Episode 37: Matthew J. Safaii of Arrowroot Capital on
Improving Alignment in Software Investments

Episode Transcript

Shiv: All right, Matthew, welcome to the show. How's it going? 

Matthew: Not bad, how are you?

Shiv: Good, good. Excited to have you on. Why don't we get started by sharing your background and what you do at Arrowroot and your mandate and we'll go from there.

Matthew: Sure, sure. Been a software investor since early 2000s, couple startups along the way, been at firms like Platinum Equity and TA Associates, ICG, which turned into Actua, and then started Arrowroot Capital. We're in our 11th year now.

Shiv: That's awesome. Actually, TA is a very close partner of ours and we've worked on about 40% of their portfolio. So I'm sure we have some common friends. But the other thing that's interesting about your background is you were on the board of directors of the Aston Martin F1 team. Talk a little bit about that.

Matthew: Yeah, I know an advisor there got connected with them when they were changing from Racing Point to Aston Martin and helped them out with some software contacts, helped them out with sponsorships. And it became more of a passion project, let's call it, which I'm a big enthusiast.

Shiv: Same here. I'm actually going to the F1 race in Montreal in a few weeks. So really down the street, but I've never been so super excited for that.

Matthew: You're going to Montreal race. It's a great race. It's a great - This weekend is Monaco, so I'm not going there. I wish I was. Yeah.

Shiv: That's a bucket list item. So yeah, we could jam out about that another time, but transitioning to Arrowroot, we talk a bit about the types of companies you're investing in and what you look for when you're partnering with a business.

Matthew: Sure, sure. So we invest $10 to $100 million at a time. Sweet spot's probably more in the 15 to 50 range. We look for $5 million ARR plus. Really, it's probably more like $10 million ARR. And look for all the traditional metrics everyone looks for. High retention rates, sales and marketing efficiencies working, gross margins are getting there, et cetera, et cetera, not too - not sticklers about profitability, which I think a lot of people are in today's environment, potentially, rightfully so. That's where shareholder value is. But if they have all the right metrics and it's working and they just need some more gas in the tank, that's what we're here for. We certainly look for great managing teams and, you know, the more confident managing teams raise their hand more for help and we want to help them as much as possible. We do it globally. So three deals in Australia, have done deals in South Africa and Israel, et cetera.

Shiv: That's awesome. And there are a ton of these companies, or PE firms rather, that are investing in software companies around this 10 million plus range. And so what really separates out what you're doing at Arrowroot and how do you differentiate yourselves?

Matthew: Good question. I think it goes to the, you know, we'll deal with - so the 10 year bull market, and even today, VC growth, PE lenders, they all act like themselves. They all act like they have rules, growth rates, profitability, size of check, ownership, size of ARR, whatever it might be. And we push that aside and say, we are experts in this space, and software, enterprise software, just in general, just broadly speaking. And we can actually structure things accordingly to make a return that's aligning with management and the past investors, if they are there. And we put those rules aside where we can act like all of the above, right? Giving liquidity out like private equity, growth capital, where the company may not need capital, but if they've had more, they grow. VC if they're, if they are in a burn and there's a need for capital. And then even debt where we come in with more of a structured equity type feature because it's needed for aligning reasons just from where the company is. All while being growth oriented and while being management friendly, which is quite different.

Shiv: And you said something to me right before we started recording. And I want to touch on that. You said that SaaS companies take a lot more money and time. So expand on that concept and how you look at that as you’re vetting companies and looking at who you're going to invest in.

Matthew: Yeah, we've invested in bootstrap companies. We've invested in businesses that have, you know, name the alphabet letter far down the line of rounds. And, you know, enterprise software companies, a lot of them - some, not a lot - hit it out of the park, right? And they're growing companies and they do a bootstrap or they one or two rounds and they're off to the races. But for the most part, enterprise software companies take more money, more time than people think. And that's for various reasons, especially in enterprise software.

One is the VCs, which have a binary outcome mentality, right? They, they need to bet on a market potentially early and sometimes they bet on it too early and the market doesn't come to them yet. And that takes time. So you could burn money there. Two is you could have the wrong go to market motion. You know, maybe you're trying channel sales and should have been direct. Maybe you're targeting the wrong profile, the customer, wrong persona at the individual and customer. Maybe you're targeting SMBs and it should have been more mid-market type businesses. You know, there can be problems with management teams early and management teams changing over, which is a reset in time-wise. 

Also in enterprise software, it takes a long time to build the right product. All the various integrations and some need replatforming, et cetera, keep up with the Joneses around them and the various other competitors they have.

And then lastly - probably not only lastly - there's probably others, but enterprise software, they're long sales cycles. And if you miss-forecast that, you get the wrong forecast there and you think it's gonna be nine month sales cycles, but it's really 12 to 15, that's cash burn, right? And then the last thing I will say is that mishaps happen, right? You have five salespeople, you have $500,000 quotas, you're growing at most $2.5 million. Two salespeople happen to leave because they got a job at, you know, Datadog and wherever, Salesforce, you know, you lost - you lost a million dollars of quota. And then it takes time to get people butts-in-seats, to get them productive. And then you're starting that sales cycle again, right? And that's just bound to happen and not everybody forecasts that.

Shiv: And so how are you - and this is a reality of a lot of companies, right? Either they're still trying to find product market fit or trying to figure out who their ICP is or getting their go to market right. And then also the technology needs to catch up and then you need certain feature sets to stay competitive. And then you have this sales motion and sales cycle and all this. So how do you account for all of that as you're looking at companies to see, is this a good business and worthy of deploying capital into, especially if you know that they're going to either be burning cash or it's going to take them some time to to recover that cash. So you're infusing into the business.

Matthew: Sure. Scale does it. Just scale of ARR, because that's probably more history of the customers, renewal cycles, hopefully a better cadence in sales, and it just de-risks the forecast that you're underwriting to. Back - this is dating here, but this is probably 13, 14 years ago. You got multiple expansion when you hit one million of monthly recurring revenue.

14 years ago there was all the SaaS businesses worth three, four, five million dollars. But if you happen to hit that one million of MRR, that's when multiple expansion happened. And multiple expansion back then was seven to eight times revenue, by the way. And everyone thought that was bonkers. But when you get to $12 million of ARR, if you have traditional gross margins, call it 70 to 80%. If you have a certain percentage of revenue, R&D, G&A, and then you want to be a break-even business, what's left over in sales and marketing should, if you have good sales and marketing efficiency, still should equate you to be a 20% plus grower. Not saying all those companies were doing that in terms of the burn or being break-even or profitable, but the fact is you get it to a break-even stance if your metrics are good at that scale. And that's when you de-risk things. So scale helps out all there. We wouldn't blow 10 million of ARR to look at, but they have to be very nice businesses, have gone through renewal cycles, not have the customer concentration, have a good history of selling, but something is hitting that inflection point. You can see it in the numbers.

Shiv: Right. Yeah. And I guess you're saying that because one of the things that I've noticed is just healthy businesses seem to have similar fundamentals, right? They have great net revenue retention. Maybe they're growing at a certain rate. They have healthy EBITDA margins, gross margins, et cetera. And so the valuation of those companies is at a premium and there's all this capital kind of chasing similar companies. So how do you drive alpha in that type of an environment where companies are at a premium valuation and there's just so much dry powder chasing after those same assets?

Matthew: Yeah, I'm sure the cost of capital is going down, which is driving up valuations. For us, it's trying to find value where others aren't, right? And that's very simple to say, but it's company - And then that goes back to the structuring. So if it's a bootstrap business and the management team, founders, they're believers, and they'd rather take a higher valuation because they're dilution sensitive and take more structure, yes, it might take away some of the upside for us, but it is a good deal and we can figure that out together. You know, on other sides of it is, you know, there could be A through G rounds. You could have $180 million put into a company that's doing $25 million of ARR. And maybe their sales and marketing efficiency has been getting better over time and it wasn't because all the various reasons we said why they burned too much money. And, you know, maybe it's, if you talk to everybody, the employees, it's an all -star company, right? The culture's there, everyone thinks they're winning. But if you look at the cap table, it's too little too late for these VCs. They've been in it for nine years. They burned a lot of money. It's doing 25, but they hit this inflection point and it's been scarlet lettered in the market. 

And, you know, it's finding those companies at that right time, seeing value where people are in and then partnering up with management team, trying to align the past cap table around it and getting management with us and truly being a partner there.

And again, it goes to what you said. And at that moment in time, you know, it burned all this money and it was burning money in the past and sales marketing efficiency wasn't as good. You could see it in the net retention and the gross retention. The gross margins are getting better. Sales and marketing efficiency is getting better. And maybe they tweak things along the way to get there. Or maybe the market just came to them.

Shiv: Right. Yeah. And so is that where you're seeing value or maybe others aren't is the misalignment in the cap table and finding the right moment to come into these companies?

Matthew: Yeah, I think that's some of the business we do. I mean, we do a lot of other more traditional looking deals. We're going to do - if it's a good returning deal and it doesn't have to be all the structure on it at all. Right. And those, how do you find those? That's, one, acting as advertised, right? Being a good partner because CEOs are part of all other CEO groups, you know, the YPO's of the world, they all talk to each other.

Other investors know from the other boards you're on, you act as advertised and you're about growth and you're about helping and demonstrably helping. And yet you have all the various stakeholders to pull in deals. So you're seeing deals that others aren't per se. And I don't want to say proprietary because I think everybody's talking to everybody and it's used for proprietary is hard today. But it's a deal at the right time and making that relationship with management. Relationships are everything.

Shiv: Totally. Yeah, everybody's - everybody talks and in those CEO groups definitely it's shared like who's a good investor and where are you? Which investors have treated you better than others like that information gets out so quickly. So.

Matthew: Oh, long-term greedy, right? You got to treat the management team great and act as advertised. 100%.

Shiv: Yeah, totally. Expand on this concept of the misalignment on the cap table a little bit more, just for the audience and even for my sake, just what are some of the common misalignments that you come across?

Matthew: Yeah. A big misalignment is on the cap table is management ownership and preference stacks. And, you know, it's - in the past, as an earlier stage company, you're a believer and God bless that. And so you don't mind this structure, but when it starts piling on top of each other, piling on top of each other, and you're doing many rounds over, if you're a founder, management team, all of a sudden you can own less than 15% of the company and have all this pref, but you have an amazing business that's growing and adding value, et cetera, et cetera. And those management teams, when you are, you know, you can get to a place where not everybody's going to win, even though there's value at the company, because the VCs are looking for 10X or zero and the management team obviously wants enough. And so when we go into the business, it's let's take care of this so everybody wins. 

You know, we love participation from the last investors just so they're aligned with us in our round. There's carve outs up top. So the manager team gets a piece of any type of exit or re optioning them up so they get more of the business. And essentially it's, it's taking a look at the company and saying with this money, it's going to get to - it's going to go from X, you know, to Y ARR. And at Y ARR, it's going to be valued at some range, right? Be it a $200 to $300 million exit, let's just say. Well, in that $200 to $300 million exit, we want to make our return. We want to make sure management makes enough of the return. So they're excited to sell in that range. And then on top of it, you've got to look at the past investors and say, do they all make enough? Right? Because everyone's got to agree to sell together and be happy about it. You know, the misalignments are paralyzing. Paralysis is devalued.

Shiv: Do you think part of it is just that founders are raising money too early in the process or are they giving up too much equity in the process as well?

Matthew: No, I don't think it's that. I think it's because the market is what it is. If you're going to take money on it, the market will set the terms and the value. So as long as you're talking to a few people. And so that's fine. But it's just knowing who you're getting bed with. The traditional VCs - and this isn't they're bad people. It's just their model. They're playing the game. If they invest in 20, that two are going to be home runs, And you know, eight are going to be good and 10 will be bad.

You don't know what - they just are betting on that and to you. And so with that mentality, they are going to just keep putting money in. And I think the CEOs just need to be cognizant of that, right? And the management.

Shiv: Yeah, I've talked about this with a lot of investors where I think founders need to have like a high degree of self-awareness of what type of company are you building? You know, if you, if you think you're like the next Facebook and you start raising money like that, but it turns out you're just a standard SaaS company that whose potential is like 25, maybe a hundred million dollars, you're going to raise very differently. And so knowing what you are changes that fundraising structure and which investor you're partnered with. And how much equity you try to retain in the process and how decisions are ultimately made. So I think that maybe there's like a mismatch on that front where founders judge their companies as one thing and so do the investors. And so you end up getting misaligned over time.

Matthew: Yes, it's a great, great point. And you do have to know what the management team's thinking and have a real heart to heart because if you are trying to turn this into a billion dollar business and we're thinking that this is our last round, you know, but it's not going to be, well, there's other investors for that. And we'll probably connect you with people we think are top shelf, right? To help that cause. And I think that's right. There's - I think it's something like - this was maybe an old data point, but it was like less than 5% of SaaS companies sell for over a hundred million bucks. Like, like 5% of SaaS companies, software companies sell for over a hundred million dollars. Over time. I mean, it could take 15 years. Like it's, it's, you know, you're, you're talking one in, you know, 20 to 40 companies here, that are backed. And so you just gotta be cognizant of that. And a lot of the times in the businesses in later stage where there has been a lot of money raised, there's professional CEOs in place.

Shiv: Mm hmm. Yeah, you might, you might have one turn PE investor comes in and then they lay on acquisitions and other things happen. And then collectively that entity is sold for more, but a founder led business selling for a hundred million dollars plus is far more rare.

Matthew: Yeah, it's, it's, and then the professional management teams, they understand, and their awareness, as you stated, Shiv, it doesn't matter what value the company is when they come in at, that their mentality is, Hey, look, if I'm making three, five, $10, $20 million in the next three years, because they're not thinking about - I mean, the average VC hold today is 8.9 years, and so, you know, that's a lot of money and it is a lot of money. I mean, there's no way around it. Right? And, and a lot of our businesses - I don't know, I don't want to say a percentage, but a heavy minority, maybe 30% of them, there was professional CEOs in place from the past investors, but the founders are still there doing what they're good at, which is being an evangelist in the market or being the CTO and being head of just really developing that product and being the thought leader. Or maybe it was a very salesy CEO that's now just out there and managing the sales team and being the whale hunter. And it's a good outcome. It's a great outcome for everybody, right?

Shiv: Yeah, I think in those kinds of situations, retaining the founder is so valuable because they have all this institutional knowledge. And oftentimes you see in companies when the founder leaves, you kind of lose part of that secret sauce that made that business great in the first place.

Matthew: 100% and it's good for the employees, good for culture, it's good to hear that they typically can double click in an industry quite well. And no scenarios, the biggest ones that have worked I've seen are the ones that where the founder still has a very good relationship with the new CEO and is very mature about it all.

Shiv: Yeah, and I guess the value of the professional CEO there, as you're saying, is just to professionalize the business and take it to the next level of growth, right? Which maybe the founder is not in their sweet spot to do that.

Matthew: That's right. It's institutionalize it. This person has been in front of many boards, so know how to handle the boards through the ups and downs. And then also typically as a person who has driven companies to exits - because an exit process, you know, it's not like everyone has been through it.

Shiv: Right. Not everybody's been through that and knows what it takes. So is that the main thing that you're looking for in that professional CEO? Are there other characteristics that when you're bringing in a professional CEO, you're trying to bring into these founder led companies?

Matthew: Yeah, someone that can communicate with the board. Someone that is a very balanced person, because it's not always rainbows and butterflies. Somebody who has deep relationships for partnerships and corporate development. Typically somebody who has been through fundraises, be it debt raises, be it equity raises, depending on the situation, someone who has done add-on acquisitions and integrations in the past. But, you know, it probably is a bit of a bespoke for every situation for the company.

Shiv: Yeah, and expand on this point about just the companies getting to a point where realizing that, hey, in general, founder led companies don't exit for more than $100 million. And so how should that change behavior upfront when you're thinking about your software company as a founder, as you're trying to build it out and thinking about fundraising and actually eventually exiting it at some point?

Matthew: I would say it depends on the person, Shiv. I mean, the people that make billion dollar companies are the ones that set out to make a billion dollar company. Right. But I think they just have to know that there is a chance that failure happens. And for that type of result. But also be malleable and be committed to the company, to a point - unless they want to bring the professional CEO themselves - that there will be some pitfalls along the way and you know, this might end up being a $200 million exit, $150 or $50 million. And then that's all great if they're comfortable with that through it all. I mean, some people are just hard charging, want to make a billion dollar company, especially somebody who's had a couple of exits below them and has resources, et cetera. And that's awesome too. So it goes back to what you said, just be aware.

Shiv: When should a - this is a tricky question, obviously you're in this business, but just curious for your take. When should a founder not take on capital or delay that because they're in a specific stage where maybe it's not as necessary? How do you see that?

Matthew: Tough question. There's so many variables there. Again, what does the founder want? You could have a $20 million business that's making five EBITDA, growing 40% year over year, That's probably worth, I don't know, $150 million. And just making numbers up here, but maybe that is good enough, right?

But you can take that same person and say, no way, I want to raise money because I want to do an acquisition of a same size company because I want to just keep going. I, you know, for, for me personally, if I were to start a company, I would just want to make sure that I was raising - and it depends on the economic environment - but I had proper uses for the capital. And it was very confident in the assumptions I was making, such as if sales and marketing efficiency is so-and-so, however it might be, and I'm at five salespeople again, and I want to go to 10 salespeople, then I'm making the correct assumption of what's going to happen there with the sales and marketing efficiency and not drink the Kool-Aid. If you're just taking on capital because you're burning and it's just the right thing, you raise a series B after a series A, and that's your mindset, bit of a question mark.

Shiv: Yeah, I think a lot of companies actually, even just a couple of years ago, you were seeing tons of companies almost get unicorn valuations, raising $100 million a year, $200 million there. And there were a lot of assumptions that were incorrect in some of those valuations and investors had to write down some of those assets or we'll have to.

Matthew: if they got some silly valuation or high valuation, which is probably normal at the time, and they weren't getting diluted as much and there wasn't a lot of controls and provisions and bells and whistles, then that was probably a great move for them.

Shiv: Right, because they're stocking up their cash reserves and they're able to ride out this time a lot better.

Matthew: Yes. Right. And but you have to be aware that if it doesn't go as planned, it might not have been as dilutive. But if four or five years passes and you're still not around that valuation, that misalignment occurs with the cap here. And please be aware of that.

Shiv: Right, right. But what are the - just help me understand in that situation, as the market turns, right - and it has turned with the interest rates and everything - but you've raised that kind of capital, you're in a really great place because you can say, hey, we know that our customers are not spending as much money or purchasing the way they were 18 to 24 months ago. So instead of over-investing in sales and marketing today to hit our targets, we're gonna be efficient right now until the market turns again and then be more aggressive with this capital at some point. Isn't that like a way to get to alignment even though maybe you're missing on sales projections?

Matthew: Well, it depends on what the valuation is. It depends also what type of returns a past investor is looking for. If you get an investor and they were looking to make two or three times their money more in the private equity mindset, that's one thing. But if you were going with an earlier stage San Al Road firm that needs a 10x plus or a zero, or something that's not 10x, that's different. It's a different mentality. And then going back to what  - In this down market, if you have the right metrics and you're upscale, you can make some changes to become profitable and slower growing. And that actually is increasing shareholder value and just getting out of the mentality of, you know, growing at - if I'm growing at 50% and not 30%, that 50% is worth more. Well, no, if you're a breakeven company, comfortable to making some cash flows, no, actually in this market, it sits cashless.

Shiv: Isn't the - so we talked about self-awareness for founders, like doesn't, doesn't a similar concept apply to the investor, right? And I get like a PE firm, 3-5X, they're going to be quite happy over a seven year period if they return that kind of, if they return the fund in that way. But on the side of investors that are making these large scale bets and expect 10X returns and have a bunch of these bets out there, isn't there like a conversation about self-awareness there too, because you can't force a business to grow into something that it's incapable of growing into as the market changes, especially, right? Certain things are affected by macro factor. Certain things are affected by the realities of consumers or existing customers or what have you. So how do you bridge that gap on the investor's side?

Matthew: You're saying in terms of it's just not hitting the underwriting, you're not hitting the forecast. And then how do you act as an investor?

Shiv: Yeah, for example, you could change out the CEO, you could fire the CRO, this type of stuff happens all the time, but maybe the business is just not as a vehicle capable of going there in current market conditions. And you kind of need to have like a reset of expectations, regardless of what you expected out of that investment initially when you deployed that capital.

Matthew: So as a founder, management team, you need to do the reverse diligence that I think a lot of founders don't do, especially at the earlier stage. Talk to every CEO that that investor sits on the board of - not just the firm, that individual. Ask about the ups and downs. What happened when you missed three quarters in a row sales forecasts? What happens in a downturn in the market? What happens when there was a cash crunch? Not just, you know - everyone sings when they win, right? Like that, not just when they upside and how do they act? And I've been on many boards and I've seen various ways some people have acted and some people are emotional volatile and some people are so even keeled and, you, you definitely want a balanced person at the board. That's one. 

Two is the founder CEO should ask - if in a downturn or if in a situation - try to find a situation where they weren't making the returns they were going to make. And that was pretty evident. Not only were they balanced, but did they still want to help? Did they still want to get involved? I mean, that board member is probably on eight other boards, you know, seven, 10 other boards and their own personal juices with the winners. And they want to spend all the time of the world on them. And just you want somebody who's going to be responsive, someone who's going to be helpful, still bringing in resource during downturn and then overarching that is just someone who is balanced.

Shiv: Yeah, I think that's phenomenal advice. Just the reverse diligence and understanding who are you actually adding to your management layer or investor layer in your organization so that when the going gets tough, like when people really - that's when real personalities actually come out. Is this somebody that you are going to be able to negotiate with and have tough conversations with and navigate uncertainty with? I think that's great advice. I don't think founders do that enough.

Matthew: No, especially at the earlier stage, because again, that average hold is nearly nine years for a VC, right? This is a marriage. You're not getting out of it. And you've got to get reverse diligence. In the later stages, if you have other investors or you bring somebody in, it's probably a shorter hold. But still, you've got to be aware, right? It's everything you've worked for, who you're bringing on board.

Shiv: Totally, totally. And I think the marriage analogy is very appropriate and you are stuck together. And I think sometimes in the early days founders are just happy to get capital because they -

Matthew: 100%. And the same goes for lenders. When you're bringing on any venture debt or traditional debt, you do want to do reverse diligence there and how have they acted. And of course, hopefully it never occurs, but you got to prepare for the worst.

Shiv: Yeah. And so beyond just talking to other CEOs and - of that investor, what are some other things founders can do to do this reverse diligence so that they feel like they've gotten their bases covered?

Matthew: Yeah, well talk to other CEOs that have been through it who have raised a lot of money and talk to them about their experience. You know, maybe what other - if you're bringing on a firm, what has that firm done for other companies and the winners and losers? I do think it's more about the individual partner or professional investment professional on your board rather than the firm. But there is an overarching culture of various firms that you need to be cognizant of. But it is really more around the individual. In this day of Zooms - when it wasn't Zoom, we were spending - like at TA, you'd spend a lot of time with management before you did a deal. And today it's not uncommon to go through all of diligence and management presentations and everything with Zoom and all you did was one big in-person management presentation and maybe a dinner along the way.

Shiv: Right.

Matthew: Again, marriage analogy. I mean, it's not a marriage. It's not a marriage. It's not a marriage. Go, you know, go meet the people. Go meet the people. Meet the firm. Meet the other partners. And if they're very serious about your business, they'll open the doors to that too. To when you want it.

Shiv: I think that's a great message and a great note to end the episode on. But with that said, Matt, thanks for coming on and sharing this wisdom. I think a lot of founders, when they're thinking about how to raise capital, who to partner with, and how to plan out the vision for their business, can learn a lot from it. So I appreciate you coming on and sharing your experience. Thanks.

Matthew: Yeah, thanks for having me on. All right, take care.