This article was published as part of a PitchBook VC Valuations Report for the first half of 2019.

What are the key trends across the late-stage, VC backed company universe that have evolved the most over the past five years? How has your business conducted with these companies evolved?

Stan: A significant shift from the business vantage point is the growth in sell-side due diligence assistance. Educating our clients around sell-side issues wasn’t as common five to seven years ago. In the last three years, however, the sell-side portion of our business has grown to nearly 40% of the overall quality of earnings (QoE) business. Buyers now expect a sell-side report at hand when they’re initiating transactions. Currently, everyone is always fundraising, so we’ve developed a continuous process of education for our clients. Companies come to us for sell-side QoE assistance in preparing to raise money or for introductions to kickstart the fundraising process. Since investors are more demanding given the sizes of rounds and valuations being asked, we must assist in justifying the quality of revenue, preparing for due diligence and more.

Thomas: The trend that immediately comes to mind is the massive increase in capital flowing into the market, but let’s put that in context. When I started with Moss Adams in 2014, it was already getting easier for companies to raise money from VCs after the difficult period between 2008 and 2011. Since then, it’s not that it’s become substantially easier to raise capital, but given the abundance of capital, there are multiple sources to target when companies are looking to raise. With that said, everyone is aware of this capital-rich environment, and there is consequently a degree of caution. In short, if you’re hurting in any way, it will be harder to raise money. However, some companies do elect to undertake more stringent terms as they strive to move capital to the next investment stage. Interestingly, much if not most of the capital that has flooded into the market is concentrated in a small percentage of the market (i.e. unicorns). There is a segment of the small but growing company population taking longer to raise capital.

Is it more a matter of demand, in that investors are much more cautious, or is it a matter of supply, in that companies that are looking to raise are simply not as alluring? How do companies stand out in this environment?

Thomas: It’s a nuanced balance between the two. We’ve seen an increase in the number of companies looking for funding, so regardless of an abundance of capital, investors need to be careful. Granted, the number of investors has also increased, given successful exits that generated angel investors or verified a firm’s investment strategy and enabled them to raise another fund. The key dynamic is whether the company can justify the valuation and attract money to help it progress to the next stage beyond capital considerations.

Stan: Often, companies opt to save on ensuring the fundamentals of clean books, strong corporate structure and clear controllership in the early stages. However, if you can thoroughly prepare in those areas, you demonstrate to investors your capacity for overall growth. Given how much money you can raise in this environment, the minute details of your company structure will be scrutinized by anyone outside of your existing investor relationships, so you must be responsive and ensure operations and accounting are squared away. Currently, there are unicorns going public that are impacted by an indefinite path to profitability.

How do you see those dynamics playing out across stages, from the earliest to the latest?

Stan: First off, from an investor’s perspective, everyone has their own interpretation of when a company is in early, late or growth stage. For me, growth stage doesn’t start until you have the fundamentals of traction, and many software businesses aren’t even profitable at that point. At the growth stage, it’s about predictable burn rates, expansion of existing production and sales and research and development (R&D) investment into additional products. Prior to that, companies are seeking traction, acquiring good customers and establishing the marketplace.

For example, at the early stage, I once worked as CFO with a software company that was performing decently, trending close to $10 million in recurring revenue. However, they had a legacy services business that was breakeven at best. When I arrived, the company was performing a debt refinancing, which made it clear the services business should be split out from the software business. They sold that legacy services unit, which then went on to be flipped by its acquirer for three times its initial price. Once that software business wasn’t burdened by its services unit, it was able to take off. Those are the types of decisions early stage companies often must make, and which enable companies to eventually move into the growth stage.

Thomas: Currently, companies are staying private longer and are continuing to raise significant amounts of money before they choose to go public. The timeline previously ranged between four and five years, but now, we often see timelines stretching upward of seven or eight years. More importantly, the companies we’ve worked with often fall into diverse camps. Some don’t plan on raising again and instead target an acquisition. Others look to keep raising until they are well positioned to go public. Where each company falls is usually determined by where they are in their lifecycle.

One unifying factor across all stages is a more dynamic, responsive fundraising strategy on the part of founders. From the investor side, we have seen some examples of significant accommodation—some players are willing to pay preferred prices for common stock ownership of well-positioned companies. Others are not so inclined, especially at the early stage. There simply is a proliferation of diverse responses and strategies in the current landscape at far greater scale than we’ve seen before.

On which issues do you work most closely with companies in this landscape?

Thomas: For companies that are looking to raise, there is an emphasis on revenue recognition, especially given Accounting Standard Codification (ASC) 606 coming into effect early this year. Investors will want clear financials in general; the more sophisticated firms can draw conclusions from even murky figures, but overall, the degree of clarity for which VCs are looking has only intensified.

For example, firms want to know aggregate contract value undertaken, duration of recognition periods, and sustainability and growth potential of the customer base. At the end of the day, multiples are a function of growth, which must be proven out. Companies must be able to tell a story of growth that is convincing over a potentially long timeframe because, as mentioned previously, timelines are increasingly protracted. When I began with Moss Adams in 2014, I had multiple clients that were concerned to be early stage (i.e. prerevenues or minimal revenues). These clients primarily had been founded over the last couple years. Five years later, we are still estimating four years to exit for one client; for another, three years. Most of the companies that we work with are targeting an acquisition. I most often with work with early-stage companies to tell a compelling story of their growth as they pursue an acquisition.

Stan: We work with the companies as they prepare for their financing rounds, so I’m most experienced in investigating matters from the investor’s side. To allude to an earlier question, what investors focus on tends to lead to frequent disconnect across stages. At the early stage, investors are primarily focused on the efficacy and applicability of the technology at the core of the business, whereas at the late stage, investors want more rigor in the financials (e.g. traction of revenue).

Let’s walk through an example of some metrics we use to analyze. From the investor’s side, I often look at headcount on top of sales in order to get started. Average cost per head should drop as development scales, and maintenance costs are optimized. Then, you target calculations of churn and renewal rates and see how dollars spent on sales versus R&D cost curves eventually intersect. Once they intersect, that means you have a mature product and can focus on going to market and sales. That’s where a company really becomes growth stage. Those signs are what aid investors in justifying different scales of valuations.

In the population of companies with which you work, are the majority in an indefinite status, wherein they’re still private and don’t have a clear path? Which proportion is more prepared to exit?

Thomas: It often depends on the size of the company. Some businesses have been around for close to a decade and aren’t prepared to go public, so M&A is the likelier option. A few are positioned for loss. Many of our smaller companies with the option of going public realize how onerous that shift can be (e.g. undergoing audits and the additional scrutiny of their financials). Those may opt to remain private. Some enterprises will always have an exit on their mind, which is usually the case for the Bay Area based companies with which we work, especially since they typically raise plenty of VC.

Are there other topics you’d like to address, or any responses you’d wish to expand upon?

Thomas: For those companies that can sustain themselves for longer periods of time without financing, there can be significantly less stress, and they can focus on their core business. After all, raising large rounds is complex and has tradeoffs. At what rights and preferences are you going to take on equity, and how will that dilute your current shareholders? If the funding can’t come through at the valuation you want, what is your response going to be? When you’re public, you have ups and downs and your performance is all over the place, but for private companies, they have not yet had that counterpart, public market experience. There are competing interests in and for any company, and you must have a solid plan in place to justify significant fundraises, as well as obtain them in the end.

Stan: Successful companies and investors understand that firms are really backing management, particularly at the early stage. Management teams need to be coachable and able to react and pivot. At the growth stage, you’re investing in the management team’s ability to articulate and execute a growth plan. You need to be able to answer not only all the questions your existing investors may have, but also what questions new investors coming into a round may have of both the management team and extant investors. New VC firms should also look for these signs, as they are hallmarks of quality management teams.

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