Tomasz Tunguz, Partner at Redpoint Ventures, chats with Connie Loizos, Silicon Valley Editor at TechCrunch, about benchmarking your SaaS startup when you’re raising Series A funding. In true Tomasz style – thanks to his clear affinity for numbers – he throws in plenty of charts, graphs, and statistics into his talk to illuminate and clarify his points.
Given the calibre of companies he’s worked with in the past (e.g. Twilio, Zendesk, Stripe, JustEat, RelateIQ) and his focus on early stage software companies, Tomasz knows a thing or two about what a company should do to prepare for raising a Series A round, the changing landscape of funding, private market devaluations, and how to reduce burn – all incredibly important considerations when it comes to ensuring the growth of your company.
Check out the full transcript below! You can view the slides here.
Tomasz Tunguz: Thank you [indecipherable]
Connie Loizos: Hello? Hi everyone. This is really big.
Tomasz: Thank you.
My name is Connie Loizos, I am an editor at Techcrunch and I’m here with Tom Tunguz of Redpoint, a general partner, and Tom is going to take us through a great presentation about the state of venture financing for enterprise companies. SaaS in particular, and series “A” rounds.
Tomasz: Terrific! Thank you so much, Connie. It’s a pleasure to be here. Thank you very much to Jason, who invited me. My name is Tom Tunguz, I’m a partner at Redpoint Ventures. Over the next 10 or so minutes, I’ll walk you through a little bit of data about what is going on in the Series A fundraising market. Then, we’ll have some Q&A. It’ll be a lot of fun.
Redpoint Ventures is an early stage and gross stage venture investment fund. We manage about $3.8 billion. Out of the early stage fund, we do about 80 percent Series As. That’s where I’m focused on early stage software companies. That’s where this presentation is focused.
We’ve had the opportunity to partner with about 434 different companies. We’ve taken public or sold about 136 of those. These are some of the companies that we’ve been lucky enough to work with. We’ve learned a lot from it over the past 16 years that we’ve been working with them.
Over the next couple of slides, I’m going to walk you through an analysis of premium software companies. These are the companies that we look at and are probably the best in class companies.
We’re going to be walking through one of the questions that I hear a lot from founders, which is, “What does my company need to look like when I raise a Series A?” We’ll be looking at it from the point of view of revenue.
A couple of key points about this analysis, there’s clearly a selection bias. I am only picking about 60 premium SaaS companies over the last three years. There’s also a sample size bias. For you statisticians out there, this is not a population analysis. This is a sample analysis.
The average SaaS Series A for these businesses is about $9.5 million. You can see the distribution here. A small number of companies raise between zero to two and a half, which you could call a seed. The majority of them raise between 5 to 15 million dollars in their Series A. A handful raise more.
The average round size has increased about 11 percent a year. In 2014, it was $8.5 million average. Then, it grew to $9.3 million average. Finally in early 2016, and yes, there are enough data points already, it’s about 10 and a half million. That’s been growing.
It actually parallels a broader trend in the VC industry. This is not just for SaaS companies. This is actually for the totality of US startups.
You can see that on an inflation adjusted…This is inflation adjusted numbers, the average dollars raised by a Series A startup in the late ’90s was about five million dollars. At the height of 2000, it was more than 12 and a half million.
Then recently, as recently as Q4 2015, it’s been above 10 and a half. The SaaS market has also benefited from the tailwinds that have benefited the industry broadly.
In terms of MRR, the average MRR that these companies have when they raise a Series A has grown from about $50,000 a month to $163,000 a month over that time. That’s really driven by the fact that the round sizes have gotten larger.
As competition amongst investors has increased, the metrics and the milestones that software companies need to show, or what investors expect, has become much greater.
Those averages don’t reveal the entire truth. This is the distribution of those Series As by MRR. You can see nearly a third of these Series As have zero in MRR when they raise those Series As, which is unusual. Most of the founders who I speak to, they come in and they say 100K. They’ve got this number. It’s either 75 or 125K. That’s the number I need. That’s true.
You can see there’s a little bit of a bell curve in the middle right between $75,000 and $125,000. There definitely is data to support that thesis. There is an entire class of companies non trivial size, a sample set, that raise with zero in MRR.
As we’ll talk about later, those are companies who venture investors perceive as having a unique go to market advantage. The founders know the space really well. There’s unique technology and a really large market opportunity.
What’s really interesting is and this was completely counterintuitive to me, we also have a growth fund. In that growth fund, we look at valuations of SaaS companies on a multiple basis. This is how publicly traded investors value software companies.
A lot of the times, they’ll value a company – its enterprise value – is a function of next 12 months revenue, which means take the sum of the next 12 months of revenue, and then divide that by the enterprise value. That ratio has typically been 15X.
In other words, in order to value a Series B or a Series B company, I’m going to take the sum of the revenue for the next 12 months. I’m going to multiply it by 15. That’s the post money on that round.
At the Series A, there’s been a lot of talk that this is also the case. The data actually shows there’s no relationship between monthly recurring revenue and post money. The correlation is 0.3. It means it’s effectively meaningless.
What’s also really curious is there’s an even weaker relationship between post money and NTM. The conclusion of both of those slides is, when Series A investors look to value a Series A SaaS company, they are not looking at the revenue metrics in order to come up with a post money valuation. It’s still more art than science.
As a lot of people have talked about today, 2016 is a year of change. One of the hardest parts about preparing for this presentation is, I’m not sure if these numbers still apply, because the markets have changed so much. I can share with you these guidelines, and I can tell you what the market was like in 2015, but in 2016, things are going to be different.
To put it into context, the top 5 years for tech VC investment over the last 20, 2 of those top 5 were 2014 and 2015. It’s basically 2X. There was a decade there from 2003 to 2013 when we were between $17 to $20 billion a year invested. The last few years have been about twice that.
What lots of people have said, and I think it’s really true, we’re going to see a reversion to the mean. We should expect that over at least one year, maybe two years that 37 and 43 basically fall to about 20.
In Q4, we’re starting to see the first signs of this. This is a chart that shows seed investment early stage, AKA Series A and late stage B or later investment over time.
For each plot, we start the year 2010, and then we go to the year 2015, and the number. The X axis is the investment amount indexed relative to 2010. A one means that’s the average for how much money was invested in that stage throughout all of 2010.
There’s a couple different conclusions we can draw from this slide. The first is, seed investments have grown 5X in five years. There’s a huge amount of investment. There are dedicated seed funds that verticalized. That’s really benefited the startup ecosystem.
The activity rate of those investments in Q4 fell 18 percent. In early stage or Series As, the amount of money over the last five years has basically doubled. In Q3 and Q4, it fell 15 percent from its highs. In B or later rounds, the amount of money that’s gone into that category has tripled, but fallen off by 26 percent in Q4.
Meanwhile, the public markets are reacting in tandem. As I talked about before, public market investors value SaaS companies on a multiples basis. Those multiples have fallen. The newest number is 3.3, as of late last week. That’s a 57 percent reduction in valuation, even if the business is generating the same amount of revenue.
LinkedIn fell 50 percent on Friday. Tableau fell, although it’s not a SaaS company. Basically what’s happening is, the private markets are slowing down and the public markets are valuing SaaS businesses at less of a multiple, in fact, half of the premium multiple that they used to forward those companies two years ago.
Terrific. That’s the presentation.
Connie: I don’t cover SaaS terribly closely, so I might be asking questions that are a little bit obvious. Forgive me. A lot of that, I found pretty shocking that you said, especially valuations really having no correlation to revenue.
Let’s back up. Most of the people in this audience are maybe early stage entrepreneurs. Bottom line, what does it take right now to raise a Series A round?
Tomasz: It’s think it’s still pretty similar. You’ll see lots of Series As raise between 50 to 100K in MRR.
Connie: Once they get to 15 to…
Tomasz: 50 to 100k in MRR. You’ll also see companies continue to raise at zero in MRR, the way that they always have been, at least in the data set that we shared today.
Connie: Let me interrupt quickly. How long does it take on average for a company to get to 50 to 100,000 MRR?
Tomasz: It really depends on the business, but roughly two, two and a half years. Some companies are much faster. Some companies take a little longer.
Connie: They’ve got to bootstrap until then, essentially or…
Tomasz: There is a seed round. We often see companies raise seed rounds.
Connie: I’m sorry.
Tomasz: No, no, no. Actually, I remember there are three slides missing from this presentation. I’m going to touch on them really quick.
Connie: Yeah, go ahead.
Tomasz: I’m going to get up.
Tomasz: The consequence of all these different factors is as a fundraising market slows, we’re going to see a couple of different things.
The first is we’re going to see a rationalization of public and private market valuation. It used to be that we would pay 15 times forward revenue for a later stage SaaS company. Now that the publicly traded median is about 3.3X, that means that we’re paying four times or five times nearly the median.
Those valuations have to compress. Valuations in the private markets are going to decline.
The second thing that’s really going to happen is it used to be that a SaaS company could crown themselves or anoint themselves the winner of a particular category by raising the biggest war chest. That’s going to go away or it’s going to happen not nearly as frequently.
The last is as the valuations of SaaS companies fall on a relative basis, you’re going to see a lot more M&A. There are quite a few businesses with billions of dollars in capital that need to invest in next generation software platforms. You’re going to see them acquire startups. Thank you.
Connie: In terms of the funding…
Connie: Thank you. I know, he’s great. In terms of the funding picture changing so dramatically, what’s going on exactly?
I had written today on a study that the law firm Fenwick & West published. It noted that in the last nine months of last year, there was a spike in the number of newly minted unicorns. The very last quarter, there was a precipitous drop. That was the first where we actually saw a peak and a downturn in the number of the limited companies.
Those companies that were still getting funded, were still getting funded by non traditional venture sources, like the hedge funds and the mutual funds. It seems like those guys are still involved, but they’re applying many more owners terms to deals.
Is it a mutual agreement that entrepreneurs are going to say, “I can’t sign up to this deal, despite the valuation you’re willing to give me,” and they’re going to say, “Your trajectory is less sort of certain than I thought,” what do you see happening?
Tomasz: I think you’re right. In the late stage market, non-traditional venture investors have grown from about 30 percent of the dollars to more than 80 percent, is the last data that I’ve seen. Those are hedge funds, mutual funds, family offices. That’s what you could call fast money. Fast money in, fast money out.
In talking to many of them, their interest in investing in software companies and also consumer companies is, they really want to get exposure to these businesses before they go public for a wide variety of different reasons.
One of them could be they could get better insight into a company when it’s private than when it’s public because of how little a public company wants to disclose, and those kinds of reasons.
The other thing is, private companies have been growing historically, or at least over the last couple of years, significantly faster than the public counterparts. The projected returns can be really high.
The last thing they consider is that, a lot of non-traditional venture investors don’t have the return targets that we do. A hedge fund might be looking to beat the S&P, which has been at a five percent IRR or less over the last couple years. That’s not a very high hurdle rate.
Now that you’ve seen that we’re in this crazy time where there’s an illiquidity premium, historically you afforded a liquid security a premium, which is that you were willing to pay more if you could get out of your stock really fast. Now, it’s more expensive to buy an illiquid security. It’s more expensive to buy privately-held shares than it is to hold publicly-held shares. That is going to go away.
What we really saw on Friday was a general rotation out of high multiple, high growth stocks into more conservative stocks.
Connie: With LinkedIn and Tableau, you mean?
Tomasz: With LinkedIn and Tableau. What do I know? That’s basically foreshadowing a lot of these hedge funds and mutual funds starting to look at the public markets, as they have for a long time, before they entered the private markets.
That will definitely change. They represent about a quarter of the 40 billion or so invested last year. It’s not inconceivable that, that $10 billion goes away this year.
Connie: What about corporate investors? They historically get freaked out easily, too. They represent something like 20 percent of all of the deals getting done right now, or they did last year. Are you seeing in your day-to-day work anyone retrenching?
Tomasz: I haven’t seen it yet. We’re only a month in, and a lot of the financings that, when startups go out to raise in January, probably take six to eight weeks, maybe a little longer for those financings to be announced. There’s no real trend I can point to yet.
Connie: Series A you have to, in order to get it, you mentioned there are certain types of founders that are more likely to get it, including what? Founders who are coming out of these big companies, or else have had success in a previous startup? Who’s more best positioned to lend money right now?
Tomasz: One of the things that’s going to happen in this environment is, because you can’t anoint yourself the winner with a huge war chest, you’re going to have to compete upon a bunch of other competitive axes. They’re the classic ones. It’s the better technology, it’s the better go to market, it’s better relationships, or it’s a unique and novel approach to the market.
All those things, or some combination of them, afford a startup a long-term sustainable competitive advantage.
Increasingly, investors and certainly for us, we’re going to be looking for those characteristics in founders much more than we have in the past. If you can demonstrate any one of those four things at the early stages, then it’s very possible that you’re able to raise a Series A at zero in MRR.
On the other hand, there might be an unknown entrepreneur who comes out of university and who suddenly built an amazing SaaS company. That happens very frequently. What that person is going to have to show is a remarkable sales and marketing execution. Those are going to be the rounds that get done at around 100K.
I don’t think necessarily the dynamics around the Series A market are going to change in terms of when companies raise, or the characteristics that we’re going to be looking for, so much. We’ll be weighing the sustainable competitive advantages more than we have in the past.
Connie: For those companies that are going to have a little bit harder time or they’re going to need more time to get to your offices, what can they do? Trying to get to lower their burn is easier said than done, I guess I should say. What are some ways to reduce burn? Is layoffs the most obvious thing?
Tomasz: Yeah. Layoffs is an extreme measure. The way that I think about it is, I wrote this post once called “The Fundamental Unit of SaaS Growth.”
When you hire a salesperson, you don’t just hire the salesperson. You hire a salesperson. You hire some fraction of a sales development representative to provide them sales qualified leads in order to hit their quota.
Before that person, you hire some fraction of a marketing person to provide the marketing qualified leads. Then, you also invest some marketing budget in order to help the marketing person. Then, you also need post-sales people. You need customer success, customer support, professional services. When you hire one salesperson, you aren’t hiring one.
Your cost isn’t 120k, or 150k for an inside sales rep, or 300k for an outside sales rep. Your cost is really probably closer to $750,000 or $1 million, all in to be able to feed that sales rep the right leads and make that person successful.
One of the best ways to reduce burn is to slow your sales hiring, because the amounts of money that we’re talking about with those fundamental units is so substantial.
Connie: Right. Of course, then you have to worry about distribution, which is never easy. What are some ways to get your product out in the world without your sales team?
Tomasz: I get lots of questions by email about really effective customer acquisition strategies for SaaS companies. Most of the SaaS companies that we look at are probably 60/40 inbound outbound. Their ACVs are 20k to 40k. Some of them are bottoms up built through content.
The four main channels of distribution that we see pretty frequently, one is content distribution. Obviously, HubSpot is the leader, created that category. That works really well for SMB.
In concert with that, content marketing plus mobile app store distribution are really cost effective mechanisms of, particularly with Facebook now and the retargeting with the email matching, those are really cost effective mechanisms of acquiring users where your ACVs aren’t large enough to support a traditional inside sales team.
Then, there’s inside and outside sales. Those probably won’t change. Hopefully, the cost of those things go down and the efficiencies improve, particularly with lots of the tools that many of the vendors here displaying are selling to the market.
The last and the most novel is our channel partnerships. Channel partnerships existed worked really well in the classic, client server, big software era. It worked really well because you would buy this monolithic system. You were an enterprise company and you were paying a lot of money, millions of dollars in some cases. You really wanted a system that was bespoke, or fit to your needs.
You were willing to pay either the software provider, or a valu- added reseller, or some consultancy like an IBM, to configure and shape that piece of software exactly the way that you wanted it.
When SaaS came on the scene 2001, 2002, depending on which company you want to point to, most of the products that they were selling was really off the shelf software, and meant to be bought with a credit card without a whole lot of customization.
What we’re starting to see now is, there are new kinds of SaaS software, like an ERP or really big categories where they do lend themselves to channel.
The other part of it is what I alluded to before in the presentation. These large incumbent software companies are looking for new products to sell because their existing products aren’t flying off the shelves anymore.
It’s quite possible that a startup can find a way to effectively rent a large enterprise company’s sales team and push their product through the channel. That’s something that we’re seeing increasingly, which was a little bit of a surprise to me.
Connie: Not that pivoting is also easy, but what industry should these guys be targeting or what subsectors? You told me something backstage which was shocking to me, which is that something like two percent of software now is in the cloud, just. Obviously, there’s tons of opportunity. But at the same time, there’s something like 2,000 sales and marketing SaaS apps, which seems like a lot.
Tomasz: That seems like a lot.
Connie: What’s a little bit overdone and where are some of the great opportunities?
Tomasz: I don’t think I could point to a particular vertical or sector that hasn’t been touched by SaaS. All of them eventually will become SaaSified, or whatever you want to call it. Going back to that statistic, there’s about $2 trillion in enterprise software market cap and only two percent of that is now cloud market cap.
Even if you assume that two thirds of the dollars are untouchable, we still have something like a 15X growth from here. We’re really still in the early days.
The main things that we’re going to be looking for, you can think of software going in three ways. You have the client server era, basically Oracle founded in 1984, or 1981, sorry, to the early 2000s. Then, you had Salesforce in 2004, that spawned the SaaS era. Now, you’re going to see just being SaaS is no longer enough to be differentiated.
With the explosion in the number of SaaS companies, sales, and marketing. It’s probably the greatest example right there, is that Lunascape, that the number of sales and marketing companies has grown from 500 to 1,000, to 2,000 in three years. Being a SaaS product and using the go to market advantages innate in SaaS, they just aren’t enough.
There are two forces that we’re paying attention to right now. One is machine learning.
RelateIQ is a great example of this that we were lucky enough to be investors in. RelateIQ used machine learning in order to simplify one of the most painful parts of using Salesforce, which is data input. There are lots of other ways to use machine learning, anomaly detection, or suggestions, or recommendations.
We’re going to see machine learning infiltrate every part of SaaS. That’s going to create a new wave of SaaS companies that are first going to try to aggregate enough of a proprietary data set to be able to produce a unique machine learning model that they can bring to market. Then, change the nature of the game, what the buyer wants, and all that stuff.
The second is changes in user interface. There’s definitely a trend around chat and that user interface. The way we’ve been thinking about it internally is it’s really much more…I don’t want to talk to a database. I don’t want to fill in a bunch of fields in a form that looks like a visualization of a database. I don’t really mind having a conversation.
Could there be a world in which every SaaS app where you’re doing some data entry is actually replaced by chat? Machine learning also powers that because, the chat bot at the beginning is a human, and when you have enough of a data set, ultimately becomes some automated bot. That’s a much more agreeable user interface than the lists or the collections of text boxes that we have in our…
Connie: That’s really interesting. Is Redpoint an investor in Slack?
Tomasz: We are not so lucky.
Connie: You’re not? I’m surprised. You don’t think that technology’s going to be rooted necessarily in Slack? They do seem to have such a strong foothold.
Tomasz: They do. Slack has an opportunity that very few software companies have, which is to become a platform. They’ve demonstrated this already, at least in the engineering world, where you have lots of integrations for code commands or pushes. All the alerts come up through these groups.
I think there’s going to be a category of applications where they use chat bots that are probably core to their platform. We don’t know what those are yet. If you’re going to build the chat bot or Slackbot, there’s clearly platform risk. That’s innate and intrinsic to the category.
There’s going to be a much larger set of products. A great analogy is the Salesforce app ecosystem. Salesforce can’t do all those things. They can still build big businesses like Viva or others. There’s a lot of opportunity there. The sky’s the limit, in terms of chat.
Connie: Also, mobile-first companies, I’ve talked to a lot of VCs this year who are like, “Enterprise mobile apps, that’s where it’s at. Putting technology in the hands of these people who’ve never sat behind a computer…” Something like 80 percent of the world’s workforce works not behind a desk or behind a laptop. Is that a huge opportunity that you’re tracking?
Tomasz: Yeah. The way we think about mobile is like you said, there are 90 million blue collar workers in the US. Many of them do not sit in front of a computer all day. There’s clearly an opportunity to build software for them.
The thing that gets us the most excited about mobile is, we really want to invest in companies that use a technology advantage to enable go to market advantage.
All of a sudden, there’s some discontinuity, whether it’s machine learning, or mobile apps, or distribution, that suddenly whoever figures out the dynamics within that new technology paradigm or distribution paradigm, whoever figures that out first is going to win disproportionate market share.
We’re investors in Expensify and Expensify has grown to quite a significant run rate exclusively through mobile apps or distribution. We don’t have any traditional sales models.
That bottoms up model can be quite powerful. What ends up happening is a bunch of salespeople download the app. They say, “We don’t really like our existing expense management software.” They get the finance team to switch. That works really well. That’s one up sales model through mobile. It’s the bottoms up.
The other is a meet in the middle where you have mobile app store distribution to get software in the hands of people, typically using a free model. Then, you have an inside or outside sales team that sells top down.
By the time the sales team actually reaches the executives, the company is basically primed to buy, because they’ve got enough social proof within the organization that everyone agrees whatever software it is that we’re talking about is the right one to actually buy. That’s really effective.
Then the last part about mobile is unlike SEO, or different than SEO, SEO’s really expensive because it’s super-competitive and a highly-efficient auction.
Because of places like Facebook and LinkedIn, you can still acquire a download for two or three bucks. If your conversion sales funnel is efficient enough, then you can make pretty attractive unit economics using paid mobile acquisition.
Connie: Great. We’re almost out of time. I did want to ask you about Zenefits. You are not an investor.
Tomasz: We are not.
Connie: I don’t know what’s going to happen with the company now that Parker Conrad’s been seemingly elbowed out the door. How does that impact…? Is that going to have a broader impact on what you’re doing and company valuations? It was the highest flier, or one of them of the past year.
I’m wondering if it’s a big black mark or if it’s seen as more anomalous, in terms of at least he’s understanding what they’re getting into in some of these.
Tomasz: Zenefits is an amazing business. It’s definitely top two or three fastest growing SaaS companies ever. I have tremendous respect for Parker and David Sacks. Both of them are amazing entrepreneurs. They’ve built an amazing business in a very traditional category. Lots of businesses hit potholes. There’s no perfect execution and there never will be.
When you’re such a high flier, every once in awhile when you hit a pothole and you’re so much under the microscope, it can be amplified.
I don’t think Zenefits in and of itself is really going to change the way that we think about investing. Some investors are more inclined to invest in regulated industries. Zenefits is operating in a regulated industry. You definitely have to be clear on how you satisfy the government regulations when you go to market.
I don’t think them in and of themselves are really going to change anything. The macroeconomic picture that’s changing and particularly this division or this public/private market disparity in multiples is a much bigger force than one company.
Connie: Great. Tom, we’re out of time. Thank you so much.
Tomasz: Thank you very much.
Connie: Great talking with you.
Tom’s slide presentation is here.