell their shares on the public stock market, as they are no longer illiquid.


investment roundA set of one or more investments made in a particular company, by one or more investors on essentially similar terms at essentially the same time.


issued sharesThe total number of shares that have been granted by the company and purchased by a shareholder. These are also commonly referred to as issued and outstanding shares.

FURTHER READING


Form K-1A tax document that explains to the IRS the attributed income received by partners in a partnership. As hybrid of a partnership and a C-Corp, LLCs demand that all “partners” file K-1s annually.


lead investorSee deal lead.


liquidation waterfallThe sequence in which all parties, including investors, employees, creditors and others, receive payouts in the event of a company’s liquidation through acquisition or bankruptcy.


liquidity eventWhen investors have the ability to convert some or all of their equity interest in a company into cash. Typically as the consequence of an acquisition, this can also happen if a company is very successful and new investors are willing to buy out the interest of early investors.


lock upA period of time (typically after an IPO or an acquisition of a startup by a public company) during which certain shareholders are not allowed to sell their stock. Often 90 or 180 days, but could be a year.


Main Street businessA colloquial term used to describe traditional small, local retail and service companies. They typically serve local markets, provide jobs and benefit the local economy, but are usually not high-growth industries or eventual targets for investment or acquisition by larger companies.


major investorAs used in investment term sheets, any investor who puts in more than a defined amount into a given round, and is therefore entitled to specific information and/or voting rights.


micro-VCThe correct term for organizations often referred to as “super angels.” Structured similarly to a traditional venture fund, a Micro-VC is typically much smaller in size, with fewer partners, and invests less money but at an earlier stage.


non-disclosure agreement (NDA)A legally binding arrangement between two parties where one or both parties will classify confidential information and prohibit the other party from disclosing shared information.


optionsA different way of distributing ownership-options are the right to buy shares based on a set of conditions. When an option is “exercised,” the option to buy stock is used and the result is issued shares. They’re typically used as part of a compensation package in the form of an incentive to employees, directors, advisors, and other people key to the company’s success.


option poolAn allocation of shares reserved to be granted as options via a company’s equity incentive plan (or stock option plan). You can also issue other derivatives from this reserved pool (e.g. warrants, RSAs, RSUs, etc).


patentAn exclusive right, granted by the federal government, conferring the rights to exclude others from making, using, or selling an invention, design, or process for a fixed amount of time.


pay-to-playA term in VC financings that requires investors to participate in future down-valuation financings of the company, or else suffer punitive consequences (such as getting their preferred stock converted into common stock). One reason why investors keep some dry powder on hand.


peer-to-peer lending (P2P lending)A type of online financing solution through which individuals lend money to other individuals or small businesses.


pitchA presentation, typically supported by slides, in which a startup company’s founder describes his or her company and seeks an investment from angels or venture capitalists.


portfolioA collection of companies invested in by an angel or VC.


post-money valuationThe value of a company immediately after it has received an equity investment, including both the company’s pre-money valuation and the amount it received from the investment.


pre-money valuationThe value of a company immediately prior to receiving an investment, used to determine what percentage of a company’s ownership will be purchased in exchange for a specified investment amount.


preferred stockA type of equity ownership of a company that has both a fixed value and priority in liquidation sequence.


private companiesCompanies that are not publicly traded on the stock market.


public companiesCompanies that are freely traded on the public stock exchanges such as NASDAQ and the New York Stock Exchange.


QSBS exemptionThe Qualified Small Business Stock exemption allows a C-Corp’s stockholders to—under specific circumstances—write off 100% of personal taxes up to $10,000,000 after five years of ownership.


QuoraA leading question-and-answer website where questions are answered by industry experts in entrepreneurship, investing, and other fields.


representations and warrantiesA list of material statements or facts included in the investment documentation to which the entrepreneur unequivocally commits.


return on investment (ROI)The amount of money or net benefit generated by an investment or spend.


runwayHow long a startup can survive before it goes broke; that is, the amount of cash in the bank divided by the burn rate.


SAFESimple Agreement for Future Equity, a new form of funding for early-stage companies developed by Y Combinator to solve a number of issues with traditional convertible note funding.


SBIRSmall Business Innovation Research grant program from the US government.


SECThe United States Securities and Exchange Commission, charged with regulating all sales of corporate securities.


seed fundA venture capital fund specializing in very early-stage startups.


seed roundWhen a number of investors provide capital to a new company with anywhere from $500,000 to $3 million. Investors are typically rewarded with convertible notes, equity, or a preferred stock option in exchange for their investment.


SendGridA customer communication platform for sending transactional and marketing email.

FURTHER READING


serial entrepreneurAn entrepreneur who has previously founded and run one or more ventures.


Series AWhen a number of angel investors or VCs contribute typically $2-10 million in exchange for equity. The fund is named after the type of equity investors hope to receive: Series A preferred shares. This implies they will be the first group of investors to receive preferred shares.


Series A crunchA putative problem that occurs if more companies get early-stage funding from angels and seed funds than are eventually able to obtain later-stage funding from venture capital funds.


Series B, C, D…Investment rounds from venture capital funds subsequent to the first Series A round.


series seedUsed generically to refer to a company’s first equity round from serious seed or angel investors following its friends & family round but prior to a Series A.


shareholders’ agreementAn agreement signed during a financing transaction by all of a company’s shareholders in which they agree in advance to various provisions. These will typically include indicating which parties are entitled to designate members of the board of directors and thus control the company.


SimplexityA bookkeeping service with a long history of working alongside startups. The Gust Launch Financials package includes a subscription to Simplexity.


social proofAn investment approach leaning heavily on the identity of other well-known people who are supporting the company.


social ventureA company established to create societal benefit through entrepreneurial methods.


soft landingA face-saving acquisition of an unsuccessful startup, usually for little or no compensation.


strategic investorA corporate investor funding an early-stage company primarily for reasons related to the investing company’s interest.


success feeA percentage commission paid to an intermediary or other individual as an incentive on the closing of a large financing transaction.


sweat equityThe equity or ownership interest created in a startup by its founders as a result of their contributions in the form of hard work and toil.


term sheetA summary of the major terms of an investment round that is agreed upon by all parties prior to beginning extensive legal documentation for the round.


trademarkGrants a business the exclusive right to use the mark, words, symbols, or title in commerce.


unissued sharesThe total number of shares that are authorized to issue, but have not yet been issued to shareholders. Mathematically, this is the difference between authorized shares and issued shares.


Valley of DeathThe period between a startup’s initial funding and the end of its runway. If you get through here, you should be OK.


value propositionA statement a company uses to express why customers should purchase their product or service, including the ways it adds more value than that of alternative offerings.


venture capital fundAn investment fund that puts money behind high-growth companies.


venture debtA type of debt financing provided to venture-backed companies from specialized banks or non-bank lenders.


vestingA concept applicable to both stock and options, which prevents the recipient from owning all stock or options outright and instead earn them over time. For stock, vesting typically refers to stock that’s earned over time and, therefore, not re-purchasable by the company. For options, vesting indicates the number of options that become exercisable.


vulture capitalistA VC whose operating method is to deliberately take advantage of an entrepreneur’s troubles.


waterfallThe order in which investors (and everyone else) get their money out on an exit. Almost always this is “last in, first out.”

Valuations 101: The Venture Capital Method

We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors.

The Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since. It is one of the useful methods for establishing the pre-money valuation of pre-revenue startup ventures. The concept is simply…since:

Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation

(in the case of one investment round, no subsequent investment and therefore no dilution)

Then: Post-money Valuation = Terminal Value ÷ Anticipated ROI

So, let’s address each of these:

Terminal Value is the anticipated selling price (or investor harvest value) for the company at some point down the road; let’s assume 5–8 years after investment. The selling price can be estimated by establishing a reasonable expectation for revenues in the year of the sale and, based on those revenues, estimating earnings in the year of the sale from industry-specific statistics. For example, a software company with revenues of $20 million in the harvest year might be expected to have after-tax earnings of 15%, or $3 million. Using available industry-specific Price/Earnings ratios, we can then determine the Terminal Value (a 15X P/E ratio for our software company would give us an estimated Terminal Value of $45 million). It is also known that software companies often sell for two times revenues, in this case, then, a Terminal Value of $40 million. OK…let’s split the difference. In this example, our Terminal Value is $42.5 million.

Anticipated ROI:

Assuming our software entrepreneurs needs $500,000 to achieve positive cash flow and will grow organically thereafter, here’s how we calculate the Pre-money Valuation of this transaction:

From above: Post-money Valuation = Terminal Value ÷ Anticipated ROI = $42.5 million ÷ 20X

Post-money Valuation = $ 2.125 million

Pre-money Valuation = Post-money Valuation – Investment = $2.125 – $0.5 million

Pre-money Valuation = $1.625 million

OK, but what if the investors anticipate the need for subsequent investment? I have seen some complex methods for accommodating anticipated dilution, but here is an easy way to adjust the pre-money valuation of the current round. Reduce the pre-money valuation (above) by the estimated level of dilution from later investors. If investors in this round anticipate eventually being diluted by half, the pre-money valuation for the current round would be about $800,000. If only 30% dilution is anticipated, reduce the pre-money valuation of this round by 30% to about $1.1 million.

Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for these seed/startup companies. The Venture Capital Method is often used as one such method