It has been a rough couple of years for startup founders, emerging from the pandemic only to find themselves in the grips of one of the toughest markets for venture capital and investing in recent history.
But there’s reason for optimism starting in the second half of this year, according to Gordon Pan, the president of Baird Capital, the Chicago-based venture capital and global private equity firm.
Pan spoke during a VIP reception sponsored by Baird in advance of the GeekWire Awards on Thursday evening. He was interviewed by Jonathan Sposato, the Seattle angel investor, serial tech entrepreneur, and GeekWire chairman.
“Focus on getting your fundamentals right, because I think the market’s coming your way,” Pan said, citing factors including pent-up demand from investors in predicting an upcoming rebound in funding and M&A deals.
After an era of growth at all costs, the key now is growing with discipline, Pan said, citing three fundamental metrics that Baird Capital weighs in potential investments: growth rate, net revenue retention, and capital efficiency.
Those are some of the takeaways from the interview. Watch the full video below, and continue reading for a transcript, edited for brevity and clarity.
Jonathan Sposato: What are some key attributes that a top firm like Baird Capital looks for when they think about investing in a new company? What are the things that are the most important to you?
Gordon Pan: I have to say, the fundamentals of investing haven’t changed. You want to back strong, proven management teams. You want to look at industries that are growing, that have really good trends, and you want to invest in companies that have a product or service that is highly differentiated. And if you have a company that has those things, it’ll show up in the financial results of your business, if you have a good management team, good marketing, and good product.
Sposato: When when I was starting out, I remember, the hashmarks were always, when you get to a certain point, you can do your seed round, your Series A, and you can’t even contemplate going public until you have $50 million to $55 million in annual recurring revenues. So what are these hashmarks now? For the operator CEOs out there, growing their companies, what are the important milestones that they need to think about?
Pan: The environment has completely changed. In a zero-rate environment, cash is basically free. And so it was all about growth at all costs.
Today, the environment has completely changed. Now it is all about growing, but in a disciplined manner. So it’s about capital efficiency. Now, a lot of firms are more focused on very specific, fundamental financial metrics. I’m going to give three metrics that we focus on that hopefully will be helpful to everybody here.
- First, we focus on growth rate. So if you’re going to be a Series A, B, or C company, you want to be growing at least 50% to 100%. If you’re not growing 100% and you’re an early stage company, you’re not going to get a lot of looks from a venture capital firm.
- The second one is net revenue retention. Net revenue retention focuses on the durability of your revenue model. So if you want to entice venture capital firms, you want to show at least 100%. If you bring in 90% of net revenue retention, we probably wouldn’t look at you. But if you have 115%, that’s exceptional performance. And we will be all over you. So that is another important metric.
- The other metric is the rule of 40. That measures capital efficiency. Today, it is about capital efficiency: how do you grow but in a prudent way. So we want to see businesses that grow, between their growth rate and their margin rate, at least 40%.
If you have those three things, you have a very attractive business model. If you have an attractive business model, people are going to be interested in talking to you. Then it’s going to be up to you to find the right partner. Make sure you find a partner that can deliver the value-add that you want.
Importantly, today, the market is changing. Every firm is specializing. So every firm is coming up with their value proposition that allows them to deliver value to you, as a management team. Make sure you find the one firm or two firms that can help you the most, because capital is a commodity for attractive companies.
Just remember that. You build the fundamental value in your business, then go find the right partner. And then the right partner will help you build the business to the next level, which is to hopefully take it public.
Sposato: We’ll zoom out to the million-dollar question that everybody’s interested in knowing, with the understanding that the current fundraising environment is difficult and challenging. First of all, level-set us on where we’re at today, and where you think it’s going, and perhaps some predictive thoughts about when it might get better.
Pan: This is a very important question. I think everybody in the audience is thinking about this, and I’ll share my perspective.
There is a lot of capital out there today, a lot of capital. There’s $300 billion of dry powder in the venture capital industry today, $300 billion. There’s $1 trillion in private equity dry powder today in the market. It’s all looking to be deployed.
The problem is that the buyer-seller expectations have not converged yet. The valuations are still just not level-set. If you’re a buyer today, relative to the last several years, you’re seeing higher interest rates. You’re seeing slower growth, geopolitical risk, an impending national election. All these things dampen down valuation from a buyer’s perspective.
The problem is, on the seller side, the people raising money, they have yet to fully capitulate to this idea that the valuations that were done over the last several years aren’t still valid today. People are waiting to see if they can get that same valuation. The problem is that only really the exceptional companies — exceptional companies with all the metrics I mentioned — and also operating in great markets, like AI, may warrant some of those valuations.
But the vast majority of companies today are not going to get the valuations that we saw over the last several years. So until that happens, until this capitulation happens, the markets not going to fully unlock.
The good news is it’s starting to unlock. We are seeing this. Our firm predicted it was going to happen at the end of last year. It didn’t happen. We thought it was going to happen in the first half of this year. It’s starting to happen.
And why? It’s because buyers are realizing we have a lot of money; we’ve got to spend it. Sellers, people who are raising capital, they’re realizing we need to raise the capital to drive our business model. So it’s starting to happen.
The good news is, I think that momentum is going to continue. My prediction and our internal team plans are that the back half of 2024, into 2025, are going to be very, very strong investment and M&A markets.
So my words of encouragement to all the entrepreneurs out there: Focus on getting your fundamentals right, because I think the market’s coming your way.
