Read this before you raise that next round

We just published our Q1 State of SMB Software report, looking at all the venture, private equity, M & A + IPO deals in the SMB space for Q1. By any measure it was a torrid quarter with over $35B of deal value in the first three months of the year in North America.

There is so much capital in the market at the moment that it can be tempting to just keep raising. A few anecdotal data points: PostMates officially announced their IPO just one month after raising another $100M in January. This represents the company’s 3rd raise in the past 6 months. DoorDash raised $785M in 2018 and added another $400M in Q1 2019 with Toast raising $365M over the same time horizon.​

These headlines certainly make it tempting to pile on more capital. There is more dry powder than ever, over $2 trillion in private equity alone. Many of our clients are getting multiples inbounds from investors daily.

This is less the case in the SMB software market, but more broadly what we are seeing is the polarization of the market in to the haves and have nots. The haves can raise more and more capital and thus have a disproportionate advantage over competitors. This is the Softbank effect. Mega rounds rig the game in favour of mega-funded companies. This is one major reason why Uber is so much more valuable than Lyft.

Musical chairs

As long as the music is playing and more and more capital is available, we can keep this party going. However, the frothiness of the funding market is largely at odds with the cold, harsh realities of the M & A market. As I wrote about last month, fundraising valuations are very different from exit valuations. Buyers don’t care how much capital you have raised and don’t care whether your VCs make money.

Going back to the Softbank effect: the haves will continue to be in a prime spot to raise and postpone the exit reality check and/ or have such a strategic market advantage that buyers will pay significant premiums to acquire them.

If you compete with a have company, you are not in a good spot. More broadly, if you are an “ordinary” company (i.e. the vast majority of the market), then there is a significant risk in the current environment that you will end up raising too much capital and end up with an exit where no one makes money.

We recently met a well-funded company where their valuation was ~ 260x their annual revenue. How the hell does this happen? In my view, barring capital intensive sectors such as chip design or drug development, where revenues can be far in the future, revenue and capital raised should correlate with each other to some extent.

“R” is for recession…

The musical chair analogy is an apt one at the current time, as many people feel that we are overdue for a recession. Bull markets typically last about five years. We are in serious overtime on the current bull run.

However, there are signs that give rise to a concern: As an example, the interest rate yield curve just inverted (typically, long term loans cost more than short term ones. When the yield curve inverts, short term capital actually costs more than long-term capital). The sudden increase in tech IPOs suggests that people in the know feel like the IPO window is about to close. Finally, online lenders are preparing for a recession soon. It’s just a matter of time.

That’s probably enough doom and gloom. The question is what should you do about this? Here are my suggestions:

Be brutally honest about the state of your business. Only raise capital if i.) Your go to market machine is proven and repeatable (so you have a high degree of confidence that more $ invested will lead to multiple of those $ returned); and ii.) There is clear precedent for the natural buyers in your category buying companies at the target valuation implied by your level of funding.

Absent these conditions, then you just have hope. That should not be the basis for raising the bar on exit success.

Next, solve for optionality (if it’s not too late and you have not already raised too much). Build a business that can choose to transact vs one that must transact. Be in the drivers’ seat.

Finally, just ignore the headlines. Who cares about the latest unicorn! Focus on your repeatable go to market fundamentals so that you can scale (and raise) with confidence.