SaaS CFO

A decade of lessons from building SaaS businesses

As head of the screening committee for the Birmingham Angel Network I get to see a large number of funding requests come across my table.  I realized today that my response to an entrepreneur asking about his submission may be helpful to others.  Here it goes:

 

XXXXX wrote:
I thank you for taking the time. On the XXXXX project, we’re actually making a presentation to several local venture capitalists.  Our powerpoint, which needs some explanation, is attached.  I’d be interested in getting any feedback you might have in advance of that.  If there was something about the project you did not like, I’d like to be able to address this with the investors.  I understand you may not even see this e-mail before that date, but if you could give me some pointers, I’d love to hear them.

 

Hi XXXXX,

Sure – I hope this helps.

We see a *lot* of web ideas come through.  Unfortunately, the barrier to entry is so low for web ideas that execution is the only sustainable differentiation we can rely on.  We look for web ideas that already have significant traction (i.e., a lot of paying customers) and a clear, near-term path to profitability if they aren’t already there.  Any funds raised are used as growth money – usually just sales and marketing.  In other words, we add gas to the fire already burning.  Given the realities of an angel investment portfolio, we know we will have some flame-outs, some zombies, and very few successes.  All angel investors across the world are aware of this… or soon become aware of this when experience happens!  We have to pile on to those companies that are already moving along nicely.  This creates the nice bonus for entrepreneurs in that they are able to negotiate good valuations if they have already knocked through several major risk milestones before asking for money.

The single most common bit of advice we give to entrepreneurs of web start-ups is to bootstrap the business to traction as much as you can.  If the founders can all code then that is best.  Get friends and family money after your personal savings have run out.  Since VCs have moved further out on the risk range (more mature stages, larger rounds), angel investors must be able to fund their portfolio companies for a long period until the company hits the stage VCs are interested in.  If the company is at or very near profitability by the time it takes angel investment then time is on the side of both the angel investor and the entrepreneur.  In this situation, everyone can focus on growing the company while staying above the cash flow break-even line.  Time also tends to wash out your competitors who don’t heed this advice.  New competitors may continue to pop up but they have to play catch-up while going through the same trials and tribulations you already passed through.

I wish you luck with your conversations with the VCs.  Perhaps you will get some traction with them but, even if you don’t, be sure to ask if you can stay in touch as you grow the business.  All investors – angels and VCs – are more likely to invest down the line if they are already familiar with the company and have watched it clip along over the years.

Please let me know if we can help again and keep us posted on your progress.

Best,
Jonathan

I was watching a session from AngelConf 2009 on Justin.tv the other day and one of the speakers said something that I realized is so true.  It hurts to do the right thing.  Otherwise, everyone would do the right thing.  It is easy to see that you will always do the right thing but what about when the choice is fuzzy?

“Should I take money off the table even if it will hurt my investors?”  (No.  If you have trouble with this one then remember that karma is alive and well in the business world and the angel/VC world is very small.  Thus, you can be selfish by doing the right thing here.)

“Should I take source code for a project I developed at my employer and use it for my personal gain?” (No.  Starting a business is hard enough without getting the s%$& sued out of you.  Besides, your employer already paid you for your work so you are just stealing at this point.)

“Should I change a contract during negotiations without red-lining my small change?” (No.  A contract is merely a record of the trust between two parties.  If you break this trust during the up-front part of the relationship then the paper contract is worthless.)

Here’s a hard one that I’ve heard some justifications for:

“My business is going to go under and folks will lose their jobs unless I do X.”  (No.  Think harder.  There is always a better way.)

Harvard advises its business school graduates to save up enough money for a “go to hell” fund as soon as possible upon graduation.  This fund gives the grad the financial means to be able to walk away from an employer if the grad is pressured to do something unethical.  I like this idea of a fund because it points out that you need to think about, explore, and plan for these situations before you get into them so you will know what you need to do.

Good luck!

ATM photo by Futureshape on FlickrYou’ve found a great venture partner to give you growth capital.  The term sheet is signed.  You’ve got a good valuation.  Conditions of the deal seem fair.  Nothing left to do but a sign a few documents.  Ah, if it were only that easy.

The stage between a signed term sheet and seeing the wire come through can be either a nerve-racking mess or a fairly smooth and mechanical process.  I think it really comes down to preparation and that you deftly drive the deal to completion.

Following one equity deal I took some time to figure out why the deal went so smooth.  You may not have seen some of these tips before but they work.  We closed one deal by 10 a.m. on the scheduled closing date.

Before Shopping for Money

  • It is best to dissect and splice/dice your operations a lot before even asking for venture money.
  • Ensure your projections are tight and foot to everything else being said or written (business and sales presentations/materials).
  • Consider going through an audit (or review) and correct any issues before shopping for equity investment.
  • Scan all contracts (vendors & clients) to electronic files as part of your normal contract processing system.  Be sure all contracts are dual-signed and complete (all schedules, statements of work, and anything else described in the contracts).
  • Be sure all employee and contractors have signed confidentiality and work-for-hire agreements as part of the standard employment/engagement practices.
  • Review all vendor and client contracts for change of control, assignment, or other impediments to the deal.  Keep them out of negotiated contracts with vendors and clients in the first place.  This is important because when getting consents for the deal from parties not part of the deal, you could have a vendor or customer extort you for the consent if you are unlucky.
  • Make certain that all intellectual property used in your products is tracked and properly licensed through written and specific license agreements.  Open source licenses give lawyers heartburn if they are not properly considered when creating products.
  • Be sure to have all insurance policies in place and up-to-date.
  • Have a back-up plan for contingencies (e.g., debt lenders won’t go along with deal).

During the Deal Closing Period

  • Focus on the deal at hand as the #1 priority.  There will be a lot of pressure to divert your attention elsewhere but you must press forward.
  • Focus on closing the deal on time, with an abundance of disclosure, and all issues wrapped up or put on a post-deal actions list (in the agreement and all parties noting this).
  • Be very organized with actions and commitments.
  • Pace yourself.  Anticipate what will be needed or needs to be done when.  No one will likely tell you this until it is too late.
  • Stick to committed deadlines no matter what.  Stay late, really late, work all weekend, get in early, but no matter what, get it done.
  • Return phone calls promptly.
  • Keep track of what documents have been supplied to whom.
  • Use one person as the key communicator in the deal negotiations.
  • Use the best lawyer who will focus on actions, clarity, and precision.  Use the most experienced lawyer you can since you will not be able to devote considerable time to reading all the documents yourself.
  • Hash out the deal structure at the high-level during the term sheet stage but drill down into the details of the corporate structure and any tax effects as soon as possible.
  • Bring debt lenders into the fold early enough to avoid delays but late enough not to cloud negotiations with potential equity investors.
  • Be courteous to everyone at all times (this includes auditors late at night on a Sunday).
  • Plan for last minute delays.  Brainstorm continuously with lawyers, accountants, and other advisors about anything that may hold up the deal.  Talk with the other side of the deal to make sure there aren’t any potential issues or delay brewing.
  • Let your lawyer negotiate the legalese with the other side’s lawyer.  However, substantial business issues should be hashed out one-on-one between deal participants.
  • Make a list of post-deal actions as you think of them (by reading documents, conversations, commitments to people).

Once the deal has closed and you see the wire in your bank account then celebrate… but, be sure to get back to work in the morning!  You’ve now got new bosses to please.

I’m sure you’ve heard about the genius of Gillette’s concept of giving away razors to sell razor blades.  It still amazes me that when folks are pitching business ideas and they get to compare their idea to Gillette that they will pause and proudly announce that it is “…like giving away the razors to sell razor blades.”  Really?  I didn’t see that one coming ;-)

Razor blades on Flickr by scottfeldstein

So where’s the razor / razor blade analogy with SaaS businesses?  It’s upfront professional services necessary to launch a customer on an application versus the recurring usage fees.  But, it’s not quite that simple.  You can give away your implementation and training services to launch a new client but I think that’s a poor idea.  Getting a customer to pay for those services gets some skin in the game.  No one wants to walk away from an implementation when you’ve sunk enough money into it that your boss will be asking about it or, worst, the board will be asking.  Up-front cash is also extremely helpful in the early days when your cash flow is more of a trickle.

Fortunately, we’ve got more cash nowadays with our company so we can afford to dial in our up-front fees to suit various purposes.  The first goal of up-front fees should be to make sure you’ve got fully qualified clients signed up.  If a client won’t cut a check then they aren’t in.  It’s much easier for the sales team to bring you signed paper if a client doesn’t start paying until they are launched and they don’t have to put out any cash up-front.  However, don’t act surprised if you find a sizeable group of those clients staying in a nebulous stage where they are signed as customers but not making any motions to get launched.  Imagine how many people would back out of car purchases if when they got home they could just pretend the car wasn’t there and it wouldn’t be (along with the resulting car payment).  Thus, if you can get someone to sign a contract and hand over a check then you’ve got a fully qualified client on your hands.  This attribute of up-front fees serves as a lower limit to the amount of up-front fees you should charge.

The second goal of up-front fees provides an upper limit to the fees and brings the ubiquitous razor into the mix.  The main focus of a SaaS business should be to get recurring revenue up as quick as possible.  Getting recurring revenue in the door is mainly a function of closing deals and launching those customers.  I already talked about how the speed of launching customers can actually be improved by charging an up-front fee.  Well, closing deals fast sometimes requires you to cut into the up-front fee.  When I am given the choice between cutting an up-front fee or cutting the recurring fee then the up-front fee always goes down.  This is one reason why I think an obsession over the profitability of professional services is counter-productive to a SaaS business.  The poor folks on the professional services team can’t be held to profitability numbers if the CFO is constantly siding with the sales team to cut into the up-front fees that are used as the revenue measure for the professional services team.  Yes, I know that you have to keep the professional services team from getting lazy and bloated but you should look at a holistic profitability measure for the total product revenue stream with up-front fees and recurring fees as total revenue and professional services, support services, software development, and hosting expenses as the total expenses.  However, good luck calculating that measure.  An easier, real-world approach is to just focus on launch cycle times and the amount of recurring revenue.

There are razors all around.  Hats off to King Camp Gillette!