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BUILDING YOUR OPERATING MODEL
You can build your operating model around these “facts” and use your assumed average Annual Contract Value, Customer Acquisition Cost (CAC), and Customer Acquisition Cost Ratio to determine how much capital you will need to reach each of the Traction Gap value inflection points.
I would model Worst, Expect, and Best CAC Ratios of two, one, and one half for this exercise, implying a two-year, one-year, and one-half-year payback respectively, built off your assumed average Annual Contract Value.
A good “rule of thumb” for early-stage startups that haven’t yet reached MVT is that sales and marketing expenses should be about half the cost of running your company per month/year. So, if you want to drive the formula using this logic, then you should budget half of your monthly expenditures on engineering, GA, systems, etc., and the other half on sales and marketing expenditures.
Average net monthly burn is best kept to $150K to $250K or less while you get from MVP to MVR, and no more than $500K per month post-MVR but pre-MVT. After MVT, your net burn may be allowed to increase if you can demonstrate to your investors that this investment is generating faster growth and market share. But at this high net burn rate, you are rapidly burning a lot of valuable capital. So you need to ensure that you monitor your key growth metrics (e.g., CAC, CAC ratio, bookings backlog, billings) every month; and if your growth rate diminishes, that you are prepared and able to take swift action to curb the net burn.
Again, the top public SaaS companies have established a revenue growth model that other SaaS companies must meet or beat.
On average, they have grown from MVP as follows:
Y1 = $1M ending ARR
Y2 = $3M ending ARR
Y3 = $10M ending ARR
Y4 = $25M ending ARR
Y5 = $50M ending ARR
I will expand on this topic in Chapter 7, “The Final Sprint to Minimum Viable Traction.”
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DEVELOPING A CAPITALIZATION STRATEGY
You need capital to hire a team, develop a product, take that product to market, and invest in the systems that support all your business functions. In other words, capital is the foundation that girds the four Traction Gap Architecture Pillars—product, revenue, team, and systems. Where you get your capital may be optional, but going without it is not.
Consequently, you need to develop a capitalization strategy from the inception of your startup.
One of the many questions I’m asked about this topic is “How much capital should I raise?” The simplest answer is: as much as you can, at a valuation you can live with, and at least enough to reach the next successive Traction Gap value inflection point and slightly beyond.
To address this, I constructed this chart, generated from industry data, to give you a better idea of what you can expect:
■ Startup Capital Needs for Each Value Inflection Point ■
IDEA/MVC
/IPR
MVP
MVR
MVT
Capital Raised at This TG Inflection Point
$1M
$5M
$11M
$20M
Pre-Money Valuation
$5.3M
$14.2M
$40M
$77M
Valuation Step Up from Ideation
N/A
3x
8x
15x
Dilution from Prior Round
16%
26%
22%
21%
The data suggests that from Ideation through MVT, a successful technology startup can expect to raise about $37M and give up 38 percent of ownership through dilution—if it does everything right. This calculation does not account for dilution from increases to employee stock option pools.
These are median values—and these funding rounds (Seed, Series A, B, C, etc.) are not precisely tied to Traction Gap value inflection points. But these funding rounds are linked to startups that are, for the most part, successfully generating traction—or else they would be unlikely to raise new capital.
The main point here is that if you hit all the Traction Gap value inflection points on the time scale I’ve laid out, you should be able to raise similar amounts or more of capital at equal or potentially higher pre-money valuations. A word of advice: until you are beyond MVT, I would not concentrate as much on valuation. Yes, it’s important, but at this stage the more important issue for you is securing the capital you need to continue.
■
RISK MANAGEMENT
Your focus should be on having enough capital to reach a value inflection point where your startup is viewed as “less risky”—and therefore more valuable—than it was the last time you sought capital.
What does “less risky” mean? It varies based upon stage. It can mean you built the product you said you would in the time frame you set for yourself. You found multiple customers or consumers who would buy/use your product. You demonstrated that you could acquire new users cost-effectively. Or you are rapidly scaling quarter over quarter.
My Wildcat partner, Geoffrey Moore, wrote the following, which I think sums up the “risk” issue nicely:
There are no hard and fast rules here, but one way to calibrate a venture valuation model is by what risks you have taken off the table. For example:
Technology risk is often the first one to tackle. A seed round of funding might go to proving technical feasibility for a product idea. If proof of concept is achieved, then technology risk can be said to have been taken off the table, and the company’s valuation should reflect that.
Product risk is another step in the journey—can you deliver a minimum viable product, and can you get at least a few customers to buy it, use it, and be a reference for it going forward? If so, that takes another risk off the table.
Market risk is a third category—can you cross the chasm from early adopters and find at least one target market segment that will adopt your new offer with enthusiasm? If so, your company is well on its way to being a going concern, and that takes a whole bunch of risk off the table.
Team risk is a fourth area—can you successfully recruit high-quality leaders with strong resumes that demonstrate they know what they are doing when it comes to building out a new company? Will they come work for you? If so, that sends a great signal to the next-round investor.
Financing and systems risk is a fifth area—having proven you can make the top line, can you make the rest of the P&L work as well? Can you put the systems in place needed to operate effectively and efficiently at scale? Can you get to escape velocity on the capital plan in place? If so, you protect your current investors’ ownership from further dilution.
Execution risk is a sixth area—have you consistently demonstrated that you are able to do what you said you were going to do? Can you forecast accurately and then meet or beat your numbers quarter after quarter? That’s what it takes to do a successful IPO and to keep your valuation in the quarters thereafter.
Now every one of these risks is something that keeps a venture investor up at night, so the sooner you can take any one of them off the table and do so definitively, the better. That said, “definitive progress” is often in the eye of the beholder. Given such ambiguity, it is critical to get agreement with your prospective investors as to what state change they think they are funding, what milestones they think will clearly demonstrate to a new investor that it has been achieved, and then together with them make a bet on that model being right. The more experienced your prospective investors, the better your odds will be, for these are the folks that have seen this movie many times before.2
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CAPITAL MANAGEMENT
Earlier in the chapter, I provided you with a chart that outlined the approximate median values raised by startups at various Traction Gap value
inflection points. But that doesn’t tell you exactly how much you should raise or how much you should be spending at any given stage. Again, venture capital is expensive. You are exchanging points of ownership for dollars that you can apply against your product, revenue, team, and systems requirements. So it’s critical that you make significant progress with that capital and that you spend it wisely.
So, how should you think about spending this capital? Well, the answer to that question depends upon how much you were able to successfully raise, what stage you are in, and what risk you’re willing to assume. What I’m about to share with you is not solely based on industry data; it also includes my personal experience working with many different startups over the prior decade. Thus, this information has some subjective opinion heaped on top, so use it accordingly.
■ Capital Expenditures ■
IDEA/MVC
/IPR
MVP
MVR
MVT
Revenue (ARR)
$0
$0
$2M
$6M
Max Monthly Net Cash Burn
$100K
$250K
$500K
$750K
% R&D Spend
80%
80%
70%
50%
% Sales & Marketing Spend
0%
0%
10%
35%
% Sales/Marketing Split
0%
0%
70/30%
70/30%
% G&A Spend
20%
20%
20%
15%
CAC Ratio (Median)
0
0
2
1.2
% Gross Margin (License)
0%
0%
78%
78%
% Churn Rate (Median)
0%
0%
10%
10%
Headcount
4–6
10–12
15–25
35–50
Depending on where you are located geographically, you should expect to pay about $15K to $20K per month per Full Time Equivalent (FTE) employee. Once you have reached Minimum Viable Repeatability, you should be generating revenue (e.g., $2M ARR), which should give you additional operating capital on top of the capital you raised previously to invest in more R&D, Sales & Marketing resources, or to simply extend your cash run-out date to remove more risk from the business before raising your next round of funding.
With respect to spending, for SaaS business models there is a generally agreed-upon concept called “The Rule of 40%.” This rule requires you to add your annual growth rate to your EBITDA percent (which can be, and most often is, negative). If the result is 40 percent or greater, you’re in good shape. The purpose of this metric is to prevent “growth at all costs” operating models.
That said, McKinsey issued a report a few years ago that looked at more than 3,000 software companies over a 32-year period and determined that growth rate was the single most important variable, by a wide margin, in determining value. And while you may have a small startup, as I stated earlier, the truth is that venture investors value growth over almost anything else.
When you are an early-stage startup, investors are primarily concerned about whether you can continue to scale at previous rates (e.g., will your growth taper out due to competition?) or you can manage external growth so that your internal systems and governance scale accordingly and don’t cause customer, employee, and/or other related issues.
If you’re growing more than 100 percent per year, continuously, investors will help you finance that growth. They may ask you to try to improve your CAC ratio, gross margins, and a few other metrics, but for the most part they will be cheering you on.
KEY TAKEAWAYS
■
At the Ideation stage of your startup, we believe team members should be focused on statistically verifying that any product or service concept has merit in the market and that the product or service can be developed and brought to market cost-effectively and with relative certainty.
Product—The company should perform quantitative and qualitative market research and document that research to statistically validate the overall market opportunity. In addition, the team should have a really good idea of how it will build the product or service and how much time and personnel are required to reach IPR.
Revenue—The management team should explore potential business models—and remain flexible—along with a few hypotheses regarding what it believes it will take to identify consumers/customers and to monetize them. This exploration process should include basic assumptions regarding the total addressable market size, customer/consumer acquisition techniques, pricing models, customer/consumer acquisition costs, sales cycles, etc.
Team—At this stage, members of the team should have relevant subject-matter expertise and consist only of people who can determine what product/service needs to be developed and people who can actually develop the product/service. There should be a rough organization chart of what additional product/service skills need to be hired at subsequent Traction Gap value inflection points. Anyone who isn’t contributing significantly to getting to an IPR should be replaced as rapidly as possible.
Systems—Not much needs to happen at this stage with respect to systems. The team should acquire basic tools that enable them to communicate and collaborate effectively and share information easily. Applications such as email, spreadsheets, collaboration software, word processing and engineering applications (e.g., build/QA system, bug database, user stories) are typically sufficient at this point. Once the team becomes a legal entity, it should also have systems in place to track expenses, payments, equity, hiring, payroll, benefits, etc.
Traction Gap Architectural Pillars
FIGURE 8
Percentage of emphasis at this stage.
The following are the key principles Wildcat Venture Partners looks for at Ideation.
■ Traction Gap Principles ■
Ideation
Product
Focus on product-engineering tasks: Perform statistically valid market research and prioritize initial product features based upon that market research.
Revenue
Focus on market-engineering tasks: Build draft business model and initial value propositions—estimate customer acquisition costs and marketing/sales funnel conversion rates.
Team
Invest solely in people who can specify and build the product.
Systems
Implement basic systems for engineering, collaboration, and back-office functions.
Traction Gap Hacks ▶ Ideation
Raising Venture Capital
Most savvy entrepreneurs know that getting a warm and positive introduction to a venture firm substantially improves their odds of getting a meeting — and hopefully an investment—with that firm.
But what if you are an entrepreneur and don’t really know anyone at a venture firm?
Many startups are now using LinkedIn to initially contact potential venture investors. I get a lot of unsolicited requests from entrepreneurs this way. I pass on almost all of them for a variety of reasons, but I always try to quickly scan the opportunity and provide thoughtful reasons for why I’m passing.
So if you don’t have a relationship with a venture firm or specific venture investor, or know anyone who does — how do you get an opportunity to present your startup idea?
Here’s an approach — along with some simple modern tools you can use — to increase the likelihood of getting that meeting. Note that this is a multi-st
ep process.
First, you need to target the right firm. Venture firms and their partners tend to invest across two dimensions — investment stage and investment type. Seldom do firms invest in all stages across all investment types — only the largest firms can afford to do that.
In particular, venture firms may invest from very early stage (e.g., ideation/pre-revenue) to late stage (e.g., scaling)—and across a variety of investment types around key markets, technologies, and business models.
Further, some venture firms raise funds to go after specific areas such as early-stage, late-stage, technology-centric (e.g., blockchain), market-centric (e.g., fintech), or geo-specific (e.g., China) startups.
Each of these funds has been marketed to limited partners by the venture firm, each of whom has agreed with the venture firm’s investment theses, unique insights, strategies, expertise, and projected returns.
Fund Investment Strategy
FIGURE 9
Note that the vertical arrows represent the magnitude of the investment at each of these stages.
So, how do you find the right firm on this matrix with the right fund and/or the right partner that aligns with your startup?
First, you need to understand who you are. What kind of company, at which stage of development, and targeted at which markets? If you can’t answer the following two questions with both confidence and data, you aren’t yet ready to reach out to investors:
At what stage is your startup?
Which companies participate in your market?
Competitors?
Companies in the same market but in a different sector and not a direct competitor?
That was easy. Now, you are ready to use Crunchbase.
It’s just as important to know which firms and partners you aren’t going to target as it is to know which ones to target. So, take your list of all the startups you consider to be direct competitors and search Crunchbase to determine who their investors are. These are venture firms and partners that aren’t as likely to invest in your startup—they’ve placed their bets elsewhere—so you may want to steer clear of them, at least initially.
Traversing the Traction Gap Page 5
