There are two major failure modes in startups.
The first common failure mode is the thing you make doesn’t get adopted. That’s called not finding product market fit in startup lingo.
The second common failure mode is “getting too far out over your skis” and it happens to companies that do find product market fit but mess things up by building an inappropriate cost structure (and capital base) and it all comes crashing down on them when they either can’t continue to raise money at ever increasing valuations and/or when they can’t grow into their cost structure quickly enough.
The first failure mode comes with the territory. The world of startups is all about experimentation. Most experiments fail. If this happens to you, it sucks, but that is what you signed up for.
The second failure mode is entirely avoidable and way more common than you might think.
The capital markets are efficient over the very long run but highly inefficient in the moment. So just because investors are willing to throw gobs of money at you and your company, it doesn’t mean that it is smart to take it. And, as I have written numerous times here before, having lots of capital does not derisk your business plan. In many cases, it amplifies the risk of your business plan.
So how do you stay in balance and avoid getting too far out over your skis?
I like this framework that I call “Finance To Value” which means you finance your business to regular valuation targets that are driven by fundamental value analysis.
The first thing you need to know is how your business will be valued by a buyer or the public markets when it is a scaled business. I like to use EBITDA and Revenue multiples for this work. And the best place to get them is from bankers who work in your sector and/or investors who are active in your sector. The key point is these multiples are what you are going to be valued at upon exit or IPO, not currently.
Revenue multiples work better for this than EBITDA because very few companies have positive EBITDA during their growth phases.
Here are some examples. Please don’t use these multiples without verifying them with someone who knows your industry and your business. These are simply examples:
E-commerce business – 1 to 2 times revenues
SAAS business – 6 to 8 times revenues
Marketplace business – 4 to 6 times revenues (which can be less than 1x GMV depending on your take rate)
Once you know this number for your business (and don’t be aspirational or agressive in determining it as that will just lead to problems), you can apply the Finance To Value framework.
There are two Finance To Value rules:
Don’t raise more money in a given financing round than you can create in incremental value during that capital window.
Don’t let the post-money value of your round get higher than you can grow into during the capital window.
So let’s apply it to a fictional company.
Let’s say you have a SAAS software company that is doing $10mm of annual recurring revenue and you want to raise money to fund the business for the next 18 months. Let’s say that your business is growing at 40% per year and that your annual recurring revenue will be $18mm in 18 months. And let’s say that the post money value of the your last round was $60mm.
So using a revenue multiple of 6x revenues says that you should not raise more than 8×6 or $48mm. But that means you won’t create any incremental value. If you want to create incremental value then you should raise some fraction of that, maybe half of that.
Also, you should not let your post-money value get beyond $108mm (6×18). So if you raised the entire $48mm, it would be a flat round with your last one.
This is a bit of art vs science, but what those two calculations tell me is that the right raise for this company would be something like $20mm at $70mm pre/$90mm post, leaving some cushion to miss plan and still be able to raise an up round.
The challenge for founders and CEOs operating in startup land is that investors are often willing to throw more money at an opportunity at a higher price than you should accept. Who wouldn’t want more capital and less dilution?
But that is how you get out of balance. Don’t be tempted by the money and the valuation. Stay in balance and always make sure you can get the next round done on fundamentals.
If you stick to that practice, you can significantly reduce the possibility of getting too far out over your skis.