Riding the Startup Roller Coaster - And Driving Optionality

Coney Island is known for many things - from the Cyclone roller coaster, to Nathan’s Famous hot dogs. While Nathan’s was born on Coney Island in 1916, and the Cyclone is nearly 100 years old -  Coney Island’s most significant sight is only operational in the history books. 

The Switchback Railway debuted at Coney Island in 1884, and was the first (modern) roller coaster ride designed for amusement. At 5 cents per ride (~$1.60 in today’s money), Switchback maxed out at 6 mph and lasted a minute. It also reportedly paid for itself within the first month of operation.  

Modern roller coasters easily max out over 100 mph (including Formula Rossa at 149 mph), and often cost far more than $1.60. However, the core concept is the same - thrills, adrenaline, and excitement…even for just a minute or two. 

Since I’m not a physicist, I’ll skip a “how coasters work” paragraph. However, amusement parks need the cars to stay on the tracks, need to keep riders in their cars, and do not want the cars to get stuck on the coaster. If there is not enough kinetic energy to make it up a hill, the ride ends, cars get stuck, and riders can get hurt. 

Startups are often equated to roller coasters, mainly from the founder perspective - for the frenetic pace, rapid twists/turns, and spikes of adrenaline. From the investor perspective, it’s a much slower ride - sometimes in all directions, along a far less predictable track. Some rides hit escape velocity very quickly, and march down the tracks. Others race around for years, and end up where they started (around a 1x return). And, some actually do get stuck, or fall off the tracks.  

Momentum (particularly related to ARR growth) is the overriding factor - most startups need to hit an escape velocity (i.e. build up a lot of potential energy and continually turn it into kinetic energy). Rapid growth and potential energy (sales pipeline) are a huge factor into who gets funded, how much they raise, and how quickly they can raise again. In many ways, it’s a race for market share and race to hit points of optionality. 

My portco founders are probably sick of me mentioning “optionality” to them…I’m probably a broken record at this point. However, optionality points boil down to this:

Controlling their destiny - either being able to very easily raise a healthy venture round, sell the company (but not need to) at a good multiple, or cut spending and hit sustainable breakeven (with the ability to continue to grow). Every business is different, but most B2B software businesses have healthy margins, and have strategic acquirers at certain ARR thresholds. $5m ARR and $10m ARR are two common thresholds - most seed stage companies try to race for $5m ARR and A/B stage companies race to $10m+ ARR. Some companies continue to race to bigger targets and thresholds (which vary with their total preference and debt stack too) - including $100m+. 

For both acquirers and VCs, there are a few core metrics that dictate their level of interest (to diligence and eventually write a check), and “fit.” Strong metrics equate to strong optionality. OK/good metrics with a high degree of control (breakeven or profitable without debt and with an appropriate preference stack) equates to good optionality. Optionality could mean opportunistically selling, opportunistically raising money, or even opportunistically making acquisitions. Most of these core metrics are part of the VC screening questions - and this list are just the three most common: 

ARR Growth - If a company is rapidly growing, and has accelerating growth (i.e. over the last quarter), they should have plenty of VC interest. Additionally, they will be able to generate FOMO on acquirers, quickly build a possible “margin of safety,” and eventually hit a sustainable breakeven point (where they could cut their burn close to 0 and still grow). When a startup is in rocket ship territory, most doors are open, and money is also cheap/easy (valuations, debt terms, etc). When/if ARR growth slows way down across a few quarters, startups can very quickly be mired in quicksand. Some founders will cut costs, and reorient the company with runway (i.e. will not need to raise more VC money). Some founders will double down on the burn, in hopes of reigniting growth. And some founders will just try to sell the business (can be good, or really bad in these cases). However, when growth stalls (or things get messy with the cap table/preference stack), exit multiples tend to drop quickly. 

Net Burn - Most founders use VC money to generate potential energy - and hopefully translate it into kinetic ARR growth. The results vary widely, and often dictate the “winners” from the “losers.” In most cases, burn rapidly increases after a funding round, to generate enough momentum for the next future round. Hires take time to get up to speed, prospective clients take time moving through the pipeline stages, and existing clients take time to be upsold (or provide client referrals). When spend translates into efficient and quick ARR growth, things are great. When spend translates into slower ARR growth, things can get bumpy. Founders often lean on insider-led bridge rounds to buy time to either turn a real corner, or hit rapid growth. However, I’ve seen many founders lean on several insider bridge rounds, or even lean into heavier spending after raising a new round (without efficient growth pathways). It’s akin to throwing very expensive spaghetti at the wall, and hoping it sticks. In these cases, founders can very quickly dig themselves into deeper holes (where they cannot get out). From the acquisition lens, high burn and/or a heavy preference (or debt) load, coupled with less than amazing growth = terrible outcomes. There is a gigantic exit multiple difference between a $5m ARR company growing 100%+ with realistic burn, growing 25%-50% near/at breakeven, and a company burning $250k/month with marginal growth. The 100%+ grower likely has financing options and exit opportunities. The 25%-50% grower can opportunistically sell (or even raise if growth picks back up). And, the slow grower with burn (with a likely already bad preference stack) has generally only bad options. 

Net and Gross Retention - Strong net retention is a good indicator of product value, and team quality (i.e. having the right people in client facing roles). It’s also a sign that the revenue is sticky, and that LTVs could be strong (i.e. the revenue bucket does not leak - it actually refills itself). There are plenty of ways to game the system so to speak, but good net retention figures help with cash flow, and an ability to hit sustainable breakeven. It also helps drive better exit multiples, gather more LOIs, and even raise venture money at better terms. 

I could write very long newsletters on any of these three metrics (there is much more nuance than above). However, there is a very common theme I see when companies start an M&A process (with or without a banker), or raise a round:

If a company has runaway growth (especially if it’s increasing quarter over quarter), and is doing it even somewhat efficiently, they’ll have good optionality. Acquirers will usually pay higher multiples, VCs will pay higher valuations (and write bigger checks), and the level of interest from everyone is dramatically higher. Founders can drive real FOMO and urgency - and play everyone off each other. Once/if growth stalls, founders almost always turn to their boards. Some boards sign off on small cuts, or even more spending. Some boards set firm targets, and then decisively act (usually making serious cuts to hit breakeven once they miss growth targets, plus injecting a small bridge round). And some boards just decide to sell off the company and move on (for a bad price). 

As a VC, I’ve seen all these scenarios unfold - across a giant range of outcomes. The best founders know when, and how to spend. Or in other words, the best founders know how to translate potential energy into kinetic energy at the right times. They’ll know when to raise, or when to sell too. At the end of the day, having real optionality is often the difference between smiling at the end of the ride – or getting stuck on the tracks.