Some of the world’s biggest ecommerce enablers are starting to look a lot like fintech companies.
Millions of Amazon’s Indian customers, for instance, are now taking advantage of instant zero-interest and low-interest credit to pay for products weeks or even months after receiving them. Shopify saw its revenues jump 57% year-on-year after unveiling a new Shop Pay checkout tool. And in Indonesia, ecommerce giant Tokopedia merged with fintech innovator Gojek to create GoTo, a tech giant that contributes 2% to Indonesia’s GDP.
This “great convergence” between fintech and ecommerce is partly driven by the global pandemic, which compressed a decade’s worth of ecommerce growth into a few short months. Customer trust in fintech, perhaps out of necessity, skyrocketed as we worked and shopped from home, and consumers remain eager to use innovations like contactless payments in the post-pandemic era. That’s left fintech players looking to ride the ecommerce wave, and ecommerce companies seeking to tap new fintech revenue streams such as payments.
As investors, we’re never going to turn our noses up at this kind of unprecedented opportunity. But we believe this “great convergence” isn’t just about companies scrambling to grab market share and drive revenue. The reality is that this is one of those rare instances where 1 plus 1 really does add up to 3 — because when you bring the right ecommerce and fintech companies together, you wind up with something that’s much more than just the sum of its parts. And that can only be a good thing for both merchants and consumers.
For example, two members of the Oak HC/FT family — financing pioneer Clearco and ecommerce innovator Cart.com — recently joined forces to provide merchants with access to capital and an end-to-end suite of ecommerce tools to scale their businesses. Cart.com users can now access up to $10 million in instant financing via Clearco — and Clearco customers can use Cart.com’s unified console to quickly and effectively deploy the capital they’ve raised towards marketing, fulfillment operations or software capabilities.
That’s good for both companies, which benefit from reaching a shared customer pool representing over 8,000 top ecommerce brands. But it’s even more exciting because it isn’t just about the synergies that come from bringing together powerful fintech and ecommerce solutions. It’s also about the shared vision for what intelligent fintech integration can help founders and merchants to achieve.
More on this partnership below:
Both Clearco CEO Andrew D’Souza and Cart.com CEO Omair Tariq have witnessed the challenges that developed as ecommerce grew increasingly fragmented and over-complicated, leaving founders scrambling to manage a patchwork of third-party services and vendors. Both companies were founded on the belief that there is a better way, and that by creating streamlined financing and operational support systems it is possible to help more startups achieve success.
Seen through that lens, the Clearco-Cart.com partnership is more than just a smart business move. It’s the logical next step toward something bigger: a world in which ecommerce brands and fintech solutions operate seamlessly to give founders the tools they need to grow. By taking the friction out of entrepreneurship, Cart.com and Clearco are making it easier for ecommerce founders to execute their visions, scale their businesses, and achieve their dreams.
That kind of value-add is why the “great convergence” between ecommerce and fintech is such a big deal. But it also reminds us that the goal shouldn’t just be to add a fintech layer to an existing ecommerce product or platform. What’s needed, to make this convergence multiplicative rather than merely additive, is a real mission to empower the next wave of ecommerce merchants. The best players in this space aren’t just trying to bring ecommerce and fintech together. They’re using ecommerce and fintech purposefully — to create a more level playing field for every founder.
This piece was originally published in TechCrunch here.
There’s an old startup adage that goes: cash is king. I’m not sure that is true anymore.
In today’s cash rich environment, options are more valuable than cash. Founders have many guides on how to raise money, but not enough has been written about how to protect your startup’s option pool. As a founder, recruiting talent is the most important factor for success. In turn, managing your option pool may be the most effective action you can take to ensure you can recruit and retain talent.
That said, managing your option pool is no easy task. However, with some foresight and planning, it’s possible to take advantage of certain tools at your disposal and avoid common pitfalls.
In this piece, I’ll cover:
The mechanics of the option pool over multiple funding rounds.
Common pitfalls that trip up founders along the way.
What you can do to protect your option pool or to correct course if you made mistakes early on.
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A mini-case study on option pool mechanics
Let’s run through a quick case study that sets the stage before we dive deeper. In this example, there are three equal co-founders who decide to quit their jobs to become startup founders.
Since they know they need to hire talent, the trio gets going with a 10% option pool at inception. They then cobble together enough money across angel, pre-seed and seed rounds (with 25% cumulative dilution across those rounds) to achieve product-market fit (PMF). With PMF in the bag, they raise a Series A, which results in a further 25% dilution.
After hiring a few C-suite executives, they are now running low on options. So at the Series B, the company does a 5% option pool top-up pre-money — in addition to giving up 20% in equity related to the new cash injection. When the Series C and D rounds come by with dilutions of 15% and 10%, the company has hit its stride and has an imminent IPO in the works. Success!
For simplicity, I will assume a few things that don’t normally happen but will make illustrating the math here a bit easier:
No investor participates in their pro-rata after their initial investment.
Half the available pool is issued to new hires and/or used for refreshes every round.
Obviously, every situation is unique and your mileage may vary. But this is a close enough proxy to what happens to a lot of startups in practice. Here is what the available option pool will look like over time across rounds:
Note how quickly the pool thins out — especially early on. In the beginning, 10% sounds like a lot, but it’s hard to make the first few hires when you have nothing to show the world and no cash to pay salaries. In addition, early rounds don’t just dilute your equity as a founder, they dilute everyone’s — including your option pool (both allocated and unallocated). By the time the company raises its Series B, the available pool is already less than 1.5%.
While the option pool top-up (5% in this example) at the Series B helps to grow the unallocated pool, it is typically done so on a pre-money basis, meaning the new equity coming in as part of the round immediately dilutes the top-up. So, the resulting increase to the pool is closer to 4 percentage points than 5. The real dilution to everyone else on the cap table (founders, employees and investors) ends up being closer to 25% versus the 20% it would be if this was only an equity round with no top-up.
The company is again at less than 1% in available options at the Series D (two rounds after the top-up). This means further top-ups may be required, albeit at smaller amounts. The good news is that by the time of Series C and D rounds, 1% of equity can afford many more multiples of employees than 1% at the seed or Series A. Larger growth rounds also mean that cash compensation can become much more competitive, making up for smaller equity packages.
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Common pitfalls
As you can see, even in this relatively “clean” scenario where the founders had the foresight to open with a 10% option pool, raised good up rounds (with stage-appropriate dilution), and only had one top-up round along the way, they were likely still managing/hiring on close to a shoestring budget. This is not a position you want to be in, especially in today’s competitive talent market.
The reality is that things can get much messier, leading to a thinner option pool earlier on that can impair your ability to hire great people. Here are a few common traps that can pop up and wreak havoc on your option pool:
Poor planning: You simply don’t have a sizable option pool right from the outset. You underestimate hiring needs or are overly sensitive about ownership. Many first-time founders make this mistake.
Co-founder departures: Your co-founder, who has material ownership, leaves after a year or two. While they only vested a quarter or half of their shares, that can be 5%-10% of dead weight on the cap table doing little for the company.
Giving out too much to early hires: You give out too much equity to early employees who are unqualified for their role or demand too much equity even after adjusting for stage risk. They then have to be replaced a few years in with a more seasoned hire, which makes you “double pay” in equity for that role.
Hiring execs at the wrong time: A derivative of the above is hiring senior leaders too early. For example, hiring an expensive CRO at the Series A stage, when you would be better off doing founder-led sales or hiring a few AEs. The CRO hire will be more impactful to the company by the time of the Series C and likely less costly on the equity front.
Not firing quickly enough: Failing to use the one-year cliff as a forcing function to make decisions on performance. If you let poor performers linger too long, you will almost always regret the equity that could have been used for an awesome hire. This needs to be balanced carefully with maintaining a healthy work environment and positive hiring dynamic.
Not using data/benchmarks: Making an equity offer on a whim/using your gut almost always ends badly. Either you end up overpaying and giving out too much equity, or you give out too little and turn away good candidates. Using benchmarks also makes negotiating offers with candidates easier, as it lends the perception of a competitive and fair offer.
***
OK, you made a mistake, but there’s still hope
If you have hit the growth/later stages and made mistakes similar to those above, you still have a few ways to correct course:
Create a bigger pool earlier on: The easiest way to ensure you don’t run out of options too quickly is simply to start with a bigger pool. As a founder, you might worry about more dilution from a bigger initial pool, and while that may be true in the short run, the flip side is that, with more options, you can hire faster and get better quality talent. That should translate to more progress, allowing you to raise competitive rounds with less dilution over time.
To use the example above: If you were to start with a 20% option pool instead of 10%, but then reduce dilution at each round by 5 percentage points, by the Series D you’d end up with higher ownership as a founder, more (and better incentivized) employees, and less heartache around pool management. Here’s a view of the end state by Series D in this scenario:
Hire slow, fire fast: Take the time to make sure you want to hire any individual. Especially early on or for senior roles, which tend to be the most expensive. And if it’s clearly not working, end the relationship as quickly as possible and certainly well before vesting starts to happen. This applies to co-founders, too.
Consider longer vest periods for founders/early employees: The co-founder departure scenario is a tough one, as founder equity tends to be significant and can result in lots of dead equity on the cap table. Consider lengthening vest periods to something beyond the standard four years, or make the vesting more back-ended — Amazon-style. If a departing co-founder has already vested equity, consider buying out their shares at a discount and put those shares back in the pool.
Hold budget/planning sessions on employee compensation each year: Forecasting key hires one or two years ahead can do wonders to help you think about the pace of option grant issuance and the trade-offs you have to make for each role/hire. At some point, usually in the mid-growth stages, it’s a good idea to establish a compensation committee, usually chaired by an independent board member, to review compensation each year and recommend decisions to the broader board.
Use benchmarking (and other) data tools to make offers: Startup compensation tools like Option Impact, Carta Total Comp and Pave are must-haves as you scale your company. They will make sure your offers are grounded in solid comps by stage, geography and title. More often than not, founders end up being too generous on the equity side. Using a compensation tool helps ground offers in data and prevents too much equity being granted too early on. You can also triangulate these benchmark tools with feedback from other founders and existing investors.
Tie refreshes and earn-outs closer to performance: As your company scales, consider tying refreshes and earn-outs closer to performance. This is particularly applicable for sales front, but can be useful even for marketing, product and GM-style roles that impact the acceleration of top-line growth. If performance leads to accelerated growth, everyone wins and such performance warrants additional equity.
Skew comp more toward cash in the later stages: As your company scales into the later stages, the risk decreases, and you have more cash to pay employees jumping on your rocket ship. 1% of equity in the later stages can be used to hire hundreds of employees; especially when you have the cash from growth rounds to pay higher bases + bonuses.
Utilize buybacks as a non-dilutive way to grow the pool: Buybacks can be used with angels, early investors and even employees, all of which may have made a nice return by the time of the Series C/D round, and may be willing to partially or fully exit, allowing you to use cash on the balance sheet to repurchase shares and put them back into the option pool.
One important concept to remember is the value of fundraising at milestones where you can minimize dilution. In the example above, we started with the notion that founders can manage to keep dilution to 25% before the Series A. However, this number often ends up closer to 30%-40% before the first major institutional round.
Future fundraises and option pool top-ups then end up diluting more, which can catch founders by surprise. Focusing on achieving clear milestones before raising capital prevents premature and heavily dilutive rounds.
Managing your option pool is key to the long-term success of your startup. In many ways, your option pool is the most important currency you have as a founder. With careful planning and some thought, you can turn your option pool into a powerful driver of growth and enterprise value.
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As always, please reach out with any thoughts or suggestions (@MrAllenMiller.) I’d also like to thank Addie Lerner (@addielerner), Alex Kurland (@atkurland), Brian Murray (@murr) and Michael Sidgmore (@michaelsidgmore) for their help in reviewing early drafts of this and providing invaluable feedback.
When I first landed in venture, it was with an early stage focus: predominantly Series A. The body of knowledge available to founders raising a Series A was pretty robust at the time thanks to investors demystifying a once opaque process via public blogs and forums. YC has since added even more transparency, creating a great Series A guide for founders looking to raise a Series A.
As I’ve move into a multi-stage environment (early + growth), I’ve been surprised by the dearth of information on fundraising for growth rounds, particularly that first growth round: the Series B. There are of course lots of good posts focused on metrics of all sorts, scaling in the growth stages, etc, but the existing literature doesn’t really cover how to raise a Series B — and certainly not in a tactical way.
This is particularly relevant in a post-covid world. If you look at the Pitchbook data from the last few quarters across stages, the story is quite interesting. Early stage deals (Series A) and late stage deals (Series D), saw a massive drop-off in dollars invested between Q4 ’19 and Q1 ’20 but then a decent sized recovery in Q2 ’20 (not all the way back but venture dollars returned 30%+ and the upward trend will likely continue into Q3 ’20.) Series Cs actually saw an acceleration through Covid.
The Series B round, however, while declining in a more measured way, continued a several quarter decline with almost no recovery from Q1 ’20 to Q2 ’20.
Source: Pitchbook
My hypothesis here is that the market is bifurcating around this new “ugly duckling” round — creating something like the Series A crunch of 2015. Why is that? At the Series A, investors can put in a relatively small check and get higher ownership to compensate for the risk taken. Not every Series A needs to work; high ownership in a few measured bets can return a fund making up for losses elsewhere.
In the later stage rounds (e.g. C and D), the winners start to become much clear and there is plenty of later stage capital ready to go to work into obvious winners. The returns in the later stages may not be as out-sized as at the A, from a multiple perspective, but a big check can return a sizable dollar amount at a decent IRR while ensuring investors are unlikely to take a 0 on any given investment.
But that first growth round (Series B) is becoming an increasingly difficult round for investors (and, consequently, for founders.) The company is perhaps somewhat de-risked from a PMF perspective but there are still substantial GTM and scaling questions that need to be answered. As such, Series B investors are forced to put fairly sizable checks to work ($20–$40M) without the ownership level of a Series A or the “certainty” of a later stage round. This becomes a bit more amplified in a post-covid world where there are even more unknowns.
This post is my attempt to shed some light on how to approach the Series B so that you can raise a successful first growth round.
A Quick Preface
Before we get started, because the letter of the alphabet can mean many different things to different people, I’ll begin by caveating what I mean when I say “Series B.” The profile for most companies going out to raise their first growth round (i.e. Series B) looks something like:
~$5–$10M ARR (though the range has become much wider on both ends)
To-date has raised anywhere from $5M to $25M (across angel, pre-seed/seed and A rounds)
Raising ~$20–$40M with a single lead or co-lead(s) doing the majority of the round
Has anywhere from ~2–4 years of financial history; company likely ~4–6 years old
Original founder(s) most likely still at the helm and running the day-to-day
This is, of course, overly simplistic as Series B companies have a broader range of profiles (so bear with me!) I will also assume a SaaS business model (though the learnings could be extrapolated to other B2B models, including hybrid models, which I have previously written about here.) I’ll also briefly mention that many of the lessons discussed below for the Series B also extend into later-stage rounds (e.g. Series C, D, etc.)
Building on the A
The best way to frame the Series B and how investors will evaluate your company is through the lens of “building on the A.” Most investors, generally speaking, focus on five key areas: (1) team, (2) market, (3) product, (4) GTM and (5) metrics. The first 3 have some additional features that build on what was established at the Series A while the latter two have a materially increased focus vs the Series A.
This is probably obvious: more time in the market means more data investors can analyze to assess whether a company has the potential to scale into an enduring brand. Let’s take a closer look at each of the 5 focus areas and how the Series B builds on the A.
Team
At the Series A, investors are looking for exceptional founders (passion, vision, grit, deep knowledge, charisma, etc.) There is a lot to unpack there but that is a separate post on its own! We are also often looking for early signs that the founders can attract high quality talent in the form of early team hires.
At the Series B, much more attention is paid to the broader executive team and how it is starting to shape up. In addition to assessing your ability to recruit great functional leaders, who have their own strong follower-ship, investors tend to start thinking in terms of “gaps that need to be filled” as part of the post-B phase of growth. Maybe you are at the point where you need a VP of Sales to lead GTM. Maybe the founder needs to transition product to a VP of Product to focus on other areas. Or maybe it is everyone’s favorite: time to hire that seasoned COO to support the young first-time founder!
The other area Series B investors will start to focus on is culture. Often by the B a distinct “cultural ethos” has started to form. Investors will try to glean what sort of vibe your startup has and how it is perceived in the market. This can be accomplished by spending time on-site at the office, looking closely at employee NPS and digging around to see what can be found “outside-in” via channels like Glassdoor. In a post-covid world, where in-person visits are now much harder, a company’s digital footprint will likely matter even more. Investors will also spend more time 1:1 with key executive leaders over video.
Market
When raising the Series A, the market story needs to be one of a large ($10B+) and growing (5%+ CAGR) TAM. There also needs to be some story around a gap in the market or a greenfield opportunity enabled by sleepy incumbents underserving some portion of the market (e.g. SMBs, developers, a new function like SalesOps, etc.) Articulating a clear “why now?” is also a very important part of the fundraise story.
At the Series B, investors will look for validation of the story you told at the Series A and whether the early momentum backs up that story. It is most compelling if your company is very clearly emerging as the market-leading new entrant. Investors will validate that by speaking with customers, reading product reviews from G2 and digging around on sources like Pitchbook and Google trends, to understand brand awareness and signal.
Product
Demonstrating early signs of product market fit at the Series A is paramount. In the end, this may be the single most important factor (outside of the founders) in determining a successful A raise. Investors will look for customers who “pound the table” and sticky enterprise user behavior. Beyond that, they will look at the road map to see if it is compelling and headed in a direction that matches the broader vision.
At the Series B, there are a few more product-components that matter. At this point, the product should show a clear and quantifiable ROI for the customer. There should be case studies and “customer-wide data” that demonstrate the ROI (whether it is cost savings, revenue lift or some other metric.) It also often helps if the product is developing in a way where there is a tech asset that creates a broader moat.
GTM
Relatively less attention is paid to GTM at the A. At that stage, founder-led-sales is common — though there may be some early signs of a transition to non-founder AEs. Typically the pricing and delivery model has been validated at the Series A. End-state unit economics (e.g. LTV:CAC, payback, etc.) are largely theoretical but improving quarter over quarter.
When you set out to raise the B, investors will be looking for a tighter story around GTM. They will look to see a scalable, repeatable and profitable motion in place. At this point you should have a pretty well understood sales cycle (e.g. how the funnel gets filled, how much time is spent at each point, what % convert, etc.) The unit economics that were theoretical at the A should be more proven-out at the B.
It is also really powerful if you have diversified the customer base. If moving “bottoms up,” for example, you may have a core startup-base of early adopters but now also have a strong set of mid-market logos, maybe even some 6-figure enterprise ACVs. You may have also started diversifying from one industry to several — this has become particularly important post-Covid when it has become clear that reliance on 1 vertical, even if performing well, can lead to a very false sense of security.
Metrics
Perhaps the biggest difference between the A and the B is that the availability of data makes the numbers matter a lot more. Much has been written about metrics but the most important areas to focus on at the B are:
Growth rate: demonstrating the company is on a “triple-triple-double-double-double” trajectory is commonly acknowledged as the ideal path. While that is the gold standard, the reality is most companies are not going to be on that trajectory by the time they raise a B. And different companies hit their stride at different times. A more simple goal around the B, is that you should try to be growing at least 100% yoy to attract high quality investors.
Retention: High net dollar retention is what you will ultimately be judged on because that is, in the end, what matters most. But pay attention to gross dollar and logo retention as well. Some great barometers to benchmark against, depending on the underlying GTM motion and customer base are here and here.
Efficiency: Both capital efficiency and sales efficiency (sub-category) are key operating levers to scale your business successfully beyond the Series B. Aim to have an efficiency score as close to 1 as possible and your magic number should likewise be around 1 as well. As I’ve written before, efficiency is even more important in today’s post-covid world.
Gross Margins: Most SaaS businesses are naturally blessed with high gross margins (80%+) — though those margins may take time to materialize. You may also have a hybrid model with multiple revenue streams. Showing high or improving gross margins at the Series B is important as it helps investors buy into the dream that your company can command high multiples at exit.
Running the Series B Process
Now that we have covered the fundamentals of what you will be evaluated against at the B, let’s turn our attention to how to run an effective process. Don’t under-estimate the importance of running a tight and well-managed process. A successful raise is more likely to happen with careful planning.
Note: If you are 1–6 months out from raising a Series B, skip this first section and move to the next section: “Build the Right List of Investors.”
Backwards Plan
The first thing to realize is that as soon as the Series A closes, the “clock starts ticking” for the B round, which typically happens 18–24 months after the Series A — though timelines may stretch a bit longer in this current environment. When the Series A closes, start thinking about where you want to be when you raise the B. Some questions to ask:
What is the top-line ARR goal for a compelling B?
How much capital will be consumed between now and then?
What does net retention need to look like (and broader cohort trends?)
What is the target gross margin?
What are the key exec-level hires that need to be made?
What product milestones need to be hit?
Once you have the Series B goals written down and aligned with your team and Board, figure out the quarter-by-quarter plan to get there. Be thoughtful about what you aim to accomplish each quarter and hold yourself accountable to the quarterly milestones. The plan will change, but you are much more likely to have a successful Series B raise if you are deliberate about planning the journey to get there.
Build the “Right” List of Investors
Another important thing to do shortly after the Series A is to build a list of the right set of investors. Many founders end up wasting time talking to investors that are just not going to be the right fit for reasons that are “strategy-related” (e.g. stage or category.) For example, many Series A focused firms do not invest in Series Bs — check size is too high, ownership too low or valuation not in range for their strategy. Other, later stage firms, don’t do Series Bs — it’s just “too early.” If a firm is not investing out of a fund of at least $250M, they are unlikely to lead a Series B round of $20M+.
Some firms have areas they won’t touch (i.e. “we don’t do consumer.”) Others will only follow once a lead is identified. Corporate VCs/ strategics can add a lot of value, but may also take much more time. As a founder, you may also be inundated with inbound from various firms who are simply prospecting or doing research on a space. Bear in mind most firms invest in <1% of the companies they talk to. So taking meetings with lots of firms can be time consuming and distracting from the core business.
My suggestion is to “go deep, rather than broad.” Work with your existing Seed and Series A investors to craft a highly targeted list of ~10–15 firms worth getting to know more intimately. If you don’t have an existing relationship with those firms, have one of your investors provide you with a warm intro.
Allocate some amount of your time (but definitely <5%) to building deeper relationships with these firms over the course of 1–2 years — and specifically with the person at that firm who would be sponsoring the investment. This will allow you the opportunity to really assess whether they would be a good long-term partner. It also allows the investor to get to know you and to socialize the opportunity internally so that you are a “known entity” when it comes time to formally raise.
Create the Data Room
In the weeks before you decide to kick-off the formal raise process, you will want to have your data room fully structured and ready to go. Do not start the process before you have this in place! Frequently founders underestimate the pain caused when they prematurely kick-off a process and have 10–15 firms asking for different data items.
Create a single, well-structured data room with everything a firm could possibly want to know and have that ready to go. You will come off as more structured/together and will also limit the back and forth requests and internal scramble that comes with being less prepared. See below for an example of how to structure your data room and the items to put in each folder.
Another best practice is to have a “go-to” list of 5–10 customers who can serve as reference checks for investors. Have these customers prepped in advance of your fundraise. Try your best to spread the customer references around as no customer wants to spend their whole day talking to VCs — no matter how much they love your product!
Rehearse the Pitch
In the few weeks before you go out to formally raise, focus on practicing the pitch. This includes understanding timing (you will typically have 30–60 minutes) depending on where you are in the process with any given firm. You’ll have to understand pacing and how to deliver concise responses. We are also in a hybrid environment right now, so be prepared for a mixture of phone, video and (perhaps) some in-person.
Another important dimension is who to bring to the meeting. In the early parts of the process the founder/CEO should be doing the meetings 1:1 but as you progress, you’ll likely need to bring in co-founders and other key exec team members. Have a plan of who you are going to bring in and at what point in the process. The firms you are speaking with may make suggestions as you progress through their process. To minimize disruption to the team, ask for the level of “seriousness” before taking team member’s time away from the business.
I also highly recommend that before you go out to formally raise, practice the pitch with your earlier investors. When you do this, ask for a sub-group of the broader firm to round-out the perspective of your lead sponsor with fresh eyes. A good way to think of this is a 60-minute pitch session where you pitch the team on doing their pro-rata. Have your lead sponsor collect the feedback from the team and share it with you. Incorporate the feedback before you go out.
Manage the Process
Once you formally go out to raise, realize that this is your full-time job and will require 100% of your time/ energy to succeed. You will also likely need to designate someone on your team as a “diligence-point-person” (e.g. VP of Finance, COO, etc) to field requests from potential investors. So make sure to have a process in place internally.
In addition, be sure to create a timeline of when first meets happen, when you want to receive term sheets by and the steps in between. Try to keep all the firms you are working with on a similar schedule. If a few jump the gun, that could create a forcing function for others to catchup and accelerate their process, but it could also result in some firms getting turned-off by a fast process. Never create a false sense of urgency or exaggerate where you are in the process.
While there is a loosely similar process across firms, each firm runs their “deal pipeline” slightly differently. When it comes to getting a decision, there is an even broader spectrum (in some firms it’s totally up to the sponsor, in other firms there is a vote and at some places there is just 1 decision maker.) As you move further into the process with any given firm, ask the lead sponsor (your original point of contact) for clarity on process and how decisions get made. This will help you a) understand the steps to a TS and b) allow you to best position yourself to navigate internal dynamics.
In general, black swan events notwithstanding, good Series Bs happen in ~4–8 weeks from intro session to TS in-hand. Sometimes things can move much quicker — especially if you have an existing relationship with a firm. If the round is taking longer than that, there is likely low interest and you may need to re-think the strategy. Explained “Nos” (if you actually get an honest explanation) can be helpful in terms of adjusting the strategy. At the same time, don’t read too far into a pass because there are a thousand reasons for passing that are well beyond your control. For example, a firm has decided they have already made 1 bet in your space and don’t want to do another.
There are differing opinions on valuation, but in my experience, it is never a good idea to throw out a number when pitching VCs. If the number you suggest is too high, you can quickly turn-off an investor who might otherwise be interested. If an investor asks you what valuation you are looking for say something to the effect of: “We care more about finding the right long-term partner than optimizing around a specific number. We have made considerable progress since the Series A and hope for the Series B valuation to reflect the value accrued, but we will let the market set the price.”
Close the Deal
Once you have succeeded in getting a few term sheets, it’s time to evaluate and make the right decision. Remember you are going to be working with the firm you choose for the next 5–10 years, so choose wisely. The first thing to do is a hygiene check on all the terms. Have your legal counsel and Series A investor take a look and make sure there aren’t any problematic terms.
Many founders get caught up in maximizing valuation but be careful here — the highest price isn’t necessarily going to be the right fit long term. It’s totally fine to use the leverage of optionality but pick your battles wisely and make sure to prioritize accordingly.
You should also run your own diligence on the firm you are working with. Ask for the firms you are evaluating to provide founder references but also do your own back-channel diligence. Get on the phone and spend time understanding how the firm has historically behaved. How involved are they? Do they contribute meaningfully? Do they operate with a steady hand through the highs and lows of company building? Do other founders like working with them? Ask for examples — the more specific the better.
Concluding Thoughts
Raising money is almost never a fun thing for founders. But the right founder/VC pairing can be a powerful acceleration to help you achieve your vision. Understanding what Series B investors look for and how to manage your fundraise is the key to success. Hopefully with a lot of careful planning and a little bit of luck, you will end up with a successful Series B outcome.
As a final parting thought, I’ve aggregated the thoughts above into a packaged view (“Series B checklist”) of the things to do before you raise your first growth round. Remember, you don’t necessarily need to have all of these checked off. But the more you do, the more compelling the round will be.
As always, please reach out with any thoughts or suggestions (@MrAllenMiller). I’d also like to thank Kris Rudeegraap (@rudeegraap), Michelle Palleschi, Rishi Taparia (@taps), Ricky Pelletier (@RickyPelletier), Parsa Saljoughian (@parsa_s), Preeti Rathi (@preet1rathi) and Lenny Rachitsky (@lennysan) for their help in reviewing early drafts of this and providing invaluable feedback.
Capital efficiency has long been a desirable trait in early/growth stage businesses. But over the last few years, an abundance of capital combined with a “growth at all cost” mindset, allowed founders to deprioritize efficiency. Ignoring efficiency, however, can lead to making cardinal mistakes like misreading true product-market-fit, over-hiring for the stage you are in and burning through too much money too quickly. Furthermore, growth rate and top-line progress are a function of how much capital a business has consumed to get to that point (i.e. getting to $10M in revenue is less impressive if you spent $50M to get there vs spending $5M to get there.)
In a post-covid world, capital efficiency has returned as king. This is especially true in SaaS (which, as a category, has outperformed almost every other category.) Many of the companies that have outperformed during this time frame have been very efficient businesses (e.g. Twilio, Zoom, Shopify, Datadog, etc.) As the fundraising markets dry up a bit and sales cycles lengthen, founders will increasingly be forced to think more about efficiency and investors will pay a premium for efficient businesses.
But how should SaaS founders think about efficiency? Several years ago, Bessemer put out a simple, but helpful rule-of-thumb called the BVP efficiency score. The efficiency score shows a “good-better-best” framework for thinking about capital efficiency (defined as Net New ARR / Net Burn.) They advised founders (under $30M ARR) to think about good-better-best using the table below:
While this is a great high-level framework, efficiency among SaaS businesses is a bit more nuanced depending on stage. In the formative days, finding product-market-fit can take time and money. In the early days of growth, building a scalable and repeatable playbook can require significant up-front investment. As the company moves into expansion-mode, the business benefits from clear economies of scale and an improved gtm playbook. In the later stages, the business should be humming and efficiency ought to be at an all-time high.
The point is: benchmarking efficiency in a meaningful way requires looking more closely at stage/ revenue profile. What we really need is an efficiency score for each stage. Or, put differently, a rubric showing how much capital ought to be consumed (and, yes, there is a difference between “raised” and “consumed”) to achieve various ARR milestones along the journey from $0M to $100M in ARR.
Below are two frameworks for founders to use to help answer this question. These tables were developed based on what I’ve seen in the field over the years and have been triangulated with what several other SaaS investors have also seen. The first table is simply a good-better-best framework for total capital consumed to get to different ARR thresholds. The second is a “stage-adjusted” efficiency score. These two tables are, of course, two sides of the same coin.
Bear in mind these are simple guidelines / “rules of thumb” and anecdotal in nature. Every business has its own set of nuances and unique circumstances. And there is definitely more variability earlier on depending on the nature of the product (i.e. some companies have to invest a lot more in R&D to get the product to market.) Where you land on the grid is less important than what the trend-line looks like and whether you have managed cash wisely (i.e. been a “good steward of capital.”)
To bring this to life a bit, here are a few “hall-of-fame” worthy examples of companies that scaled past 100M in ARR with record breaking efficiency. Note that we are listing capital raised here as a close proxy in the absence of public data on capital consumed:
Veeva raised a total of $7M pre-IPO. Current market cap: $33B
Appfolio raised a total of $30M pre-IPO. Current market cap: $5B
Ringcentral raised a total of $44M pre-IPO. Current market cap: $24B
Wix raised a total of $59M pre-IPO. Current market cap: $11B
Salesforce raised a total of $65M pre-IPO. Current market cap: $162B
Zendesk raised a total of $86M pre-IPO. Current market cap: $9B
Realpage raised a total of $86M pre-IPO. Current market cap: $7B
It is no surprise that almost all of the above examples got going in the “good old days” of the 2000s, when capital was less plentiful, and efficiency much more in vogue. Much of this changed in the 2010s, but I suspect we will see the pendulum swing back to some degree in the decade ahead. Hopefully, this helps provide some useful data points in this return-to-efficiency world we now find ourselves in!
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I’d like to thank Alex Kurland (@atkurland), Brian Murray (@murr), Chetan Puttagunta (@chetanp), Logan Barlett (@loganbartlett), Murat Bicer (@itsbeecher) and Parsa Saljoughian (@parsa_s) for their feedback and help in triangulating the numbers here.
While the 2000s and 2010s gave birth to many B2B SaaS greats, the 2020s will usher in a new wave of winners that have far more heterogenous business models.
In the pure SaaS world, the startup and venture community developed many great “rules of thumb” for understanding how to operate and value these businesses.
Understanding and valuing hybrid B2B businesses, however, is much more complex.
There are at least 4 different types of mixed-revenue models that include various mixtures of hardware, software, services and financial services revenue.
Valuing hybrid business models requires using a weighted average approach — I will present a framework to do this and provide a few examples.
As we begin to reach a certain level of maturity among cloud applications, it has become increasingly clear that we are now moving beyond the first wave of pure SaaS players that came to define the 2000s and 2010s and produced big B2B wins like Salesforce, Atlassian, Zoom, Hubspot and many others. In more recent times, we’ve migrated from this homogenous SaaS world to a more complex world of hybrid businesses, which generate different types of revenue in their quest to build enduring value. This, of course, has played out in many industries beyond software. Costco, for example, was one of the OGs here with its membership subscription fee + item price revenue model.
In some cases, hybrid models are an evolution over time: an early stage company starts with a wedge software product that customers love and then evolves in the growth stages to include additional features that drive new sources of revenue like lead gen fees, payment transaction revenue, lending revenue, etc. This is the story of Shopify, which originally generated subscription revenue for access to its ecommerce software tools before evolving to include additional revenue sources like payments, transaction fees from apps in its app marketplace and other “store-front fees” like domain registration.
In other cases, mixed revenue streams can happen right from the get-go. Our portfolio company, Sendoso, has operated as a SaaS + Transaction revenue-model from Day 1. Customers pay a subscription fee for access to the platform and a set of integrations into the sales, marketing and customer success stack. Additionally, they then pay a separate transaction fee for physical or virtual items sent through the platform to current customers or prospects.
Shopify and Sendoso are certainly not the first businesses with a hybrid model, nor will they be the last. As we enter a world where mixed-models become more common, the two questions then become:
(1) What will these mixed-models look like?
(2) How do founders think about valuation in the absence of less established rules of thumb?
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SaaS: Established Rules of Thumb
But before we get to answering these two questions, it’s helpful to review the basics behind the most successful B2B business model of the last 2 decades: pure SaaS. It is well understood that the two most important financial drivers impacting the valuations of public SaaS companies are, first and foremost, growth rate and second, to a lesser extent, gross margin (though the latter may increase in importance given the recent times.) Below is a view from a basket of SaaS businesses. For illustrative purposes, this is a snapshot taken from February, before the market volatility caused by coronavirus.
To sum: most public SaaS businesses north of 100M ARR that are growing 30–40% with 70–80% gross margins can command a multiple of ~10–12x on the public markets (or at least they could pre-coronavirus; we will know over the coming months whether the current deflation is temporary or here to stay.)
In the “earlier” venture to growth-stage world, this translates into a number of operating levers that are well understood. This post is not meant to be a review of the literature on SaaS metrics but there are some great resources for further reading on these topics, which I’ve included in an appendix at the end.
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Mixed Revenue Models: Forging into Newer Territory
In today’s world, we are seeing a notable uptick in mixed revenue models. B2B companies chasing additional growth opportunities are realizing that once they have achieved clear customer lock-in with one product, maintaining a high growth rate and expanding their TAM, can often be accomplished by cross selling other ancillary products — many times with different types of revenue. This has taken the shape and form of at least four playbooks:
(1) Software + Services
Selling services in addition to software is of course nothing new. In the on-prem/ perpetual license world, professional services were essential to the delivery and implementation of enterprise software. In the cloud application world, professional services typically play a similar role when selling to large enterprises (e.g. the customer base has a lot of F500 customers.) These customers typically require broad integrations, time-consuming security audits and a white-glove experience. While necessary and incremental to top line, services revenue is broadly viewed as less valuable than SaaS revenue.
Workday and Veeva are two great examples of companies that have continued to excel at growing both SaaS and Services revenue. To this day both companies still have a very significant (and growing) services revenue stream (i.e. hundreds of millions of revenues annually) in addition to the SaaS revenue.
(2) Bundled Financial Services
A common theme we are seeing, especially within FinTech is the bundling of financial services. Typically, a business will find initial PMF around a single product with a single source of revenue — for example payments. Overtime, the business will offer its customers additional financial products generating additional revenue from things like lending, referrals to 3rd parties, % of AUM, interchange and a range of other revenue models.
Stripe is a great example of a company that has executed very well on this playbook. In “Act One,” Stripe created tremendous lock-in around it’s payments platform by enabling companies to process card charges on a 2.9% + $0.30 per transaction basis. But as the company evolved over time they built new products with different revenue models (see here for more info):
Additional Payments Features: International payment (1% for international cards), 3D Secure authentication ($0.03 per authentication attempt), ACH (0.8% with a $5 cap)
Billing: Recurring revenue (0.5% on recurring charges)
Radar: Fraud protection ($.05 per transaction), Chargeback protection (0.4% per transaction)
Terminal: In-person card processing (2.7% + $.05 per card charge), Card readers ($299 for a Verifone device)
Atlas: Starting an LLC, opening a bank account, issuing founder stock, etc. ($500 one-time fee)
Premium Support: dedicated CSM, help with critical issues ($1800 / month)
Issuing (still in Beta): creating and managing virtual/ physical cards ($.10 per virtual card; $3 per physical card)
(3) Software + Bundled Financial Services
But FinTechs are not the only players to bundle financial services. We have begun to see a number of SaaS businesses use application software as an entry point, create lock-in with recurring revenue and then embed a host of other financial services directly into the platform. In doing so, these businesses can generate incredible momentum, widen their TAMs while also maintaining a broad base of stable recurring revenue.
No one has executed better on this playbook than Shopify, which has grown to over $70B in market cap (accelerating through covid-19 no less) and has commanded a revenue multiple of over 30x at certain times. Shopify’s SaaS business gives merchants access to its ecommerce platform + tools to build storefronts; while it’s Merchant Solutions business (i.e. bundled financial services) generates revenue from customers via lending, payments, shipping and referral fees. In the early days, software was the main driver of revenue growth, but over time the financial services have accelerated in a very impressive way.
The final hybrid model we have seen is effectively #3 above with the addition of hardware. Hardware stand-alone businesses, of course, are notoriously difficult and very hard to operate successfully at scale. But hardware combined with the margins of SaaS and the extended reach of bundled financial services can be a very powerful business. Toast is a great example of a company that has successfully leveraged all three revenue sources to build a very effective business in the restaurant vertical (see here for more info):
SaaS: menu management, analytics & reporting, inventory management, team management, etc. ($75 per terminal/month)
Hardware: vertical-specific android-based terminals (range of prices based on terminal type and size)
Bundled Financial Services: Payments, loyalty & rewards, gifting, payroll administration (pricing varies by type of product)
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Hybrids: A Weighted Average Approach to Valuation
Mix-model business are thriving and clearly here to say. But valuing high-growth hybrids is more challenging in the absence of the simple heuristics developed for the SaaS world. My suggestion on how to value these companies in the early/growth stages (~$2-$20M in revenue) is to use a weighted average revenue multiple approach. In other words:
1. Break down the business into its various components based on where it is today from a net revenue perspective
2. Apply specific multiples to each of the distinct parts of the business based on general heuristics associated with underlying characteristics like growth rate, margin profile, usage frequency, etc
3. Add in a “boost” or “mute” for external factors like TAM, LTV, retention, depth of competition, customer profile, how the revenue mix may shift over time, etc. This is a big part of the “magic”
4. Use a Sum-Product function across revenue and revenue multiple
Below is a table that illustrates the valuation equation and some general “rules of thumb” as guidance:
Example One
SMB SaaS business that helps its customers make payments to vendors and also generates a lead gen fee for referring its customers to new vendors. On the SaaS side (SMB so self-serve and no services), the business seems to be in the early innings of a strong growth trajectory (3x.3x.2x.2x.2x) having grown from 2M ARR to 6M ARR in the last year ($4M in revenue associated with the SaaS ARR.) The business did an additional $4M in payments revenue and $2M in lead gen revenue; for a total of $10M in revenue. The company operates in a large, mostly greenfield TAM and, over time, the payments revenue will grow to be the clear leading driver of revenue while the lead gen revenue becomes less relevant.
As illustrated above, this is a SaaS + Bundled Financial Services model consisting of subscription revenue, payments revenue and lead-gen revenue. In addition, we applied a relatively high Boost of 0.75 to account for the strong growth profile and large/greenfield TAM; somewhat muted by the lower-multiple payments revenue being the predominant driver of long-term growth. The weighted multiple is ~9x.
Example Two
The second example, a POS terminal business that operates in corporate cafeterias, is also doing $10M in revenue. In addition to charging for the terminals, the company charges an installation fee for set up, generates payments revenue from processed transactions and takes a cut of revenue from any 3rd party apps installed on its devices. However, this business is slower growth due to longer sales cycles (grew < 40% last year.) The company also faces fierce competitors like Square, Toast and Revel.
As noted above, this is a Software + Bundled Financial Services + Hardware company. In addition to being comprised of different components than the company in example 1, this is also a lower growth business with 2–3 dominant competitors in market. As such, we added a lower boost scale and the weighted multiple ends up being ~4x.
Template: If you’d like to access these examples, and maybe run a few scenarios yourself, I’ve included a google sheet (here) where you can give it a try. Always open to suggestions on how to improve this so feel free to send my way.
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Final Thoughts
We’re moving into a more heterogenous world, where mixed-model revenue businesses will continue to emerge and thrive. As this new class of companies grow and thrive, founders and investors will need to better understand how to operate, grow and (ultimately) value these businesses. In some cases, it may make a lot of sense to start by valuing a company with one approach (e.g. SaaS) and then layer in other approaches over time as the company evolves. But taking a weighted average approach to valuation in conjunction with a bit of good judgement is a great way to understand valuation for these hybrids.
If you have a different approach, I’d love to hear about it (@MrAllenMiller!) I’d also like to thank Kris (@rudeegraap), Dimitri (@dadiomov), Ian (@iankar_) and Sheel (@pitdesi) for their contributions to this piece.
It’s pretty clear at this point that things are going to get a lot worse in the weeks and months to come before they get any better. The number of COVID-19 cases is accelerating worldwide. Travel restrictions have gone into effect as countries around the world close their borders to curb the spread of the virus. The S&P 500 is down 30% from its peak a month ago and the Dow plunged 3,000 points on Monday alone. Morgan Stanley is now viewing a global recession as their “base case” with an implied $360B loss to US GDP.
As if all that wasn’t enough, some of the yoy OpenTable data coming in is absolutely terrifying with respect to the broader implications we will soon see in the macro economic data. The downturn ahead of us will impact many sectors and millions of households in the US.
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Restructuring & Transformation in a Recession
As I’ve spent much of the past week discussing what this all means with founders in and outside of our portfolio, I find myself thinking a lot about my time in the consulting world. During that time, I had the fortune (or misfortune!) of working on a handful of projects involving companies that had fallen into hard times and required what we called “Restructuring and Transformation Services (RTS).” Regardless of the specific situation, in all of these cases, we would follow a very basic framework designed to diagnose and then triage the (mostly) cost-cutting work from “least painful” to “most painful.”
If you are a founder/CEO finding yourself in a situation in the months ahead where you need to go through a restructuring/ transformation exercise, hopefully this basic framework can help you think through what to do and how to do it.
1. Establish dedicated owners: The first thing to understand about any transformation effort is that you have to have clear ownership. In my consulting years, we would always start by working with the client to set up a “Transformation Office” led by a Chief Transformation Officer. The “TO” would lead the effort, create urgency and drive action. As a startup CEO, the buck stops with you. But it’s a good idea to create a small, cross-functional task-force to serve as an advisory council and to drive change within the organization. These people will be working on the transformation while also doing their full-time job so important to pick people who have the capacity and commitment to the company to wear multiple hats through a difficult patch.
2. Diagnose the problem: The next step is to figure out where you stand, particularly from a cash perspective. Some basic questions to ask and get clear on before you jump into problem solving:
How much runway do you currently have? Did you plan for a fundraise in the next 3–6 months? Were there big customers that were at the finish line or moving from POC to further implementation? Be honest with yourself about where those conversations are now headed and what the timelines will now look like.
Update your forecast with a new “COVID-19 discount” to the original growth plan. You can start with a tool like this to help understand top-line growth but will need to build in your own view on the P&L and, ultimately, cash position. At minimum you should assume 50% less growth and it would be prudent to plan for a base case scenario far worse than that (e.g. 0% growth or even negative growth if there is significant churn.)
Call each of your investors 1 by 1 and understand their stance on supporting you through this time. Do they have the ability to bridge you or not? How much are they reserving for follow-on? Realize that each firm is different in terms of how they plan for successive rounds and many investors may be in a tough spot themselves during this time (as are their LPs). But getting clarity up-front here is necessary.
Look at each of the functions as a % of revenue (e.g. marketing as a % of revenue, sales as a % of revenue, R&D as % of revenue.) Do some quick base-lining using resources out there like this or ask your investors if they have any internal data cross-portfolio. Figure out where you might be lop-sided and what trade-offs you are willing to make to growth vs product roadmap vs culture/ morale. This will give you a sense of the levers you have to play with in later phases of this effort.
By this point you should have a good sense of current runway and, at a high-level, what levers you have to pull to extend runway.
3. Establish the target: After you have diagnosed the problem, determined your cash position/ runway and understand at a high level what levers you have to pull, you now have a “Baseline” to work from. It’s now time to establish the “Target” for cost-take-out. This is the total cost you need to remove from the business to get to a certain “cash-inflection” point (i.e. a new injection of cash via fund raise or getting to break-even.) This target now forms the basis for all actions you put into motion. The target should be a specific number with very clear milestones (ie. mini-targets) that you can work towards achieving.
4. Create a cadence and review process: It is important that the transformation task force you meet with gets into a regular cadence (this means meeting weekly and if the situation is dire enough, daily.) Get in the habit of tracking all transformation initiatives using a project management tool. During my consulting days, we used Wave. But you can use Asana, Trello, Monday or another project-management tool of your choice. The important thing is to ensure that the tool can track initiatives, owners, progress and tie to real outcomes in the P&L. The transformation task force should regularly review progress using the tool’s dashboards and elevate the most important decisions to you, as the founder/CEO, to ultimately make.
5. Focus first on non-personnel costs: When hunting for cost-take-out, the easiest place to start with is non-personnel costs. Here are a few areas to look into — remember any savings here could well mean one less RIF:
T&E: COVID-19 has made this an easy one on the travel side but worth looking into any other spend in this bucket (e.g. planned company off-sites, conferences and trade-shows, entertainment budget for large enterprise deal-making, etc.) Almost all of this can be reduced, canceled or postponed.
Real-estate: if you were planning on decreasing footprint or moving to lower cost locations, now is a great time to pull the trigger on those plans. Worth talking to landlords and co-working spaces to see what relief you can get on space that is not being used for the foreseeable future. Take a look at the utility bill too…it should be going down when everyone is in WFH mode.
Software & applications: Good time to take stock of all those applications and tools you are using. Which ones do you really need? Which ones are necessary in the WFH environment? Which ones can you part with or, at least reduce the number of seats?
3rd party providers: Do a full review of all consultants, agencies and other professional services. What is essential? What can you let go? What can you move to lower cost providers like Upwork?
Marketing: Budget in certain marketing categories likely needs to go. The targeted, personalized, high-ROI items should stay but anything that does not have clear ROI will be harder to justify.
6. Be thoughtful about personnel costs: For obvious reasons, things get tricky once you start tapping the personnel-cost bucket; exploring RIFs should be a “last resort.” Once it becomes clear lay-offs are coming, morale tends to slip as does productivity. This is particularly difficult at a startup where things tend to be smaller and feel more personal. Some general tips:
See if you can move people into contract work. A reduction in income is better than no income at all and contract work can help continue to move the ball forward for your company.
If the rough patch is relatively short term (ie line of sight to a cash injection), offer employees a furlough option but be realistic about the potential timeline for re-hire.
Be very clear with supervisors/ managers about how RIFs are communicated and messaged when they start happening. Consistency in messaging and empathy in delivery is critical. This will be a high stress time for many so be prepared for some challenging conversations and lots of emotional strain.
Be careful about how you are thinking about organizational structure. A spans and layers analysis can help identify areas of opportunity. Aim to maintain ~8:1 ratio on the “span” side and don’t remove more than 1 managerial layer within a function or BU or you risk destabilizing that part of the org.
Don’t assume your top employees will be thankful to have a job and just stick around. Some will flee for more stable environments outside the startup world. Hold 1:1 meetings with everyone and communicate your commitment to star performers. Highlight the opportunities to take on more responsibility and consider granting more stock in the absence of cash for bonuses / salary increases.
7. Remember the good times will come back: Keep in mind that recessions are temporary and your short-term goal as founder/CEO right now is to “just survive.” But eventually things will pick back up. Customers will return and the momentum will swing back in your favor. When this happens, you will want to be in a position to seize the moment and bounce back in full strength. Having a bit of foresight to “see around the corner” and prepare for that moment will help you return in full force.
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Additional Resources by Topic
In the last few weeks, there have been some really great resources that have come out on topics related to the coronavirus, navigating the pending recession and how to move forward during these difficult times as a founder. Below is an aggregated list of resources worth reading by topic.
Here’s to hoping that this downturn is as short-lived as possible and the roaring ‘20s come back in full force quickly! If you have additional resources I should add to the list above, send them my way and I will make every attempt to keep this list current.
**This post was originally published on the Oak HC/FT website here**
Last month, I joined Oak HC/FT’s San Francisco team. I could not be more excited to help identify and partner with the next generation of entrepreneurs in FinTech, building on Oak HC/FT’s strong legacy of investors and operators who have built enduring companies for decades.
Over the course of the last ten years, FinTech has really begun to hit its stride. There are now nearly 40 FinTech unicorns globally (more than any other vertical) worth an aggregate value of nearly $150B. Not bad for a sector that didn’t have a ton of buzz when Oak first started investing in the space in 2002.
Source: CB Insights
And this is just the beginning, there will be much more to come in the next 10 years. As I look to the next decade to come, I’m first and foremost eager to learn from the founders and entrepreneurs building at the fore-front of our industry. That said here are a few themes I have been thinking about deeply in recent months and am particularly excited about:
Vertical payments: We have already seen a few successful versions of this playbook including: Toast (restaurants), Flywire (travel & education) and PayIt (government.) But many more verticals could benefit from a bespoke, vertical-specific payments solution including pharma, logistics, manufacturing and more.
Next-generation commerce: Innovation in commerce in recent years has largely come in the form of new payments options (like Square, Affirm and Afterpay.) The next wave of innovation will enhance in-store commerce, logistics/ delivery/ returns, international commerce and buying via new mediums like voice, computer vision and mixed reality.
Intersection of FinTech + AI: Machine learning is already being used in financial services. Our portfolio company, Feedzai, uses machine learning to help banks and merchants fight fraud. In the years to come machine learning will stretch beyond risk and into underwriting, product discovery, predictive intelligence and a number of other use cases.
Middleware tools for developers: Stripe and Plaid have shown us that developers are the next big consumers of financial data and they require tools to access and use that data: be it payments meta-data, account information or piping infrastructure to connect with other financial institutions. As microservices and APIs continue to proliferate, developers will require more tooling to serve end customers.
Banking Applications: Many financial services incumbents suffer from manual-heavy tasks for workflows that have struggled to make the transition to digital. Our portfolio companies Kryon (robotic process automation) and Ocrolus (digitizing financial documents) are two examples of the new wave of companies focused on automation, software-enabled workflows and refined banking applications.
Back-office application software for SMBs: The software stack for most functions (e.g. marketing, sales, customer support, etc.) within an SMB certainly looks a lot better than it did 5 years ago when Oak first invested in Freshbooks. But the finance and accounting functions remain underserved. As SMBs demand better software for their back offices, new entrants will rise to the occasion, providing these businesses with a better way to close their books, pay their vendors and manage payroll.
Financial services for the underserved: Banking services have improved for many of us but there remain many demographics that are underserved. Oak has a history of investing in this category, dating back to NetSpend, which went public in 2010. I’m excited to see founders focus more on low-income Americans, immigrants, freelancers/1099s, older (and younger) generations, those with large sums of student debt, etc.
Future of real estate: Almost everything about commercial and residential real estate stands to be improved for both buyers and sellers. Moreover, the ecosystem players around them (e.g. brokers, agents, lenders, inspectors, etc.) are still mid-transition to cloud-based tools. New entrants in real estate will find ways to improve workflows for these ecosystem players or generate more economic value for buyers and sellers.
If any of this resonates with you, let’s get in touch. I’m focused on opportunities on the west coast (and that certainly includes more than just the Bay Area!) But even if you are outside the west coast, I still want to hear from you. Looking forward to finding ways to collaborate!
The full overview of the Matrix FinTech Index 2018 edition is available on TechCrunch here.
At the end of 2017 we published the Matrix FinTech Index for the very first time. In what we hope will become an annual tradition, we are excited today to publish an updated index and set of supporting data.
There is no doubt that this has been another stellar year for fintech. In last year’s version of the Matrix FinTech Index, we predicted the crypto enthusiasm would be short lived and that the fintechs would be the more relevant disruptors in 2018. By most metrics this seems to have turned out to be true. A comparison of search interest in “fintech” vs. “crypto” is one clear indicator of this:
Definition: Matrix Partners considers “fintechs” to be venture-backed organizations that are (a) technology-first companies that leverage software to compete with traditional financial services institutions (e.g. banks, credit card networks, insurers, etc.) in the delivery of traditional financial services (e.g. lending, payments, investing, etc.) or (b) software tools that better enable traditional finance functions (e.g. accounting, point-of-sales systems, etc.)
Methodology & Results
As a refresher, the Matrix FinTech Index is a market-cap weighted index that tracks the progress of a portfolio of the 10 leading U.S. public fintech companies over the course of the last two years (beginning in December of 2016). For comparison, we have also included another portfolio of 10 large financial services incumbents (companies like JP Morgan, Visa and American Express) as well as the S&P 500 index.
With two years of data now in, the results are pretty clear — the fintechs continue to outperform both the incumbents and the S&P 500. 2 year-returns for the fintechs were 133% compared to 34% for the incumbents and 24% for the S&P 500.
Updated Data Now Available
As we did last year, we are releasing an updated data package that anyone can download here and which has a range of other helpful information on both the U.S. fintechs and the incumbents. The updated package has much of what we had last year plus a few newer elements:
Market cap and stock price data for the fintechs and incumbents
Comp sheets with financial metrics
Data on the 20 fintech unicorns
Information on the fintech “Brink list” — companies that have raised over $100M in equity financing
M&A & IPO activity in fintech this past year
As always we appreciate your feedback and thoughts on the process and methodology. And we look forward to sharing our thoughts again in 2019!
Towards the end of 2017, we discussed the rise of the FinTechs and briefly alluded to payments as being a key area for further innovation. The payments ecosystem is an ever-evolving space froth with opportunity and plenty of buyers with deep pockets (see Paypal’s announcement a few weeks back). Furthermore, it is a deeply intricate ecosystem with challenging technical problems, shifting regulatory components and a variety of consumer and enterprise use cases. For all these reasons, it is worth a “double click” to explore further.
We have already seen huge amounts of innovation in payments over the last few decades. In the U.S., this innovation was enabled by a few important advances. The establishment (and operation) of ACH by the Federal Reserve Banks and EPN created a much needed electronic network for financial transactions. NFC technology and POS hardware enabled mobile payments. More recently, pay-out APIs and fraud management systems have allowed developers and those working in risk to manage feature build-out while also keeping an eye out for bad actors. And we are just beginning to see some applications of crypto in the payments space — such as this.
Despite these advances, most of the innovation has been focused on two areas: consumer-to-consumer payments (e.g. Venmo), business-to-consumer payments (e.g. Square) or new entrants that facilitate one of the two (e.g. Stripe). A third category, business-to-business payments, has not benefited from innovation to the same degree as the other two categories. This is particularly interesting given that the market size of B2B payments is 5–10x that of C2C or B2C payments. And yet, technology has been slower to transform the B2B payments world. Case in point, B2B payments made by the good ol’ check, as a share of overall transactions, leveled off around 2013 at a point significantly higher than C2C and have actually gone up slightly to ~51%.
Existing Challenges
In the early days of C2C and B2C payments, there were many intricacies from a technical and regulatory perspective that had to be navigated very carefully. After all, real consumer money was at play so the stakes were high. The same is true in the B2B world, with a few additional challenges that make things even more hairy:
Transaction values are significantly higher: While the volume of B2B payments is much lower (some say in the 9:1 range compared to B2B + C2C), the value of these payments per transaction is much larger. This makes enterprise transactions prime targets for hackers, front-runners and a host of others with bad intentions. Beyond the actual financial risk, enterprises also risk having the banking information of their suppliers and customers exposed.
There is greater complexity: In the enterprise payments context there is significantly more complexity. Let’s take the simple example of someone in procurement trying to pay a supplier. Post RFP, legal review, etc., the buyer will need to first work with the various business units and other internal stakeholder to issue a purchase order. The supplier must do the same in order to provide an invoice to the buyer. The buyer must then send a request to the card issuing bank (via p-card or some other mechanism.) The buyer’s bank must then handle settlement with the supplier’s bank. This may happen via check, credit, debit, ACH or even cash. Post-settlement, the buyer and seller must ensure that both their internal financial systems and/or ERP systems are accurately updated. Imagine the complexity involved when doing this hundreds or thousands of times per day across many different payment types (one-off, recurring, up-for renewal, etc.)
Many people are involved with any given transaction: As a result of the greater complexity, many heads are involved on both sides of the transaction. Procurement, legal, finance and the BU may all be involved at various stages. B2B payments affect the workflows of a much broader set of people than C2C or B2C payments.
The life cycle of a payment is longer: As a result of the added complexity and multiple stakeholders, the duration of the payment is longer than in the C2C and B2C contexts. C2C payments in today’s world can clear in a matter of minutes. On the enterprise side, the payment life-cycle can have a duration of 60, 90 or even 180 days.
The life cycle of a payment is longer: As a result of the added complexity and multiple stakeholders, the duration of the payment is longer than in the C2C and B2C contexts. C2C payments in today’s world can clear in a matter of minutes. On the enterprise side, the payment life-cycle can have a duration of 60, 90 or even 180 days.
The U.S. is not well structured for top-down fixes to B2B payments: When Europe moved to the Euro, all the participating countries did a significant overhaul of their banking systems allowing them to make significant upgrades to the tech stack. In the process, they solved a number of the pain points above (including significant reduction/ elimination of checks). But in the U.S., the Fed does not have the authority to mandate unified standards. Lack of standardization is particularly tough in the U.S. as we have many more banks than Europe (including regional and community players) — creating a major interoperability problem with few bank-agnostic solutions. Meanwhile, the U.S. banks themselves have made little attempt to create a common solution to fix the antiquated system.
Key Opportunities
While these challenges are daunting (they most certainly are not for the faint of heart!), the good news for new entrants is that the banks and other FIs are unlikely to be the ones to fix enterprise payments.We believe FinTech startups are best positioned to make progress here, bottoms-up. More specifically, there is an enormous opportunity to capture value in enterprise payments($2.1T in payment revenue by 2026) across 5 specific subcategories: (1) capital markets, (2) procurement, (3) treasury management, (4) payment dev-tools and (5) blockchain.
Capital Markets: Many parts of capital markets (e.g. HFT, commercial lending, etc.) send/receive very large transactions each day. Most of the time these payments are slow, expensive and require manual reviews to ensure they are valid. In the HFT world, for example, every minute matters when making a trade and fees add up. Payments solutions that focus on speed and automation, without sacrificing security will do well here.
Procurement: In procurement, enterprises and their suppliers face the problem of trying to integrate procurement software tools, with ERP systems and antiquated payment processes. This problem is particularly challenging with services and in the “long-tail” spend, where some enterprises have to pay tens of thousands of suppliers each year. Solutions that integrate with existing software solutions, simplify the enterprise’s workflow and get the money to the supplier faster (e.g. lower DSO) will have the most success here.
Treasury Management: Initiating andmanaging ACH payments to other businesses, auditing those payments and then closing the books at the end of the month is still not straightforward. Software tools that provide solutions for both the finance and the tech team to navigate this process have a shot at building a must-have for anyone trying to get a grip on treasury management. Particularly for SMBs who don’t have the luxury of simply throwing more people at the problem.
Payment Dev Tools: Companies like Stripe and Plaid have created great APIs and financial plumbing tools. But they are largely focused on C2C and B2C payments. B2B developer tools / APIs that work for the IT and risk departments of enterprises and address the complexity therein will do well. Certainly a hairy problem to figure out but there is a lot of spend here for the right solution.
Blockchain: In the short run, blockchains have enough technical issues (e.g. scaling, interoperability, etc.) to work through. But in the long-run distributed ledger technology can provide a single database of truth between two enterprises, eliminating theneed for ledgers on both sides and making verification/ security a bit more manageable. The real question from a B2B payments perspective is not “if” but “when.”
At Matrix Partners we are deeply interested in backing the next generation of enterprise payments companies. We focus primarily on Seed/ Series A investing here in the U.S. Please let us know if you are building something interesting here — would be great to meet up and learn more!
Global FinTech investment in 2017 was unprecedented with $16.6B of capital (+20% compared to 2016) deployed across 1,128 deals. Despite this, some have argued that FinTech’s days are numbered and that it is less clear how much opportunity still remains for future innovation. Proponents of this line of thought argue that most traditional financial services have already been unbundled and that large startups that dominate areas like payments, lending, and investing have even begun to re-bundle services. Moreover, despite the uptick in investment into the sector, the early-stage portion of overall financing dropped to a 5-year low which has further supported the belief that most of the innovation in FinTech has already happened.
At Matrix, we believe that we are still in the early innings of the financial services disruption. While FinTech startups have done very well in the last decade, there is still room for more great companies to be built. As a follow-up to our previous article where we introduced the Matrix FinTech Index, we have put together a corollary to that piece where we specify 7 tailwinds that have powered FinTech innovation for the last 10 years, discuss key drivers for future innovation, and identify the subcategories we believe are most promising.
Review of 7 important tailwinds for innovation in FinTech the last 10 years
Mobile has been leveraged as an enabler: Companies like Squareleveraged mobile as a way to reduce the cost of doing business for merchants by allowing for new features like secure payments via mobile applications.
The financial crisis created unmet demand: Incumbent’s unwillingness to lend to credit poor individuals and high-risk SMBs created a window of opportunity for companies like Lending Club and OnDeck to fulfill this unmet demand.
The payments infrastructure opened up to developers: APIs and developer tools made available by companies like Braintree and Stripeallowed developers to integrate payment processing into their websites without the need to maintain a merchant account.
Online banking penetration unlocked important customer data: Deeper penetration of online banking has made it possible for companies like Yodlee to allow users to see all their banking information on one screen and others like Credit Karma to provide credit monitoring services.
Core financial services have been unbundled: Many sub-segments traditionally handled solely by the banks have been unbundled. For example, SoFi is helping with borrowing, Xoom with money transfers and Mint with financial management.
The cloud provided a new distribution channel to serve SMBs: Companies like Kabbage, which provides loans to SMBs, can now justify serving lower life time value customers like SMBs due to the lower customer acquisition costs associated with the cloud.
Digital disintermediation provided greater value to consumers: Companies like Wealthfront, Betterment and Robinhood all reduce the fees charged by brokerages and traditional investment managers providing greater alpha to retail investors.
Key drivers for innovation in the next 10 years
Many of these 7 trends will continue to play a role in FinTech innovation moving forward. But we have identified 3 additional drivers for innovation in FinTech going forward.
1. Incumbent failures are really coming into focus.
Traditional financial institutions are anachronistic. They serve their customers with antiquated products and are often slow to innovate due to both their size and regulatory burdens. Moreover, financial products have historically not been customer-centric, as banks devote most of their resources to optimizing their data and analysis and boosting their bottom line. Consequently, incumbents in financial services have largely failed to meet the needs of consumers, and the emergence of FinTech has put their shortcomings under the spotlight.
While financial services as an industry has been notorious for low consumer trust levels, consumer trust has plunged even further in the wake of fraud, scandals, and data breaches (e.g. Wells Fargo and Equifax). Additionally, poor customer experience has left consumers with limited loyalty to their financial services providers.
2. Millennials are emerging as the new source of spending power.
Millennials are the largest generation in American history consisting of over 70 million people born between 1980 and 2000. Millennials are digital-first users who grew up distrustful of banks and are generally more inclined to try FinTech applications. Furthermore, while traditional financial services has focused on large pools of wealth characteristic of older generations, FinTech innovation is making financial services and products much more accessible to younger generations.
3. Due to the transition of profit pools, incumbents are going to become a lot more acquisitive in the coming months.
Incumbents have begun to acquire FinTech companies as a means to compete against innovative startups and other acquisitive incumbents. Many of the acquisitions so far have been centered around automation of basic tasks. In the last 5 years, 18 FinTech startups have been acquired by banks, with 8 acquisitions occurring since the beginning of 2017. We believe that there is much more opportunity and incentive to acquire — especially for technologies that go beyond automation.
5 subcategories we are most excited about
Ultimately we believe the incumbents will continue to lose ground to the FinTechs and that there is plenty of opportunity for entrepreneurs to build enduring companies in the sector. Great companies will certainly be built across the entire financial services industry, but here are a few sub-categories within FinTech that we think are particularly exciting:
Payments: Even with all the innovation to date in payments, there continue to be pain points throughout the category and many customer demographics remain underserved. In order to be successful in this category, new entrants will need to build on-top of existing payment rails, serve large TAMs and go after new use cases.
Investing / wealth management: Despite recent innovation by players like Wealthfront, Betterment, Robinhood and others, wealth management remains dominated by the incumbents. This reality makes the category a ripe one for entrepreneurs as there are large TAMs, poor customer experiences and a new generation (i.e. millennials) that have unmet needs. Success here will require intuitive design, low fees and efficient customer acquisition.
Infrastructure Apps: Financial institutions suffer from bloated cost structures in the middle and back office for tasks like fraud/ risk management, collections, invoice management and customer support. There’s an opportunity for entrepreneurs to provide software tools that reduce costs and allow for more efficient work flows if they can manage the lengthy sales cycles and procurement processes.
SMB tools: Companies like Gusto and Namely, have begun to serve SMBs in areas like payroll and benefits administration. Even so, SMBs remain largely underserved compared to larger enterprises. FinTech companies that can acquire SMBs efficiently and provide enterprise-level experiences will be able to generate enough value to their customers to create large outcomes.
B2B Lending tools: On the consumer side, lending has become pretty crowded with some of the winners already declared. But on the enterprise side, the category is very ripe. The opportunity for entrepreneurs is in leveraging data at cloud scale combined with advances in machine learning to allow enterprises to better assess borrower risk and drive higher yield.
The author would like to thank Sreyas Misra for his contributions to this piece.
Allen Miller 