Category Archives: Investment

The Myth of “SaaS”

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Software-as-a-Service (SaaS) has taken the technology world by storm. These days, all new software companies are SaaS which simply means they are based in the cloud and have subscription pricing. With the exception of mobile applications and e-commerce, almost all new companies are following this model.

It’s not surprising. The benefits of SaaS over older models of software delivery are clear. Cloud based software can be updated and improved much more rapidly than on-premise software, with a fraction of the cost of maintenance. Subscription pricing means that revenue continues to roll in month after month for the entire life of a customer. What is not to like?

However, many founders of SaaS companies have unusual levels of stress, even more so than typical founders. Your typical SaaS startup founder will:

  • Spend a few days every month trying to follow the latest SaaS metrics fad, based on blog posts like this*. They are searching for the perfect metric to compare themselves against other SaaS businesses.
  • Try desperately to reach a mythical MRR milestone that will magically open the door to raise their Series A.
  • They spend time meeting the best “SaaS” investors, even if those investors are completely unfamiliar with their space.

The ironic reality is that there is no such thing as SaaS anymore. SaaS has become so pervasive that the term is the equivalent of “Internet” or “Web” or “Software”. There are SaaS companies across every vertical, every market. Some charge millions of dollars a year and others charge $5 per month. Some are profitable with only 5 customers, others have 500,000 customers and still are in the red.

SaaS no longer means anything because the world of SaaS has become too large.

Those SaaS founders I mentioned earlier are under abnormal stress because they are chasing the myth of a “typical” SaaS business. There is no such thing as a “typical” SaaS business and all of the fancy metrics and analytics you hear about are attempts to normalize and compare SaaS businesses that are completely different. The only ones who benefit from such normalization are investors, who want help in picking and choosing which companies to support. As a founder, you only care about one business: yours.

The good news is that the world is much simpler when you abandon this myth of the “SaaS Business”. Your business, while it might be SaaS, is not governed by complex new metrics but by the The Most Important Equation for Your Business. Your MRR does not matter, there are businesses raising Series A rounds with $0 MRR everyday. What matters most is The Only Thing That Matters, just like with any other business. Investors will look at your rate of growth first and your MRR second.

In short, you are building a business. Just because it is SaaS does not mean the rules are different, only that there might be more distractions. Do whatever is right for your business.

Then, when you are successful, don’t be surprised when another founder tries to model themselves after you. It is SaaS, after all.

* This blog post is actually very good. I only point it out since every founder I meet that reads it finds it more confusing and intimidating than helpful. 

What Investors See When They Look At You

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If you’ve gotten far enough in building your mirror business to think about raising investment, then you’ve worked very hard and survived some near-death experiences. It’s been a tough road and you should be proud of the progress you have made. Well done!

However, when you sit down to talk to a venture investor about your business you need to put all of that aside. When a venture investor looks at your company they don’t see it as it is today, they are trying to envision what it might look like in 5-10 years.

Wait, let’s take a step back: How do VCs work?

If you’re not familiar with how venture capital funds work, they are easy to explain. A group of partners (known as the general partners) form an LLC to act as an investment fund. They then raise capital for the fund from large institutions like pension funds, endowments and other funds (known as limited partners).  The size of venture funds varies wildly from $20M to $1B, but almost all venture funds have a 10 year lifespan. For the first 3-4 years of the fund, the general partners are making investments in new companies and the remaining 6-7 years is spent managing those investments and making follow-on investments in the same companies. At the end of 10 years, the fund is closed and, assuming there was a positive return, the limited partners get their rewards. (For a much deeper explanation of venture funds, read Venture Deals).

Keeping that in mind, the primary motivation of a venture investor is to produce returns on their fund in 10 years. Considering the high failure rate of start up companies, out of a portfolio of investments in 10 companies they can expect 7 to go out of business, 2 to be moderately successful and one to be hugely successful. In order to produce a return on the entire fund, they need those successes to be huge (return 20+ times the money invested).

Okay, so how does that affect how they see me?

Venture investors, because of how their funds are set up, are constantly looking for companies who have the potential to produce a 20x return on investment. That is very difficult to achieve and not many companies will have that kind of potential. A neighborhood grocery store will never produce that kind of return, nor will your local bookstore.

Not only do venture investors need a 20x return, they need it within 10 years. There are businesses you can grow slowly over 20 or 30 years to produce those returns, but to do it in less than 10 years means that your business needs to grow extremely quickly. To grow that quickly, you need a quickly growing market, a well thought out plan, some critical strategic advantage and the right team to execute your plan.

So, when you sit down with a venture investor, they are looking for signs that your business can produce 20x returns within 10 years.

Ah, that makes sense. So what does that mean for me?

The most important thing for you to convey to venture investors is the potential of the problem you are solving and how large the market is that has that problem. You cannot produce a 20x return on $10M of investment if your market size is only $50M, but you can if your market size is $1B. If the venture investor can envision your company in 10 years operating at that scale, you will get their attention.

After you convince them that your problem/market is big enough, it is time to convince them that you can make that happen. It is very hard to convince anyone what will happen in 10 years, especially investors that hear similar things everyday, but there are some keys to doing it well:

  • Present a plan. Your plan might change, but you need to have a credible long-term plan for getting to the large outcome. If you can’t build a credible plan at the beginning, it’s unlikely you will be able to come up with a new one as the market changes. The plan you present will also serve to identify the key risk factors that your business will face as it grows.
  • Show you mean it. You have already been following your plan in building your business, so show off how well you have executed. Remember, your progress so far is not why they will invest in you, but your progress so far is proof that your plan is credible and that you can execute against plans you create.
  • Sell the team. 10 years is a long time. If your company is going to be very successful, it will be a long and difficult road. Your team is critical because it is those people who will steer the company through those hard times and the venture investor needs faith that you can do it. In the end they are investing in you.
  • Don’t play fair. If you really have found a big opportunity that can product 20x returns, it is likely that many others have as well. You need to show a distinct competitive advantage that will allow you to win when faced with dozens of competitors going after the same goal.

Hopefully, at this point you are starting to realize why many companies struggle to ever raise venture funding at all. It is great that you have 5 paying customers today, but can you convince an investor that you will get to 5,000? You have 2 brilliant developers writing code, but who is going to sell your product to Fortune 500 companies? You have a great plan and team, but without any customers how can you be sure your product will work in the market?

Time to Focus

The good news is that, assuming you’ve followed at least some of the advice on this blog, you have already built the foundation for a great company that can produce the kinds of returns that venture investors want. In order to successfully raise investment, you just need to make sure to present your company in the way the potential investors need to see it. Focusing on where you can go, and not on where you’ve been, will go a long way towards that goal.

Besides, after all the hard work you’ve put in, it’s fun to think about how successful you can be in 10 years.

Thanks to Leo and Beth for reading a draft of this post. Image copyright Graham Hogg and made available via Creative Commons.

Negotiation Made Easy

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A significant amount of your time is spent selling when starting a company. Assuming you are good at selling your company/product/vision, you will often get to the point where you need to close the deal. In between the selling and signing the contract is a chasm that many inexperienced entrepreneurs struggle to cross: negotiation.

Negotiation is simply the act of agreeing on terms for a deal. If you have never done it before you may envision it like a TV show with adversarial parties sitting across a table trying to crush the other party. That is rarely the case. Most negotiations are between two parties who really want to reach a mutually beneficial deal and just need to establish the terms of the deal. That does not mean people will not try to take advantage of you, but let us assume a basic negotiation where both parties have good intentions.

The actual act of negotiation is simple. One party makes an offer and the other party either accepts the offer, makes a counter offer or ends the negotiation. This continues until the parties reach an agreement or part ways.

But how do you know what offers to make, and whether the offer you get from the other party is a good offer? To answer that you need to understand some basics of negotiation and a simple process will help.

Step 1: You Win or Lose Before You Start

It’s a general misconception that whether you get good terms for a deal is based on whether you are a good negotiator. That is almost never true. Good negotiators know that the person who gets better terms is the person who has a better BATNA.

BATNA stands for Best Alternative To Negotiated Agreement and represents the worst case scenario for both parties if no agreement is reached. Whoever has the best outcome if there is no agreement has the advantage in the negotiation because they have less incentive to close the deal and can more easily walk away.

For example, let us say you are selling an apartment and someone moving to this city would like to buy it. If there are only a few apartments for sale and the buyer needs to move in the near future you have the advantage as the seller. You could choose not to sell the apartment and wait for another buyer (your BATNA) while the buyer would have to desperately find another of the few apartments for sale quickly (their BATNA). On the other hand, if there are many apartments for sale and the buyer is buying the property to rent it out then the buyer has the advantage. You might not be able to sell your apartment since there are so many for sale and the buyer can simply wait for a better deal elsewhere. In both cases, the BATNA determines which party has the power in the negotiation based on their incentive to close the deal.

The lesson here is to make sure you optimize your BATNA before even starting a negotiation. Consider some common deals you might close and how to position your BATNA for success:

  • If you are raising money, make sure you have plenty of runway (9-12 months at least) so that you are not under pressure to close quickly. Also be sure to line up as many potential investors as possible so you have your choice (and fallback).
  • If you are selling your product, always have a healthy pipeline of customers and never bet everything on selling to one particular customer. Try to avoid having one customer make up more than 50% of your revenue.
  • If you are hiring employees, start the hiring process long before you will need the person since it will take time to find the right candidate. Always interview multiple people for the position even if you think you have found the right fit, just in case you can’t close the deal.

Step 2: Get Into The Zone

While both parties have a BATNA (worst case), they also have a preference for the terms of the deal if it closes (best case). For example, if you are buying a house there is a price you would prefer to pay (practically speaking) and the seller has a price they would like you to pay. The combination of your BATNA and your preferences forms what is called the Zone Of Possible Agreement or ZOPA.

You can visualize the ZOPA as follows:

Negotiation

As you can see, both the buyer and the seller have a range of acceptable prices between their BATNA and their preference. The ZOPA is the overlap in these ranges, the difference between their BATNAs. Note that while this diagram uses Cost as the dimension of negotiation, it could easily be anything including the length of contract, legal terms or location.

If a deal gets closed, it will be in the ZOPA. Ideally, assuming both parties are interested in a mutually beneficial agreement, you would pick the midpoint of the ZOPA and that would be the terms of the deal. 

How then do you know where the ZOPA lies? Very few partners will tell you their BATNA, even if they have the best intentions. They have no incentive to reveal their true BATNA and if they can convince you their BATNA is higher/lower than it really is then they can convince you the ZOPA is smaller and get favorable terms.

And in that tension is where negotiation exists.

Step 3. Choose Your Strategy

When you are negotiating you know your BATNA and your preference but not for the other party. Hence, you know one end of the ZOPA but not the other end. There are a number of strategies you can employ to determine the scope of the ZOPA and/or reach a deal on favorable terms.

Here are some examples:

  1. High Initial Offer. To try and determine the BATNA of the other party, you can start with an arbitrarily high (or low) offer. Anchoring the negotiation will force the other party to start higher (or lower) than they might have otherwise and hopefully expose their BATNA quickly. This is why cars are priced so highly on the lot of a dealership, even though no one pays those prices. Dealerships want to determine your capacity to pay and motivation to buy.
  2. This or That. The initial offer does not need to be a single offer and instead could be two different offers with different kinds of terms. For example, you might make two offers of a loan where one has a high interest rate while the other has a pre-payment penalty. The other party, in indicating their preference for one of the options, will help you understand the ZOPA and guide the negotiations in a positive direction.
  3. Iteration. Since neither party knows enough about the other, you can make offers back and forth in an iterative fashion and slowly converge on a result in the middle. Each offer moves toward the other party’s previous offer by some small amount. This slow process of back and forth allows you both to understand the other party’s range and ensure you end up somewhere in the middle of the ZOPA. Most international diplomacy involves this kind of strategy since the parties disclose so little of their internal plans.
  4. Take it or Leave it. In this method, you make an offer to the other party that they can either accept or not but that will be the end (no counter offers). Since you don’t know the other party’s BATNA, you make a guess and give them an offer based on that guess. This is most common when one party knows it has the superior BATNA and can force the deal to be more favorable to them.

Whatever strategy you choose, it is important to consider the impact of the initial offer especially if you are making the initial offer. Whatever the initial offer you make, you will rarely get better terms and in almost all cases you will get worst terms. Hence, you need to make sure that your initial offer is not your BATNA or you will not be able to iterate with your partner.

For example, when negotiating your salary for a new job you should realize that when you are asked for your current salary they are asking you to make an initial offer. You should not ask for a million dollars, but you should tell them what you think you are worth and not the least amount you are willing to accept.

The best negotiators are the ones who can convince you that their BATNA is much different than it really is and in doing so get favorable terms on a friendly basis.

Step 4. Plan For The Long Term

Unlike selling your house, deals that you close when building your business will likely impact your business for the long term. You want to build a positive relationship with your customers, employees and investors that will span many deals and many years. Hence, you need to optimize for long term relationships and not just short term deal terms. This means choosing a strategy that will maximize both the terms of the deal and future deal potential.

With this in mind, it is often not a good idea to pursue aggressive strategies and hard nose negotiation where you win a given deal but decrease the likelihood of future deals. At the same time, friendly but prolonged negotiations can give partners the impression that you are hard to deal with and have a similar negative effect on future deals. Being practical and productive in negotiations will establish your reputation and open doors in the future.

For example, when hiring people for a start up company it can be a good idea to pursue the This or That strategy where you give the employee a choice between a low salary and high equity or high salary and low equity. This gives the employee a chance to show their preference and reduces the amount of negotiation necessary to reach a favorable term.

Conclusion: Negotiations Are Not Basic

While the discussion here involves a single dimension of negotiation where each party has a single BATNA, preference and ZOPA, that rarely occurs. In most negotiations there will be many different dimensions such as cost and time, each with their own ZOPA. You will need to give in on some terms to get better outcomes on other terms. Always keep track of the terms that are most important to you and never drop below your BATNA or else you may find yourself in deals that are not worth doing.

To learn more about negotiation I suggest reading Getting to YES, now included on the Reading List. 

Why no one will invest in you

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I often have discussions with people who have a great idea and are thinking of quitting their job to pursue it. However, they have fixed costs (rent, car payments, etc.) and can’t afford to work for free. Instead, they want to raise some venture investment to fund their new company and pay them a salary. Inevitably, they are surprised at how hard it is and rarely succeed.

The problem that these potential entrepreneurs fail to see is that investors are looking for investments to make a return, not to fund your lifestyle. If an investor is going to invest in you it will be for one of three reasons:

  • Investing in people (you). An investor might invest in you because of who you are and your track record of success. However, unless you have started and sold companies for tens or hundreds of millions of dollars, it is unlikely that investors will invest in you for who you are. The risk for new companies is too high for someone inexperienced who doesn’t have a product or a plan.
  • Investing in your product. Investors will invest in products that have no plan (or revenue) but are growing like wildfire (Snapchat is a good example). The investor might not know you and you might not have a plan in place, but they see the product succeeding in the market and have faith that you can come up with a plan when necessary. This is exceedingly rare because the product needs to be so amazingly successful as to forgive the higher risk of not having a plan.
  • Investing in a plan. The vast majority of venture investment is in a plan. A plan includes all of the other elements including people, products, marketing/growth, financials, etc. When an investor invests in your plan, it is because they see how their investment will help you achieve your plan and in doing so produce a return on their investment.

Now, before you spend weeks writing a 50 page business plan, it is important to understand what an investor looks for in a plan. The best plans are not determined by length, but whether you can answer the following questions:

  1. What problem are you solving? Explain who your customers are, what problem they have and how much money can be made by solving it. The bigger the problem the bigger the market opportunity.
  2. How do you solve the problem? There are many ways to solve the same problem, what is your solution and how is it unique? In many cases this is a demonstration of your product.
  3. Why hasn’t the problem been solved before? There are reasons this problem exists and one of them is that no one else has solved it. Why not? Are there difficulties that you have overcome?
  4. Why are you (and your team) the ones to solve it? While this is your plan, you need to give investors confidence that you can execute the plan.
  5. How will you beat the competition? Even if you don’t have competition today, you will at some point. How will you win when the competition attacks?
  6. How much money will you make if everything goes well? This is the most important question. Investors want to see a business that will become very valuable, very quickly based on the money it can make.
  7. How much money do you need? The final question is how much it will cost for you to build the business to a point where you’ve removed a significant amount of risk. Your plan, no matter how well formulated, has a lot of risk. Instead of giving you $20M now, they would rather give you $1M and see if you can eliminate some of the risk in the plan and then give you more. It is up to you to set realistic goals and estimate costs accordingly, and the investors will evaluate the risk profile from there.

Note that these are the questions for a seed level company, one that is just getting started. As your company grows, the questions you need to answer in your plan will change. Even public companies need to have a plan for their shareholders, who are their investors.

So, if you are looking to raise money for your company be sure you have a plan that justifies the investment. And quit your job first, no one wants to invest in your plan if you don’t believe in it enough to go all in.