In this second part of our first two-part episode, our guest Joel Bar-El, and McKinsey Israel’s Jay Jubas and Peleg Dekalo continue to chart the course of their start-up through the challenges of scaling through to strategizing their exit.
Mapping out a growth plan
Peleg Dekalo: So, gentlemen, I can just imagine that you’re not surprised by this point, but we made it. We’re funded by a VC—a venture capital fund—and as time goes by, we’re showing decent numbers—good revenue and profit margin growth, and we are reaching a point where we are expected by ourselves as cofounders, and also by our investors, and our employees, to scale and to take this ship into the next level. Generally speaking, Jay, what are our opportunities to scale and grow?
Jay Jubas: Well, I think there may be, typically, there are many, many opportunities to grow and at least in my experience, most entrepreneurs, most start-ups see multiple, multiple paths to grow, and the challenge is often picking the one or two paths that will be the path of least resistance to future growth. Typically, you find some companies that have latched on to a very big problem that they’re solving; a solution that they have, which is very significant, very helpful, in solving that problem. And for them, the addressable market [TAM] they’re going after is quite large.
For them, the growth may be simply continuing to invest in the capabilities of their solution to keep it ahead of the market and keep it ahead of competitors, and to scale the go-to-market—more salespeople, more channel partners, more geographies, whatever the case may be. And that’s a great situation. The execution can be very challenging, but strategically, that tends to be the path of least resistance if you find yourself in a market where you’ve got an offering, where the potential of that offering is very, very substantial.
We find many, many companies who have chosen to solve more niche problems. They have a very interesting technology. Technology with many, many potential applications, and their first application they’ve chosen to solve is an application which is not that large. So, they may see a path to 50 million annual recurring revenue [ARR], 100 million ARR.
That kind of company needs to be thinking, ’What is the next act?’ Long before it hits the 50 or 100 million ARR. It needs to already be thinking a little bit before then what do I need to be doing so that I don’t hit 50 and 100 million ARR in plateau?
I’ve got that next S-curve there, and that becomes more strategically challenging problem because they have a set of capabilities, they have a technology platform, for example, and they have to find, what are the right applications? What are the great use cases they should solve? And maybe it’s in the same vertical that they’ve solved. Maybe it’s in the same horizontal that they’ve solved. Maybe it’s selling to a different buyer in the same company, maybe it’s selling another use case to the same buyer.
I mean, there’s a range of potential solutions, so we’d have to get into your company to understand exactly what the options are. But understanding those options and understanding the size of the prize and also what it‘s going to take to execute, how differentiated you can be in these other arenas is very, very critical strategic question and one that we do a lot of work with companies on.
Peleg Dekalo: An educational question: ARR, annual recurring revenue. Ever since SaaS is the new kid on the block, not a kid anymore, yeah, but ever since SaaS is really dominating the market, then ARR became the go-to metric. Can you tell us how is it calculated and why is it the go-to metric?
Jay Jubas: It is exactly as you said. It’s an annual recurring revenue, which is typically a multiple of the monthly recurring revenue that a customer pays. And I think what investors like about it is simplicity and predictability. If you’re in a business, if you’re in a retail business where every year you are starting off with a clean sheet of paper and you’re starting at zero sales, the predictability of the revenue stream is at much greater risk. The beauty of the SaaS model is, there tends to be much more predictable revenue stream and investors and companies really value the predictability of the revenue stream.
Joel Bar-El: And the reason people use ARR just because it becomes a bigger number than revenues. So, if you are growing your revenues every month, then always the last month times 12 is larger than your annual revenues. And since valuations are dictated by multiples of revenues in those stages of companies, people use the larger number.
Peleg Dekalo: Yeah, a more sexy number. And yeah, makes mathematical sense, no doubt. Now we’re in the growth stage, so probably just to put our fingers on it, maybe after round B, after round C. Financing here is becoming in the tens of millions of dollars, and in our case, of course, hundreds of millions of dollars. So, what will be different in those financing rounds when you compare them, Joel, to the more atypical round, the seed round, when we know of a lot of private-equity funds that are entering these rounds—the rounds C, D, E—so what can we expect now?
Follow us on your favorite podcast platform
What do investors want?
Joel Bar-El: In the initial rounds, investors believe in the management, they believe in the product, they believe in the potential. I would say the big difference, first and foremost, is that they don’t believe anymore. They want proof. So, they’re actually due diligencing every aspect of your claims. They take external advisors such as McKinsey and others to go and check the market validation. They speak to your clients, they speak to other players in the industry, they speak to consulting firms, accounting firms, lawyers, and are checking every aspect of the company very thoroughly. So, I think that is one thing.
The second thing is the term sheets, and the investment agreements are by far more elaborated and more sophisticated, and not obviously for the benefit of the founders, I would say. And this is where founders should have probably good legal advice in those stages to know how to protect their interests against such investors who are obviously very experienced, have done lots of deals, and know exactly how to protect their interests.
Finding the commonality and the alignment of interest is key in those cases.
Jay Jubas: If your results are great, then an investor really wants to understand why they should be confident that those results will continue into the future. Do we have a truly defendable position? Maybe some of the big guys, the tech giants, are going to come into our space and attack it and we’ll be vulnerable. Maybe there’s another start-up or an early-stage company that’s got a more superior technology. So, you have to be convincing that you can stay ahead of the competitive set and continue on that trajectory. But that’s a good problem to have that you’re growing in the results that you’re presenting are unplanned or faster than planned.
Sometimes we see business cases or we’re asked to help in business cases where the results are good but not great. But there’s always a hockey stick, and then it’s a much harder story to tell. The investor wants to understand what’s the confidence. What’s going to change that all of a sudden, sales that were growing 30 percent a year are now going to grow 60 percent a year? What’s that unlock?
Companies often think they have it before investors are willing to grant that they have. So, the evidentiary burden in the storytelling of why there will be this kink in a hockey stick, a change in trajectory of the company having that story down in a very simple, believable way is the most critical thing.
Peleg Dekalo: And by the way, from your familiarity with VCs versus private equities [PE], the approach—is it different?
Jay Jubas: Well, we now have this class in between of growth-equity investors, right? So, these are guys who are somewhere in between VC and PE, but in many ways bring a PE type of mindset, which is results-oriented, data-driven. Whereas the VC tend to be more belief in the team, in the people, that there is a problem they’re trying to solve and believe that this team can deliver it.
So, the growth investor has got to take elements of both but brings the rigor of analysis that a PE firm would bring with some of the judgment around talent and management team that a VC would bring.
Has the time come to exit? Choose your exit strategy
Peleg Dekalo: OK, we did it again folks, and now we are starting to think of our exit strategy, be it through an M&A transaction or an IPO, an initial public offering, by which we could start to offer our company’s shares to the public. How do we do that?
Jay Jubas: Well, let’s start with, how do you know the time has come?
Peleg Dekalo: That’s a great question Jay. Then let’s address that as well.
Joel Bar-El: So, I have a few things to say. First, one of the advices I got down the road, is that from day one, you should prepare the company to be sold and be ready to do it at any time. And that is, I think, great advice because that helped us a lot on investments down the road and maintain a proper data room with proper accounting.
Trax was audited by Tier 1—one of the big four accounting firms—from day one. Because we knew that at some point, we will need that. Always take the best lawyers, don’t skimp on that. So be prepared from the mindset and the orderly documentation of the company in a way that you will be kind of ready to be sold, that will help you a lot. So that’s one thing.
Second thing, not every company needs to exit. That’s another thing people tend to forget. Not every company is meant to be a public company or be sold. Companies can just be profitable and issue dividends, and shareholders will be happy, founders will be happy, and everything will be fine.
And then, obviously, most companies, having said all of that, are trying to do an IPO as a means of exit in order to sell their shares in the public markets or be sold to enterprises that will buy them. Either private equities—in order to grow their business and sell them down the line—or just sell it to some strategic buyer that will take the product inhouse as part of the product portfolio.
What is an equity story and why does it matter?
Peleg Dekalo: Now, if and when we choose to go down that route—either to be sold or merged through an M&A transaction or to go public—then our equity story will mean a lot. What is an equity story, Jay?
Jay Jubas: An equity story is just the next version, the next evolution of what we’ve been talking about all along. It’s the story of our company and how our company creates value, how it creates value for customers, how it ultimately creates value for shareholders as well. And as the company gets more and more mature, there needs to be more components to do that story.
Early on, we talked about how it’s a three-page pitch. Because there is no data, there is no performance record. What you have is a vision, and a narrative, and a team. When the company is in its growth stage, it’s got some track record, it’s got some results. So, there’s some performance story and then there’s got to be the story. Like I was saying earlier about how this is going to be sustainable, why this growth trajectory will continue, why it will accelerate, and we’ll have a story around that.
As a company prepares itself to go public, first of all, it needs a track record. If a company is going to go public, say, into the US stock exchange, there is no forward-looking guidance as part of the memorandum. It’s all got to be based on the historical record and the narrative, and the historical record better be strong enough and come across as believable that the performance will continue, that the revenues, one can imagine how the revenues can be projected forward, and that the company will deliver on that. So, the equity story has to be rooted in the data, in the actual performance of the company, in customer feedback, in the financials of the company to explain why investors should believe that these things will continue along the same trajectory or get even better.
It’s got to have a deep competitive analysis to show why this company is going to continue to succeed in the face of all this competition and how its position relative to others. It’s got to have a lot of customer feedback to show that the customers they currently have are happy customers, they’re going to stay, are going to expand their share of wallets, and are not going to leave and pull. So, it really is just a richer dataset to support the thesis that the company is on a sustained successful trajectory in the future.
Peleg Dekalo: It sounds a bit like a fundraising pitch on steroids.
Jay Jubas: Yeah, I think that’s a way to think about it. I think it’s an evolution of the narrative, which at first place was all narrative with little data, and this is much more data with the narrative that it’s consistent with the data.
Joel Bar-El: And I think also companies will be wise not to think of an IPO as an exit. People tend to forget the company continues to live on after IPO and needs to perform with a much bigger scrutiny than as a private company. And you see some companies who are missing few quarters after being public, and then that is a penalty box that can last for years.
So, people might want to remember that an IPO is a milestone, but need to really think carefully what happens after.
Jay Jubas: That’s why I was asking about earlier on. It was a bit of a facetious question, but I’ve seen, and I’m sure we’ve all seen, examples of companies that go public too soon when they do not have the predictability of revenue, revenue is not predictable. It’s a nightmare to manage, because once you disappoint and you disappoint a couple of quarters, exactly as Joel said, it’s very hard to escape the perception that’s created from those first few quarters. And we’re seeing it now with many, with the special-purpose acquisition company [SPAC] phenomenon and a number of companies that have gone public, perhaps prematurely, and we’re seeing several of them pay the price for that.
Peleg Dekalo: So, about the when – you have any insight about that?
Jay Jubas:It’s a when and a why. I mean, as Joel said, there are companies that can be private for a long time, so there has to be a reason why they want to go public. Partly, it’s going to be investors want to get paid off and founders want to monetize the hard work they put in. But the ‘why’should also have a story of why tapping the public markets will help drive the growth. So that needs to be important part of the story.
And the ‘when,’ I think, is when the processes, everything Joel talked about in terms of the financial-reporting processes, the HR processes, the systems, are all in place so that the requirements of being a public company are met in a very, very solid way. No one will raise questions about the integrity of reporting that’s done by the company, and they have to have predictable revenue. Investors need to feel that the revenue forecast of the company, or that the revenue outlook for this company is pretty solid. Don’t like surprises.
Seek objective advice
Peleg Dekalo: Definitely makes sense. Other best practices in the exit strategy, if you have something in mind.
Joel Bar-El: I would say getting advice, and there’s not too much advice you can take, and some advice needs to be taken with a grain of salt from investment bankers, for example, who has a vested interest in the process. But you have many parties that are advising just on face value and objectively, like good lawyers. As one example, independent directors that you are hiring to your board, so I would say that should be probably a best practice people should follow.
Peleg Dekalo: I really love the point on the vested interest because a lot of, not just entrepreneurs, a lot of businesspeople, lots of people in business, when they come across business problems, management problems, they tend to forget that the other party always has some sort of interest. Can you tell us about that vested interest from the investment bankers’ side that advises the company that will go public?
Joel Bar-El: Yeah, investment bankers, as I came to know them, and I’m working with multiple firms, and for many years, tend to be very good in advising based on their experience and other examples. But they cannot give you any advice how you will perform because the company is not public yet, right? So, there is no history to look back to and kind of predict. So, trying to get the right comps, trying to look at companies who are similar to you and getting their advice is always kind of a good practice, and I found the investment bankers to be very helpful.
But having said all of that, again, put a grain of salt into it, because at the end of the day, investment bankers tend to be optimistic people, lawyers tend to be more pessimistic. So, a need to balance between optimism and pessimism and find the right path between, not to take any one route into the extreme. So, I would say these are the two parties you should listen to and find the middle way.
Peleg Dekalo: Each party adopts the approach that pays the bills.
Joel Bar-El: Yeah.
Jay Jubas: Well, I would suggest we would be another party that one might want to consult with in this process as an objective, not too optimistic, not too pessimistic, but kind of that Goldilocks ‘north star.’
Joel Bar-El: Exactly, and these are parties like McKinsey that are independent. So, either independent director, independent consultant, that can really look only on your own interest and not have any vested interest in the process itself.
Peleg Dekalo: That’s true. That’s correct. OK. We did our exit, gentlemen, and I will wire transfer you the funds as soon as possible. And it was a true pleasure having the both of you here. So much insight in such little time. So, thank you so much for both of you.
Joel Bar-El: Yeah. Thank you for having us.
Jay Jubas: Thank you, Peleg.