One of the most common questions we face as advisors is simply: should we raise more capital, or less, or no capital at all; should we exit now, raise another round of equity capital and grow, or limit ourselves to organic growth so that we can hold onto more equity? And finally: if our SaaS economics prove we can make good use of growth money, could we raise non-dilutive or minimally-dilutive form of capital like venture debt or revenue based financing and essentially enjoy a free non-dilutive ride?
Asked from the founders’ perspective and assuming a standard equity raise: how much more value must we create and by when, on a risk-adjusted basis, to justify owning 20 – 30% less of the company than we would have otherwise owned if we hadn’t raised equity financing and had instead elected to exit?
Please note we are assuming the company could pursue an organic growth path at its option; for many companies, particularly in the early to mid growth stage, having raised a few rounds of equity capital and staffed up to shoot for the moon, this simply isn’t an alternative! The first round of capital set the wheels in motion, the second funding round lead to a significant expansion in staff, and the next growth round is necessary to keep the dream alive. Assuming SaaS unit economics remain viable throughout the journey, if not fantastic, then this path makes sense; there is an explicit understanding that you will run short of EBITDA profitability until size and scale are achieved and this is the explicit game plan; the VCs are on board, they want you to spend the growth money, and everyone understands that at least one more round of capital will have to go in order to cross the finish line and exit.
This same logic does not apply to a business that is bootstrapped, or any business (SaaS or otherwise) which has entered the domain of EBITDA profitable. They have options. Let’s imagine that MidChurn is a B2B Enterprise SaaS business with $2M of ARR, a fully burdened contribution margin of 70%, and total fixed S&GA and R&D expenses of $1M:
MidChurn has a binding LOI on the table from Rollup Star Inc. with an implied valuation of $6M calculated on a cash-free, debt-free basis, and Rollup’s offer is at 3X TTM recognized revenue (it would ordinarily be pegged to a multiple of current run rate revenue, and would factor in growth, the relevant SaaS metrics, buyer revenue and cost synergies, and myriad other factors -- but let’s keep it simple and stick to the terms of the offer as presented in the LOI). As an alternative, they have a VC term sheet on the table for a $2M growth investment at the same $6M pre-money valuation (again, the pre-money VC valuation would not typically be identical to the exit Enterprise Value for several reasons, but let’s keep things simple). Assuming common shares (to avoid the complexities of analyzing the liquidity preference) and 100% founder ownership pre-investment, their new VC partner will own 25% of the company post-investment. By extension, the founders will have diluted themselves down by 25%, and once spent, the newly-injected treasury capital must increase equity value by at least $2M (on a fully discounted, risk-adjusted basis, assuming the money is spent to grow as intended) in order to be break even on the deal.
|Equity Value pre-investment||$6M|
|Treasury Raise Total||$2M|
|Post-Money Equity Value||$8M|
Fast forward to 12 months post-investment, and our hero founding team and their company MidChurn have efficiently deployed all of the growth capital; they ramped up R&D, added customer demanded features and functionality and incorporated key 3rd party integrations, raised average ACV, and have acquired new customers and expanded within existing accounts. In spite of their fantastic effort, and partially because they were so head-down on product, their financials now show recognized revenue of just $2.5M. This 25% growth is not 50% or 100% growth, clearly, but everything else looks so good: product, average ACV growth, negative churn. However: not only are they nearly out of runway, but let’s take a look at what the founders’ equity would be worth if they received an offer at the same 3X TTM revenue multiple:
|Equity Value (assume no cash remains)||$7.5M|
|Founder Proceeds at Close||$5.6M|
|Investor Proceeds at Close||$1.9M|
Now, there is arguably a case for a higher revenue multiple, here. Both because of the intangible value in the now superior product, the fact that the company is larger with more customers, and is another year de-risked in the market. However, there is something else going on here: notice that the equity value of the VC investment is underwater at $1.9M versus $2.0M invested. And it’s also a full year later! This is because the $2M of invested capital needed to grow the revenue by at least the implied entry multiple, just to keep pace. In this case, the $2M needed to grow revenue by $2m / 3X = $667k, whereas actual revenue growth was just $500k. But there’s more: both the VC investor and the founders expect to be compensated for risk. VCs call this their required IRR, and founders should really think about it the same way. At 30% / year, the equity value of MidChurn needed to grow from $8M to $10.4M:
|Initial Post-Money Equity Value||$8M|
|Risk-Adjusted Rate of Return||30%|
|Required Equity Value +1 Year||$10.4M|
|Required Revenue +1 Year||$3.47M|
|Required Revenue Growth Rate||73%|
This is quite a remarkable result. If the founders had not raised any money whatsoever, then they would have achieved exactly the same result with just 30% organic growth:
|Initial Equity Value||$6M|
|Risk-Adjusted Rate of Return||30%|
|Required Equity Value +1 Year||$7.8M|
|Required Revenue +1 Year||$2.6M|
|Required Revenue Growth Rate||30%|
The take away: equity is expensive. Imagine if the founders could have found a way to achieve the same growth with non-dilutive debt or revenue based financing; their equity value remains entirely preserved. Said another way: sometimes outside equity capital is the only way to the finish line, but certainly not always!
If you’re in the crucible of the equity versus exit decision and would like to know what you’re signing up for if you take on an outside equity partner, please try our interactive calculator, below: