House Of Cards: The Risks Of A Startup-heavy Customer Base

Originally posted on April 13, 2015

Growth is king…for now anyway. Growth is now the most sought after and defining characteristic of a company. Growth defines momentum and is the key metric upon which companies today are being valued. Of course investors seriously consider other characteristics when evaluating the attractiveness of an investment opportunity, including size of the addressable market, profitability, sales efficiency and other quantifiable metrics, but investors today seem to be most enamored with growth.

Looking at just the SaaS enterprises in the Pacific Crest software company universe, companies with projected 2015 revenue growth of greater than 40 percent, 30–40 percent, 20–30 percent and less than 20 percent have average projected 2015 revenue multiples of 9.8x, 7.6x, 6.4x and 2.4x, respectively. This growth, especially with SaaS businesses, typically comes with heavy operating losses. While the public markets have become more discriminant in 2015 of accepting these losses and revenue multiples have come down, they remain tolerant of them.

Quality vs. quantity of growth
An important and distinguishing characteristic behind growth, though, is the cost to achieve it. Can you grow cost effectively, i.e. Magic Number and CAC Ratio (check out suggestions on how to do this in our previous blog, SaaS and the Impact of Cash Collection on Cumulative Cash Needs)? Is it a ‘nice to have’ versus a ‘must have’? These questions will help you triangulate in on TAM, customer need and willingness to pay for the solution.

What a lot of folks fail to consider when evaluating a company, whether public or private, is where this growth is coming from. Investors want to see startups with long lists of growing customers, and startups are keen to provide those lists to investors. Sure, everyone does a customer concentration analysis, and everyone is looking for big brand-name logos in the investor deck, but what happens when these customers happen to all be in the tech sector? And what happens when an increasing proportion of them are startups themselves?

Tech startup concentration
Think about it. It’s a dangerous proposition for private and public companies alike. If your customers are all tech startups, what happens if, and certainly when, the market corrects and many of these customers disappear. You don’t have to look back too far to see how this game plays out. Look at the 2001 tech bubble burst when growth was feeding growth at unsustainable levels. MicroStrategy, Startups.com and Inktomi, all of which relied heavily on other startups as customers, vanished overnight or saw their stocks fall to pennies on the dollar. Ask Ben Horowitz about the early days of Opsware (formerly Loudcloud) when many of its “dot-com” customers quickly turned into “dot-bomb” customers. And remember Sun Microsystems’ late 90s slogan — “we put the dot in dot-com”? Well here’s an apt account of what happened in Sun’s heyday and its aftermath, as described on Wikipedia:

“In the dot-com bubble, Sun began making much more money, and its shares rose dramatically. It also began spending much more, hiring workers and building itself out. Some of this was because of genuine demand, but much was from web start-up companies anticipating business that would never happen. In 2000, the bubble burst. Sales in Sun’s important hardware division went into free-fall as customers closed shop and auctioned off high-end servers.

Several quarters of steep losses led to executive departures, rounds of layoffs, and other cost cutting. In December 2001, the stock fell to the 1998, pre-bubble level of about $100. But it kept falling, faster than many other tech companies. A year later it had dipped below $10 (a tenth of what it was even in 1990) but bounced back to $20. In mid-2004, Sun closed their Newark, California factory and consolidated all manufacturing to Hillsboro, Oregon. In 2006, that factory also closed.”

We’re seeing a similarly concerning reliance on startups as customers in many of the earlier-stage companies we see today through our direct fund and fund of funds prospecting efforts. It’s cheaper than ever to begin to scale a company and many of these startups are early adopters of new technologies. Consequently, this has created more and more customers for startups.

Those most at risk
Sectors like marketing, HR, customer success/retention and next-gen software infrastructure are booming with more and more players popping up by the day. Many of these companies rely on the tech sector as their primary avenue of growth. The companies in these sectors have growing pipelines of young startups that are eager to use their technology solutions to improve internal processes (e.g., payroll, HR, infrastructure, etc.), more efficiently target customers (e.g., SEO, SEM, etc.) and more effectively monitor, retain and upsell existing customers (e.g., customer success, etc.). In many cases these new offerings only need to be moderately better or marginally cheaper to find adoption among these earlier-stage companies.

The problem is that many of these customers will not grow to become sustainable businesses themselves. In the case of a market correction and associated pullback in venture funding, many of those customers will disappear and companies that rely heavily on them for growth will be hit particularly hard.

The right mix of customers
Let’s be clear, we’re not suggesting you don’t sell to startups. They can be good customers. With the growing number of unicorns out there, they can be great lighthouse logos. And they can be low hanging fruit. But there are risks associated with selling exclusively to customers that rely on the capital markets to weather long periods of unprofitability. Young customers also don’t have the long sales cycles, customization requirements and bureaucracy of more established companies making them easier targets (look for more on this topic in a forthcoming blog). But beware of developing a culture of selling only to fellow startup journeymen and women. You must be careful because you can quickly build a house of cards that only needs a single blow from the broader market to topple if you don’t expand at the right point.

So while it’s great to have startups as early customers to get validation, our advice is to shock proof your business by prudently and purposely diversifying your customer base as soon as you can. Your Series A should be used to build the initial customer base, but once you exceed a dozen customers and as you approach your Series B, you should make sure to begin diversifying away from selling exclusively to younger companies.

There’s a clear danger of an overreliance on other startups as the predominant segment of your customer base, especially as the private markets continue to get more and more frothy and a correction is surely around the corner. Grow your business quickly, but do so in a sustainable and enduring way.