How to Buy Companies That Aren't Profitable Yet

How VCs Value Early-Stage Companies

[VCs] are really valuing companies on two major pieces, with a couple of secondary pieces. The two major pieces are the reputation and scalability of the management team. Being a previous founder or a large company executive really helps with your fundraising and valuation. The other thing they're trying to fit is: what is the opportunity for market disruption? That's where you're going into seed rounds, Series A, Series B, trying to prove out that there's a large market and that you have a product you've developed or are building that fits that large market.

What a VC is looking at is the potential for a company to capture revenue over its funding cycle, which is usually eighteen to twenty-four months. In a lot of ways, a VC is valuing a company today at what they believe the company will be in a year and a half or two years from now. They de-risk that by understanding how big the market is and the problem that company is solving.

Where the Valuation Disconnect Happens

Valuation dynamics change, and they change based on the market. The disruption of the VC life cycle for companies like Anthropic or OpenAI hasn't happened yet. If you look at previous cycles, companies that had large consumer followings never really got to profitability. We hung on to "grow at all costs" in the last cycle a lot longer than the metrics would tell you.

The disruption happens as growth in a market starts to decline or stall. Depending on the market you're in or the type of asset you're building, you can feel that disruption as early as the Series B round, where you have to go to growth capital and you start looking at profitable growth versus market capture share.

Where I'm typically seeing this in today's environment is that disruption is truly happening even before the Series B round in enterprise software and cybersecurity. The reason is that AI trends have really disrupted how quickly a company can scale into its value proposition.

The old adage of triple, triple, triple. For anyone who doesn't know what that is, to get your Series A through a venture capital fundraise in previous years, you had to convince the VC that you and the management team could triple your revenue every year for three years. So if you started with a million, you'd get to three million, then nine million, then twenty-seven million. That curve was an acceptable curve to get to pretty standardized valuations.

With AI, that curve is steepening. In certain markets, people are expecting you to 10X in a year. That's why you're seeing valuations in certain markets that are way ahead of where the revenue is. VCs are betting on the disruption of a major incumbent and believing that a company at a million can get to ten million in the first year, and then from ten million to a hundred million in year two. We aren't seeing that pace, but that is the belief of a lot of VC firms. The number of assets they believe will do that are much smaller, so you're really seeing a two-way market for VC right now. One where those appointed at large markets with AI-native technologies and a solid management team are getting multiples that don't make sense to a lot of people, and everybody else who is struggling for fundraising. What we're seeing is a higher concentration in fewer assets with higher valuations.

Profitable Growth and the Rule of Forty

When growth stalls, you need to start thinking about EBITDA and profitable growth. Rule of forty (for everyone who doesn't know): you take your growth rate from the last year and your EBITDA percentage, add them together. If it equals forty, you've optimized your business at scalable growth.

With some of what we're seeing in the AI market, there's a lot of literature coming out that says forty should be fifty or fifty-five percent to be a well-run SaaS company. But that is ignoring the investments needed in AI or the true token cost of usage for the various AI platforms. We are still in this period where people are pointing towards the old standard of forty percent. The theory says it should be higher because of AI, but no one really knows what good looks like right now.

That growth premium is still persisting. It's collapsing a little in the current market. Growth is two to three, three and a half times more valuable than a percentage point of earnings. So how you get to that forty by adding the two together does matter. If you're growing at thirty percent and you have a ten percent EBITDA margin, that company is generally worth more than if you have twenty percent growth and twenty percent EBITDA margin. The empirical evidence shows that has persisted for a very long time, because growth allows more optionality for the company to invest in areas that it deems fit and makes the company more flexible in its areas of expansion.

Zero percent earnings is always really hard. What I think is happening is that even though it is valued higher, there is more risk in that operating model because you don't have the ability to absorb a shock. That depends on the strength of the balance sheet, the investor base, and cash reserves.

Going that far used to be the standard. Forty-zero was better than thirty-ten. In the current environment, folks in corp dev are looking for companies they can get profitability into over time, so that forty-zero mix is becoming less valuable now than it was even three or four years ago.

The Current Deal Environment for Venture-Backed Targets

The deal environment has changed even in the last three to six weeks. With some of the recent advancements in AI, the defensible moat of a lot of companies, even startups, has shrunk.

What we're seeing is a bunch of assets that have had stalled growth but are remaining subscale. They don't have a customer list you would need for a technology in an area safe from AI intrusion in the short term. Those assets are stalling in their sale processes because nobody wants to catch a falling knife. You never want to get to the point where you got a good deal but you could get a great deal.

There is a portion of the market that is totally locked up, where the threat of the next generation of AI is making the value proposition of the company less valuable. The other side, where VCs are really dug in, are opportunities where it is an AI-native development team. They have historical data that is of value. They have a loyal customer base or the starts of one. They have a unique value proposition. Those are the ones where you're competing against the promise of VC right now, but those are the assets that have the greater potential for growth.

I think the strategy that the company has is pointing it toward one way or the other: am I trying to find a company that has been disrupted by AI and I want to transform that within my ownership? Or am I looking for areas of growth? At Jamf, we have a unique situation being focused on the Apple ecosystem, where we're actually trying to balance both of those aspects at the same time. We're looking for assets that have real growth potential, while also looking at areas of competition and availability, where finding a competitor that has been disruptive, has earnings, and is still growing is of interest.

AI Disruption of Wrapper Products and Acquihires

For wrapper products, the threat isn't competitors. The threat is the customers themselves using AI to vibe-code out another solution. A lot of the startups that happened in the last year that were AI-native have already been disrupted by the LLMs themselves.

Those wrapper products were great. They had good knowledge of a specific domain. But the large language model tools have become so capable that an expert without a technical background can get to those workflows or tools the same way a development team did six to twelve months ago. There's a real disruption of wrapper products, and at that point, you're really just doing a hiring exercise. They know how to use AI natively. They were wrapping a product, so they've shown an understanding of how the LLM works.

There's always been in the software industry a view of acquihires. Typically, an engineer or team would go for about $500,000 per engineer. In this environment, an AI-enabled or AI-enlightened engineer is going for anywhere from $750,000 to $1.2 million per head because companies are looking for that expertise. But at that point, the technology they built or the early customer traction is almost entirely discounted.

On the other side, companies in more protected use cases, where the actual IP matters or the IP is protected from the LLM, still carry real value. Think about defense contractors or someone who has developed a system to deal with medical records within the Department of Defense or the VA. The LLMs aren't going to understand the complexities of those systems or the rules on protecting the data. The IP there still has more value. The IP in those areas is more significant precisely because there's a protected moat.

Negotiating Valuation with Founders

There are two elements to negotiating valuation with founders. The first is very human in nature. You have to develop a relationship with the founder, the founding team, the operating team, so they'll actually listen to your advice. You have to know their investors. You have to be talking to their investors. You have to know the bankers that might be bringing them to market. But if you don't have a relationship with the founding team, you're just competing against a process.

Building that relationship is really important. Doing that when they're not just starting their funding cycle is another important approach, because nobody listens to what is viewed as an adversarial stranger when you're out there fundraising.

When you are in that position, there's a really important piece to the counseling you give a startup: what is your risk tolerance? Because remember, these folks will grow at all costs. Let's say you raise ten million on a hundred-million-dollar valuation as a company that has a million dollars in revenue. You better get to ten million of revenue by the time you're at about eighteen months, or your cash burn is going to put you out of business.

The way the VC sets this up is: here's ten million bucks, give me fifteen percent of your cap table. The entrepreneur is negotiating that percentage of the valuation most of the time. You then have complete power over the company, because you say to the founder, "Go spend it." And you take your cash burn from breakeven to spending about $500,000 more every month than you make. If you're not growing to that ten million by the end of eighteen months, then you are in a really bad position as a founder, where that all-in growth bet basically means that the asset you thought was worth $100 million is worth zero.

I'm not actually coaching an entrepreneur through their valuation at that point. I am coaching them through their own risk tolerance, their own view of their market, and trying to shape their view of when do you think you'll be worth $100 million?

As soon as I can start to get them to think about that horizon, I can say: as a scaled business, you're only going to trade at five to eight times or eight to ten times revenue, which means to get to that $100 million, you need to be at $12 to $15 million in revenue. Do you think you can get there in eighteen months?

Then I start to talk to them about the dynamics of the deal they're actually agreeing to, which usually has liquidation preference, voting rights preferences, and different tools where, even if they hit that plan, the entrepreneur's share is lower than they would get in a direct deal now.

A $25 million M&A deal today can be just as valuable to a founding team as a $125 million deal three years from now that a VC has funded them. Because of the mechanisms of liquidation preference and the overall venture exit plans, that difference in a VC valuation tells you what you need to sell for in two years to be equal to what you would take today.

Stakeholder Mapping for Founders

One of the first conversations I have when starting the conversation around risk profile and goals, I very clearly point out to the founder: there are about seven or eight different key stakeholders you need to think about. A lot of them sit back and go, "How many?"

You've got to think about your investors. You've got to think about yourself. Not just you as someone who created this, but you as an employee, you as a supervisor. Your family. What is this going to mean for your family as a founder? The team. A lot of founders have built this with very loyal people that they want to take care of. They want to make sure those people are going to have a job. The customers you've made traction with. In some cases, the vendors who were key contributors in the process of building.

When you put that picture together as an entrepreneur, for the first time you realize it's not win, win, win. There's always a sacrifice. If you do better by your investors, you do worse by your employees. When there's real money on the table, you have to face those trade-offs, or you're not actually preparing yourself for the exit.

Dealing with Underwater Valuations

Those are really hard conversations. When a company has raised a bunch of money and their growth has stalled and you value the business less than what they've raised. Deal structuring is the only way to do it. Come back to your stakeholders. How much do I have to get to the preferreds for them to vote yes? How much has to flow through to the common shareholders for them to put some money in their pocket? What are the retentive packages I have to offer those founders or employees? How much severance is in the deal?

Those processes, you actually have to be very calculated and patient, or you will leave a key stakeholder group behind. As a corp dev team that has to operate that asset post-closing, there's more risk in damaging the asset through the decisions you make during the process. Because you haven't run it, you don't know it, there's more risk in the process decisions than in the turnaround itself.

Those situations will generally take longer, and you have to spend a lot more time with the bankers, the founders, and the investors to truly understand the willingness of each stakeholder and how you can put a deal together that allocates value across those stakeholders in a way that you still get a team operating at a high level and excited to come work for the company that acquired them.

You have to refresh equity. That communication is really hard, but there are kind ways to do it, and there are brutal ways to do it. One of the most formative experiences of my career: coming out of EY, I went to an automotive parts manufacturer. The first deal I worked on, the day it closed, our executives walked into the factory and told all five hundred and twelve people their jobs were going to be eliminated. In that same communication, they said: we need you for up to two years. We will provide quality and production-level bonuses that will double your salary over those two years if you hit targets. We will offer resume help and job search coaching. We will give you up to four hours a week paid after the period of notice for you to conduct interviews at other companies. And we will be part of your journey to your next spot.

At twenty-eight years old, that hits you as brutal. And then I got to spend a lot of time in that factory with those people as we were resetting costing and making sure production was hitting targets. That element of understanding the difficulty you are putting someone in and being a part of the solution is really important.

When there are severance activities, I think about how do you make it as palatable as possible? There are conversations where I say to the sellers: I am carving out under our severance policy. I don't care what your severance policy said. I'm going to subtract severance from my enterprise value, keep it as a pool, and that will be paid directly to the employees based on our policy, which is more generous than yours. Those are not easy conversations. They can kill deals for sure. But you have to think about that balance of taking care of the employees with the voting power of the shareholders and the founders' interests.

Bridging the Valuation Gap

It depends on which stakeholder, and that's where each deal is different. If the founder is more worried about go-forward compensation or the employee base, more valuation in retention bonuses, RSUs, or equity in the parent company goes a lot further than an earnout or a deferred payment.

When you're truly trying to close a valuation gap with the equity holders, that is the hardest one to close, because the expectations of the sellers are set by what they believe is market. You really have to understand your bid power in the process. Sometimes you're closing the gap on your own side. For example, recognizing that there's a robust process underway because things are showing up in the data room you didn't ask for.

You can start to gauge where you are in the process. You have conversations with the people you have relationships with on the management team. You talk to the bankers. Closing the gap with the financial sponsors is the hardest, and it is usually done through the mechanisms of deferred payments, earnouts, carve-outs, or other ways to share the risk of the upside.

The beauty and curse of finance is that it truly is all math. You're either trading value or you're trading risk. In any negotiation, you have to figure out where someone is more dug in. What's most important to them? Is it the top-line number, or is it certainty of payment? Is it timing of payment? Shared liabilities? Escrow? There are so many different mechanisms within the contract you can negotiate on. You have to find out what they are most seeking so you can understand where you can make those trade-offs.

Working with Investors Directly

The preferred approach is to go around the CEO and directly to the investors. There are processes where the CEO will early on introduce you to their investors and key board members. But where you build your reputation over time and your connectivity over time, it's natural for you to be talking to some of the investors anyway.

That's been a concentration for me and my team, finding ways to seek out the investors in the spaces we're interested in and having a quarterly or semi-annual check-in scheduled, so it's not awkward when I reach out to say, "I'm really interested in this asset and I want your perspective on how this process is going."

In the community of M&A, deals, and financing, especially in software and cybersecurity, the community is so small that the chances of doing only one deal with a firm over a whole career are very low. So a lot of those firms have a longer-term view. If you're a known entity to them, if you're taking the time to build that relationship, you can have a hard conversation: "This deal, I have to take care of the employees more," or, "I need you to give on your preference because the founder is getting squeezed too much. We can do another one later where we'll have different terms, but I need this now."

If you don't have that relationship, if you don't have that long-term view with the VCs, you're never going to be able to ask for a concession.

Advice for Entrepreneurs Raising Today

It comes down to a real hard look in the mirror at how steep and how fast do you want the treadmill to be. The biggest logos in VC may not be the best fit for you as an entrepreneur. Knowing what type of journey you want to take as a founder, as a leader. That's an important step to take first.

The first check might not be the right one. Think about the process as an interview that goes both ways. The investment committees interviewing you to give you an answer. You are just as much interviewing them to be your board member, your advisor, your partner in growing the business. Don't get blinded by the first yes. Do your homework on the firms before you start getting to investment committee meetings.

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