Raise or Exit; A Founder's Dilemma
The expectations of high valuations
While the majority of VCs find it difficult to achieve this metric, they typically look for a 3x return to consider a venture investment a success. As a result, 80% of returns typically come from 20% of startups.
This means that VCs are shortening their time horizons and increasing their return expectations – a high valuation is good on paper, but once a company is benchmarked at that level, they have to execute…they have to prove their value and deliver on growth to grow into a higher valuation and therefore return for the VCs.
Lofty valuations, disappointed founders
Often, founders expect higher valuations upon exit relative to the numbers they received when they raised capital. However, this is not always the case. There has been a significant expansion in valuations over the past few years that leave us all doubtful as to whether these amplified valuations can be sustainable. “The data has started to show signs of late-stage valuations becoming inflated relative to the public markets, as the median late-stage valuation step-up at exit fell to 1.3x through 1Q 2018—the lowest value we’ve recorded since 2009. So, while most late-stage companies are exiting above their last private valuation, the number failing to meet that benchmark is growing.” – VC Valuation 1Q 2018, Pitchbook.com
We’ll touch on this again below, but VCs are paying for growth right now and knowingly putting forth term sheets that are at significant premiums to exits (both IPOs and M&A).
What the numbers suggest
Take an example of a software company doing $5M in revenue. Here’s what would result if the company raised VC money;
If the VC invested $8M at an implied pre-money value of $30M, this means that the VC applied a pre-money revenue multiple of 6x on the raise. Given that M&A multiples are lower than VC multiples (VCs are paying up for future growth expectations), if we assume a 3x exit multiple in 5 years, the company would need to grow at a compounded rate of 50% per year for 5 years to achieve a successful outcome for the VC. Even at a 4x exit multiple, you still need to achieve 42% compounded annual growth rate per year for 5 years. Many technology companies have achieved this strong consistent growth, but many haven’t, so when assessing a decision of this magnitude you’ll need to be very confident in your growth expectations.
The difference between needing funding and continuing to grow organically
There are different founders for different stages of a company’s journey. Some founders are great operationally, some founders are great at scaling the business, some founders are great at tapping into new markets and finding additional revenue streams, etc. The point is that with each stage of a company’s growth, there will be different skillsets required to achieve new levels. Depending on your business and how you generate revenue, if you have positive growth with recurring revenues, maybe continuing to expand organically is the way to go – without having to dilute yourself. If you’re in a position of wanting to tap into a new market or win a over a big client but need to grow the sales & marketing team, maybe doing a raise is necessary. It really comes down to why you want to raise money, how much of it you NEED (not want), and whether or not you think you’ll achieve the valuation expectations (and therefore growth) that come along with the capital.
Knowing when to exit
At Sampford, we’re of the mindset that if you focus on growing your business, a good exit will follow – instead of you chasing it. Founders with successful exits will tend to agree. With that said, here’s a general guideline you can use to measure whether or not you’re in the right position to start thinking about an exit;
If we’re sticking with the example of a SaaS/Software company;
1. Revenues; do you have at least $5M in revenues?
2. Growth; are you growing at 10% or more?
3. Recurring Revenue; is your recurring revenue greater than 50%?
4. EBITDA; are you profitable, with at least 10% of EBITDA?
5. Monthly Churn; is your churn low (less than 2-3% per month)?
6. Market Size; is your total addressable market greater than $500M?
If you answered “yes” to most of the questions, then an exit could be a topic of discussion during your strategy sessions. This is not to say that if you don’t meet the above criteria you won’t be able to exit, but that your multiple upon exit will be significantly lower – which would serve as a disadvantage to the founders and investors (if capital was raised).
As a base, the median software/SaaS M&A multiple in 2018 YTD is 2.8x and this type of multiple usually applies to companies with financial metrics similar to the above. Multiples could go beyond 5x for much larger companies, doing $25M+ in revenues (for instance). The reason you want to keep this in mind is that if you raised VC money at a high valuation and weren’t able to meet the growth expectations set, an exit will be possible but at a lower multiple.
4 Key Takeaways
1. The multiple you raise capital at will likely be higher than the multiple you exit at
2. Raising capital can be necessary, but make sure you can grow into the expected valuations
3. Focus on growing a successful business and a good exit will follow
4. Know if you really need to raise capital and carefully consider the implications