We’re pleased to share the inaugural entry of “Under the Arc,” an interview series featuring some of the world’s most interesting, successful, and inspiring operators and investors, many of whom are close friends of the firm. The series is all about providing value to the founders, operators, and owners of the sort of companies we are built for: strongly growing, typically bootstrapped, vertical software (VSaaS) vendors in the $2-20mm ARR range with 10-100% growth.
To get things started, our co-founder and Managing Director, Paul Yancich, caught up with Tomasz Tunguz, Managing Director of Redpoint Ventures, one of the globally preeminent venture capital & growth equity firms. Redpoint Ventures has invested in such companies as Snowflake, HashiCorp, Twilio, Stripe, and Zendesk, amongst many other incredible software businesses.
Tomasz is a prolific and widely followed commentator and thinker on a variety of topics – all related to technology and software operating and investing. Before joining Redpoint, Tomasz was the product manager for Google’s AdSense social-media products. He is an active blogger at tomtunguz.com and is a co-author of Winning with Data, which explores the cultural changes big data brings to business and how to adapt your organization to leverage data to maximum effect.
Tomasz was an extremely helpful friend and sounding board when we were in the ideation and formation stages of Arcadea. Though we focus on different markets (horizontal vs. typically vertical) and growth rates (300%+ vs. up to ~100%), our firms have great resonance in focusing on great teams in interesting markets with long-range growth potential.
We hope you enjoy and take away from the discussion as much as we did.
One of the many important decisions that founders must make is how they will establish capital structure, that is: raise capital or bootstrap.
While there is a growing contingent of founders who choose to bootstrap for longer periods of time – especially in VSaaS – the concept of raising a round seems to still be the first thought many founders have irrespective of growth rate or market size.
In this vein, what do you look for in a company that wants to raise a Series A or Series B round with respect to current growth rates & market size? What makes a good fit?
Typically at the Series A stage, we’re looking for at least 400% – 500% annual growth. For the Series B stage, 300% – 400%+. Series A companies could look something like $500k of ARR going to $2.5mm over the next year. Series B prospects would then be in that $2.5-$4/5mm ARR range tripling or quadrupling over the next twelve months.
With respect to market, the smallest market we would probably invest in is $1-$1.5B of ARR potential.
The other fast filter is around gross-margin months payback on CAC: anything over three years would likely be a fast pass for us.
Once you’ve identified a company that passes the basic smell test, how do you think about Team, Market, and Product? How would you rank their importance?
I think team is first, market is second and product is third. Team and market are tied together in a sense, so those are hard to separate, but if I had to stack rank, then I’d put team at the top of that list.
At the early stage of a company’s life, when they are pre-scale, what matters is being able to build a team. And if you have a team that can’t itself build a team, then they’re toast.
Then the next step is that team has to choose a market or segment of a market that is going to be attractive. If you have a great team, then they’ll find themselves a fantastic market opportunity to pursue and grow in.
The product is the by-product of where team meets market. If you have a really great team and a really great market, you’re going to come out with a product that matters.
Focusing in on teams for a bit, founders are so engaging and worthy of support: they have skin in the game, are optimists, and have a bias towards action. There’s no shortage of positive biases present when it comes time to assess a Founding team. How do you assess a team generally and what metrics correlate with a quality Management team?
The first thing I look for in a team is whether or not they can sell. The ability to sell is massively underrated. If you think about the role of the founding team, they’re selling all the time.
Obviously, they’re selling their product. They’re selling their employees on why they should continue to work at the company. They’re selling perspective candidates on why they should join. They’re selling when they talk to the press and trying to get PR.
This struck me about five years ago. If you can sell really effectively, if you can position, if you can craft a story, everything else is easier. You hire a marketing team to amplify the story that the founders have created, but you can’t hire a marketing team to engineer a story.
Storytelling ability is so powerful. Think about it with respect to hiring people. If you have a really good elevator pitch, then when investors or your team are talking about your business, they’re going to use that elevator pitch and it will be more compelling and make acquiring talent (or customers) easier.
How do you measure the ability to sell?
One way of looking at it is with respect to recruiting funnel efficiency. Take for example one of my portfolio companies, whom I was just talking to recently on this topic. They have a 90% offer accepted rate. And that tells you a lot. They establish the right process and they’re able to go after people and you can see it in the quality of the employees and the efficiency of their hires.
Another area in which you can see and measure the ability to sell is competitive win rates with customers. You can see this by bringing in the CEO and maybe the head of sales and have them explain the top 20 accounts, walking you through how each of those processes went and how long they took.
Can you say more about why product is last on that list? Clearly it’s super important, but many founders think, “If I have the best product in the world, who cares what my growth is or whether I’ve figured out distribution?” We see this a lot – the idea that the best product wins.
You know, you can use customer support, sales execs, or pre-sales to cover up a lot of warts on your products. You can still get to a great market position and growth rate without the product being perfect at the start.
I’ll give you an example. We were investors in a startup. At the outset, we were competing with another well-financed company. Our competitor’s technology was fully outsourced. But as they grew, they started to bring the function in-house. In short, they picked the right market, and they got the distribution right. The distribution made them big. And then as a result of their size, they could scale and build the team, and then backfill on product quality. Our competitor won 95% of the market leaving us with less than 5%.
Would this primacy of team and market be different in a PLG (product led growth) strategy?
If you’re pursuing a pure PLG strategy, exceptional product discipline is obviously paramount. Nonetheless, you’ve got to get the team and distribution right. Only with the right approach to distribution will a great product scale.
Say more on distribution – how important is it to have proven out the growth engine or at least have a realistic strategy in place?
Let’s take a look at Slack versus Microsoft in the fullness of time. Who’s going to win that battle? It’s going to be Microsoft because Microsoft has this incredible distribution engine. 95%+ of the Microsoft software products are sold by a high leverage channel (self-serve and channel partners). So, the software doesn’t have to be exceptional in market.
If you have that channel, you can suffocate the competition. Microsoft was very well known under the Balmer era to employ a strategy, which got them in a little bit of trouble by the way, called “embrace, extend, extinguish”. They’ll embrace the new product. They’ll then make it a little bit better. And then they’ll use the distribution leverage they have to suffocate that competition.
Back to market, what makes a great market in your mind?
I think at a high level, there needs to be a discontinuity. What I mean by that is that in a discontinuity, something has changed in that market such that the way that people, think or buy software changes materially. It could also be that software didn’t exist and now needs to exist – a new problem to be solved or a new technology that can solve an existing problem (or both).
Can you share some examples of discontinuities?
Sometimes it’s an infrastructure development, for example new cloud databases, which means that you can layer new sorts of software on top of those databases.
Then there’s regulatory. In fact, I’d argue everything in crypto is basically regulatory arbitrage.
Another form of discontinuity is a change in how a market does business or how technology facilitates an industry. Take, for example, the online advertising world and what Apple and Google are doing in that space. This is the death of the third-party cookie, which means that the existing advertising infrastructure no longer works. And if you are a marketer, your job is to acquire customers. How are you going to do that with this development when most of your tools and processes have been built on the third-party cookie? There’s this major discontinuity, which means the tech, products, and approach to doing business all has to be reinvented.
One more discontinuity in acquiring customers, especially in the horizontal space, is PLG. Customers no longer want to buy only from an account executive in some situations. Discontinuities could also be a completely different sales channel.
We’ve mentioned PLG in passing a few times so far. Why don’t we see as much PLG in VSaaS (our primary area of focus)?
I think a reason that we may not see PLG in VSaaS is that in vertical markets, you are focusing the market so that you can have much better product-market fit. Your long-term bet is that you can expand your contract sizes much, much more than a horizontal software company might in the face of a much smaller total market and customer size potential.
And if that’s the case, even if you’re closing a $1,000 ACV customer today, you’re betting that that’s going to be dramatically higher in the future. If you’re Veeva, you’re going to get a small foothold but that customer is going to be a $3mm ARR account in five years. And so there’s no way that a rational person would say, “let a product do all the talking.” Each of those leads is so much more valuable because of their scarcity and because of the stronger product-market fit.
This is a bit of off the cuff thinking, in fairness.
We are vigilantly on the lookout for VSaaS businesses that have figured this out. We don’t think the traditional SDR/AE-only approach is broad enough in these markets. That said, there can’t be a PLG-only model as a starting point either – or at least that’s our current thinking, especially if you are focused on points of control / systems of record as we are.
Totally. I think you’re right. Sales generates leads, marketing generates leads, and then product should have to generate leads. And each one of them sign up for a quota. I think that’s the way it’s going to be. The initial fervor around PLG was, “let’s only do this,” but it doesn’t make sense.
Switching topics, valuation is dominating headlines and founder discussions even more than usual, what with interest rates increasing and the public markets in “deep crimson,” to use your words.
We will leave the more difficult-to-answer question of where valuations are heading for your own blog! But help us understand how you think about something that smaller VSaaS founders seem to have a lot of questions about, namely, relative valuation between a smaller business and an at-scale business.
Let’s assume a strong-but-not-VC-rate of growth of 50-75%, the top half of where we focus. And maybe compare a $5mm ARR business to a $100mm ARR business for us, knowing this is a crude exercise and illustrative only.
Let’s start with a $5mm ARR company growing at 75% a year. I would probably value it at something like 6x ARR. And a $100mm ARR business growing at the same rate is probably worth 20 times forward revenue ($175mm ARR).
The reason for the huge discrepancy is that for the small company is probably not going to amount to a very big market cap or terminal value over time. Why? Because from a venture investors point of view, if you can’t double or triple at that scale every single year, it means that you aren’t going to end up being all that big.
Why? Because growth rates very rarely accelerate once you are at $5mm of ARR.
To continue this example, next year you’re probably growing at 60%, and the next year you’re probably growing 50%, then down to 30%. And so on. If you run that series, if you figure out where they end up, it’s probably going to end up a $30 to a $50 million ARR company growing 10% a year. And at that point it’s valued on cash flows and dividends at some historically appropriate multiple. Compare this to a hundred-million-dollar company growing 75% a year, which will end up being a $1B-$2B ARR company before it reaches the 10% a year of growth. And, given the benefits of scale, being public, etc., you probably see that company being worth anywhere from $7B to $15B depending on the multiple.
And lastly, do you see any risk to application layer software companies in the face of the growth in low/no-code paradigms?
No, I don’t think so.
We did a bunch of research on RPA robotic process automation and low-code, I think ultimately this is a transitional technology. It’s kind of like the CD. We went from the audio cassette to the MP3 with CD’s being transitional in nature. That’ what low-code and RPA are in the software world.
The challenge being that you still must go through a software development lifecycle even if you don’t have to actually cut the code. You need a product manager to figure out requirements and how the software needs to work. You then need to train people with a CS or support team. You need to maintain the product on an ongoing basis, too.
Even if you can use these technologies to shrink the number of internal applications in a big organization, you still end up with this incredible sprawl, and compliance becomes really tough, both for financial compliance as well as GDPR, security compliance, and quality of the products.
Compare it to vertical software: all the compliance is taken care of for the customer. You only have to train people. The product gets better over time, all you have to do as the customer is pay for it. And then you’re running a standardized process, which means you’re getting the best practices across lots of different customers.
So as a manager, it’s much easier to just pay somebody than it is to take on the risk of doing it yourself. The idea of going to bosses and pushing them on functionality you’re waiting for from internally low-code / RPA products – You have no leverage over that engineering team internally. It’s a disaster. Anybody who’s been through it will agree.
I think low-code and RPA is a glue that will be useful to fill in gaps; a sort of temporary solution that might be reasonable for 2-5 years. But if the segment is large enough, it will justify its own software vendors.
If the concepts discussed here are of interest, and you’re a VSaaS business owner interested in Arcadea’s unique approach to growth investing, we’d love to hear from you.