What goes into a startups valuation?
Over the last decade, this loaded question — “What is your startup valuation?” — has had a wide range of answers depending on a multitude of factors.
There is no “correct” answer to this question other than “Your valuation is what an investor is willing to buy-in at.”
In the early stages of a business, valuations are more art than science.
But there are many factors that investors like York IE take into consideration when determining how to value your startup. Factors like business model, revenue traction, customers, average deal size, team experience, path to profitability and market opportunity are a few of the areas that we think about when determining a valuation when investing. In the pre-seed/seed stages of investing, there is no magic Excel model that spits out a proper valuation. But there are several factors that investors look at to help determine a valuation.
As operators of a recurring revenue business over the last decade, we learned the many advantages of a predictable revenue stream business model.
Unlike many traditional businesses that turned the calendar over on Jan. 1, 2020, and realized that they had $0 in revenue for the year, recurring revenue (subscription, software as a service) businesses start with a recurring revenue baseline.
When they think about the year ahead, the goals and targets the business aligns around are incremental monthly recurring revenue (MRR) and the impact of lost revenue (churn). The net of those two is the net incremental recurring revenue number that will increase your annual recurring revenue (ARR) in the given year and flow through to your revenue and bottom line.
As startups grow, the recurring revenue percentage of overall revenue becomes a larger and larger percentage and provides a highly predictable outcome of business execution over the coming months and quarters. When you look at publicly traded companies with recurring revenue streams (Salesforce.com, HubSpot, WorkDay) you will notice that their valuation multiples are much higher than more traditional revenue streams. Wall Street traders and investors place a tremendous amount of value on predictable quarterly results!
Other factors to consider in startups are revenue traction. Obviously, revenue traction proves that there is an element of product market fit, meaning your product is solving a problem and customers will pay you to help them solve that problem. The more traction and customers, the higher level of confidence that a business can continue to grow and therefore the potential for a higher valuation.
Another factor to consider is quantity and type of customer. You may have great revenue, but it could be highly concentrated with one or few customers. This presents inherent risk in the business, especially if that customer decides to cancel the service. There are also risks with many low-paying customers — oftentimes those customers at low price points may be more likely to leave your platform. We look for a sweet spot of deal size and number of customers to get comfortable with an investment and valuation.
Market opportunity or total addressable market is also a major factor when considering an investment. How many customers could there be, what could they pay, and are there areas of expansion? Firms like Gartner and IDC spend a lot of time determining and predicting market sizes from the top-down approach. They consider annual spend, corporate budgets and many other inputs into their highly sophisticated models. York IE likes to think about it from a bottom-up perspective, which is simply the number of potential customers times the average deal size. It is important to have both perspectives, but the bottom-up math is a quick fact check on the given opportunity.
Path to profitability
One area that is becoming increasingly more important, and is core to the York IE thesis, is whether or not we believe a company can be profitable in a reasonable amount of time. Over the last decade or so many investors cared more about growth rate than any other factor. There have been some headline examples of “growth at all costs” not being the best way to find return on investment. Some firms like Bain consider the “rule of 40.” This simply means, a healthy business should have a growth rate plus profit margin exceeding 40%. So either a growth rate of 40% and break even, or growth of 30% with a 10% profit margin. While this is a simple and high-level metric, it is a good gut check when determining the health of a business and the corresponding valuation.
And lastly, we always consider the team, founder(s), and their experience. What is their level of obsession with the problem they are trying to solve and the value they are trying to create?
Have they built a business before, have they been on the ground floor of a startup, do they have operating experience, and do they show leadership skills and the ability to adapt? Some founders show it on day one, some have it deep inside and need it to be teased out. One of the most rewarding and important parts of our job is identifying this trait within someone and helping them develop the confidence to believe in themselves and swing for the fences.
If you have this and can prove it, let’s talk, and I assure you we will come to an agreement on valuation!
(Editor’s Note: This article was previously published by the Union Leader.)