“What is your startup valuation?” is a loaded question with a wide range of answers depending on a multitude of factors.
There is no correct answer to this question other than, “What an investor is willing to buy in at.” In the early stages of a business, startup valuation methods are more art than science. But there are many factors that investors take into consideration when determining how to value a startup, including:
- business model
- revenue traction
- average deal size
- team experience
- path to profitability
- market opportunity.
These are a few of the areas that we consider as part of our startup valuation methods.
As operators of a recurring revenue business over the last decade, we at York IE learned the many advantages of a business model with a predictable revenue stream.
Unlike many traditional businesses that turn the calendar over on Jan. 1 and realize that they have $0 in revenue for the new year, subscription- and SaaS-based 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, recurring revenue becomes a larger and larger percentage of overall revenue 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 such as Salesforce.com, HubSpot and WorkDay, you will notice that their valuation multiples are much higher than companies with more traditional revenue streams. Wall Street traders and investors place a tremendous amount of value on predictable quarterly results.
Traction should also be a consideration in your startup valuation methods. 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 startup 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 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.
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 such as Gartner and IDC spend a lot of time determining and predicting market sizes with a top-down approach. They factor 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 a given opportunity.
Path to profitability
One area that is becoming increasingly more important in the startup valuation process, 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 such as Bain Capital consider the Rule of 40, which simply means a healthy business should have a growth rate plus profit margin exceeding 40% (for example, 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 startup and the corresponding valuation.
The startup team
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? 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.
In the pre-seed/seed stages of investing, there is no magic Excel model or startup value calculator that spits out a proper number. If you have traction, a path to profitability based on recurring revenue, and a strong team, let’s talk about your valuation.
An earlier version of this article was published in the Union Leader.