The Importance of Optionality

It seems like there is no end to the supply of venture capital these days. Funds are getting larger, with more dry powder than ever. Series As are looking like series Bs. The time between funding rounds is getting shorter.

For the most part this is all good. As a general rule, when food is being served, eat.

But…it’s important to be mindful of the consequences of raising more and more capital. In today’s land of plenty it can be tempting to double down before your company is truly ready. That can lead to issues if you don’t live up the expectations that come with all that money.

While raising a funding round is a big milestone, it is not success. Success is ultimately creating a meaningful and valuable and participating in that value creation. For everything you put into your company, its outcome should change your life when all is said and done.

When I look at the distribution of exits by size and see just how few exits are large enough to justify the funding that went into them, it’s clear that something is off.

Source: Pitchbook.com

The chart above shows all 597 SaaS exits that closed in North America in 2016. 3/4 of them had no disclosed value. It’s safe to assume most of these are quite small, though some could be great, but the buyer is so big that it doesn’t need to disclose them. Only 8% of all exits were $100M+.

Now, compare this exit distribution withe probability of your startup surviving from one funding round to the next.

Source: Techcrunch.com

Jason D. Rowley pulled together some great stats on Techcrunch this week to show in black and white what your chances of exiting are from one round to the next. This graph looks a lot like the churn graphs I see at SMB SaaS companies. A lot of churn early on, then flattening out in the long term.

The importance of optionality

Strategy is ultimately about choices: what you choose to do and as a result, what you choose not to do. When you raise too much money prematurely, you remove the choice of a profitable early exit. Too much money will go to your investors. I have seen plenty of small, early exits where the founders had raised relatively small amounts of money. As a result, these exits completely changed the lives of the founders. When you raise too much too soon, you rob yourself of that opportunity.

Today’s technology markets are more dynamic and more competitive than ever. Many seed stage companies that have a grand long term visions are today mere features compared to the incumbents in their markets. As a result, the market opportunity they’re tackling can disappear rapidly due to product innovation or acquisitions by larger players.

Given this dynamic environment, it’s important to maintain choice at all stages. You always want to be in a position to either sell profitably or raise more capital without doing so at a valuation that’s completely out of whack with your traction and resultant exit value.

Putting this into practice…

Specifically, here’s what I recommend assuming you’re already funded to some level:

  • 2x per year, have a formal discussion with your board around the funding and exit market.
  • Track funding rounds and valuation multiples (for rounds and exits) in your space. I know it’s hard to get good data, but CB Insights and Mattermark publish a lot. If you’re a SaaS business then just read every post by Tomasz Tunguz.
  • Maintain an ongoing dialogue with the corporate development groups of companies in your space. Don’t tell them too much. Just enough so that if they’re thinking of making a purchase in your space, they will contact you.
  • Based on valuation trends (and the above distribution of exits by size), look at whether an exit today could make sense.
  • Always make sure the amount you raise next (and the terms of that deal) give you enough runway to drive results that will justify the deal and enable a return for you and your new investors.

The decision to sell your company is a huge one. And you have to make it on imperfect data. Two frameworks that have helped me over the years are from:

Ben Horowitz: If you think you have a good chance of being a market leader then don’t sell. Otherwise, consider selling and position yourself so that if a game of musical chairs is happening in your segment, make sure you’re not the last one standing.

Eric Paley, Founder Collective: If a potential exit is accelerating valuation by 2 years or more (i.e. a buyer is willing to pay today more than what you think you’d be worth in two years), think about the deal.

In good times and bad, always maintain your ability to choose between a profitable exit and a profitable round with terms that you can live up to.

Modified from an earlier post on StartupCFO.

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