So what actually happens before a VC decides to invest in your company? Susan Liu looks at hundreds of startups every year for B2B software investor Scale Venture Partners. She explains the top 5 metrics they look at, and how a company can prepare to pass the investor diligence with flying colors.
Susan Liu, Vice President at Scale Venture Partners: … We typically look at hundreds of companies, and then we do deep dives into maybe tens, depending on the year.
Tim Anglade, Executive-in-Residence at Scale Venture Partners: I’ve always wondered, from the outside: what do VCs do when they evaluate a company? Because all I get is the partners telling me, “You’re great, we’d love to invest in you. We just want a look at what’s happening inside.”
Susan: “Send us all your data!” That’s right.
Metric #1: ARR Growth
Susan: So, typically what we’re looking for in terms of financials is we want to make sure you have product market fit. And there are typically a couple of metrics we look for. The first I would say is we like to make sure that there is ARR growth, meaning if you’re looking at ARR for the last, maybe, eight quarters, we want to make sure that net new ARR is growing over time. So you want to see a curve going up. Right? That’s usually a very good sign. There’s a lot of demand for your product, a lot of interest, so your company is growing very quickly.
Tim: What kind of annual recurring revenue would you want to see? And what’s a rough benchmark, like what’s really bad territory, and what’s really amazing territory as far as you’re concerned?
“You just want to show that there’s a trajectory of growth.”
Susan: Yeah, that’s a good question. I would say you want to make sure your net new ARR increases over time. So let’s say you add 10,000 net new ARR last quarter. The next quarter after that, you want to make sure you add 20, and then the quarter after that maybe 40 or 50. You just want to show that there’s a trajectory of growth.
Tim: Right. And so that makes a lot of sense, and again, this idea that it’s kind of the first thing to look at, because if you have sales momentum that buys you so much freedom in terms of a bad quarter, a bad hire, or any number of things that might happen. If you have that sales momentum, you can afford to do a lot of mistakes.
Metric #2: The Magic Number
Susan: So the other thing I think is very important for SaaS businesses is making sure there’s good sales efficiency. So for us, our metric is looking at the magic number. And what the magic number does is it looks at, based off of your sales and marketing slant for the last quarter, what new revenue are you adding for the next quarter? So there’s kind of this fine balance between what you spend in terms of sales and marketing, and what new revenue you’re generating. So that also ties into ARR, of course, too, because that’s the bookings portion of it. Typically we like to see magic numbers of one.
Tim: So what would that mean intuitively?
“If you spent a dollar in sales and marketing, you want to generate almost a dollar in revenue.”
Susan: Sure. One is like if you spent a dollar in sales and marketing, you want to generate almost a dollar in revenue. If the company is ramping very quickly, as in they’re investing more in sales and marketing spend, this will often come down, but it’s something that we expect as you grow. But typically we like to see one when we invest, and that’s the metric that we look for. You have this growth, but you’re not overspending for it. It comes a little bit more naturally.
Metric #3: Gross Margins
Susan: Sure. I think our top two really is the ARR growth and the magic number, the sales efficiency. We also look at gross margins, so you want to make sure you’re in line with other SaaS companies, so typically around 60, 70%. You want to make sure that your costs are not out of control, because it is very important to make sure you have enough cash, because if you don’t have enough cash, you’re basically going to go out of business, and nobody wants that to happen.
“We want to make sure you’re in line with other SaaS companies, so typically around 60, 70%.”
Tim: Right. So this idea that if you’re really not able to capture a margin on your current pricing now, it’s unlikely to change in the future, right? And you’ve got to stay within a certain benchmark to have a good business. And so, in long term, I think there’s also something that maybe isn’t telling so much about the house or the company, but is important to VC, which is your potential return, as well, right? So is that something you also look at when you look at companies?
Metric #4: Potential Return
Susan: We definitely look at potential return. But the return part is a little bit tricky, right? Because we look at a whole bunch of different factors for this. So, financial is only one aspect of it. We also look at market size and all that. So, essentially, what we’re looking for is how big can your company become, and, based off of that, what can we potentially make on the company? So generally, the higher return the better, but it depends on stage. So if you’re investing in a more early-stage company, then the return, we expect it to be a lot higher. If the company is more leader stage, then we expect the return to be a bit lower. And we like to have a balance in terms of having a certain number of early-stage companies, and then a certain number of late-stage companies.
Tim: Right. So that could be a financial consideration that’s really not saying much at all about your company’s health, but might lead a VC from passing on a deal, just because they’re not going to get a big enough outcome out of it.
If you feel like you’re not going to get a big enough outcome and you have this model that you have for your fund and it doesn’t fit, then, most likely, the VC won’t invest.
Susan: If you feel like you’re not going to get a big enough outcome and you have this model that you have for your fund and it doesn’t fit, then, most likely, the VC won’t invest.
Tim: Right. But it could be that another VC or another financial institution of some sort would take that deal because you’re performing well, and they don’t have as high of expectations in terms of the return they’re going to make on the overall investment.
Metric #5: Cash
Tim: Are there any other things, any other considerations, that come in? Any other metrics you look at?
We want to make sure that the cash will last them at least two years
Susan: Yeah. I would also look at cash, because when we invest in a company, you want to make sure you don’t spend too much, because, again, you don’t want the company to go out of business. And if you run out of cash, then you’re out of business. For SaaS companies, you have to invest money to make money. So we want to make sure, when we invest in companies, that the cash will last them at least two years. Yeah, so generally that’s why we spend so much time looking at your sales efficiency metrics, and your gross margins, too, is to make sure that you won’t run out of cash.
Tim: So what’s the idea of two years versus a year? I know companies have different kinds of mental models about that.
Susan: Yeah. You know, I think that’s a very good question. Generally, we like to think of it in two years, because if you can make the money last two years, the company will hopefully be big enough where they can raise at a bigger valuation, and that’s what we’re looking for. A lot of companies, especially in the last couple of years, they’ve raised a little bit sooner. So they’ll raise after a year. How often you can raise, it depends on a mixture of things. Like the capital market, so I would say funding came a little bit easier in the last couple of years, now it’s getting a little bit more challenging, so the cash has to last a little bit longer. But if you’re thinking about how much you’re going to spend for the next year because you’re doing annual planning, this definitely should come into play. So if you think you’re not going to be able to raise for another year, then you should probably spend a little bit less. But if you think you can raise money in the next year, then you can probably spend a little bit more and get higher growth.
Tim: But otherwise the prototypical curve would be, you’re able to take this influx of funds, right, and really grow your company, and get to the next benchmark, the next order of magnitude, in that two-year period, and do another round, right? And some companies grow a lot faster, and they’re able to raise faster, and some of them are never able to raise.
Susan: That’s right. If you’re more capital efficient, then the cash will last you even longer. And we love finding companies that look like that.
Tim: Yeah. Which is actually a little bit atypical, right? I think a lot of people just would rather have you on that kind of curve and growing explosively, and just keep getting new funding all the time.
Susan: That’s right. I feel like the market has changed a little bit, where at lot of VCs now value profitability, a path to profitability, versus the insanely high growth. Ideally, you can find companies that have both, but it is really rare. Generally, the companies that do have this have some sort of virality. So there’s some portion of it that can make it go viral. Most traditional SaaS businesses are just not like that. You have to invest money into sales, and marketing, and sales people in order to drive the growth forward. They grow fast, but not exponentially. They’re not consumer companies, they’re different models, after all.
Other Factors
Susan: Yeah. I would say financials is just one aspect of it. We also take a lot of other things into consideration. At our stage, it is good to use financial metrics as a filter, because we’ll get many companies, right? And if you have more than a million ARR, then the financial metrics are a good way to gauge the health of the business, but at the same time, we also take things like market size, team, et cetera, into consideration. So I would say financial metrics are important, but it’s only one factor that we look at.
Financials is just one aspect of it
Tim: Okay. Is there one gigantic red flag or pet peeve when you get data from companies that makes you go, “no, no, no, no, no”?
Susan: That’s a good question. You know, I like to get the underlying data. So oftentimes we’ll have people calculate metrics for us and present it to us that way. Sometimes I find that it might not be calculated correctly, and I just want to get the raw data and then figure it out myself. So if people were to send us data, I would prefer it if they just sent us all the raw data and have us figure it out, versus calculate the magic number. I appreciate the effort, though, it shows you did your homework.
Tim: Yeah, but now they know. Thank you so much!
Susan: Yeah, thanks!