Founders are always perplexed on how valuations for their startups are determined. It is as much a science as it is an art. It can be ambiguous as art, for the value is in the beholder, to being deterministic as a science, as it is something that others have to rely on. Determining the valuation of a startup involves a combination of factors and methodologies. Remember, one mans treasure is another mans trash. This is why valuations are very subjective, and difficult to compare. The objective here is to try and justify the proposed valuation. Here are some key considerations:
- Type of startup
The valuation methodology should be different if you are B2B SaaS, or B2C or B2G or vertical specific startup. Unfortunately, founders and most VCs are not able to tailor their valuations for the type and this results in a lot of confusion, and frustrated founders and VCs. So top tip here is to focus on VCs that are either known in your vertical or geography or looking to move there.
💡A question you can ask them is “Would love to know a little more about your investment thesis and portfolio in XYZ vertical”. - Revenue Multiples
Revenue multiples are commonly used to measure the value of SaaS companies. This method involves dividing the company’s enterprise value by its revenue. The multiple can vary depending on factors such as the company’s growth rate, industry, and market conditions. B2B SaaS companies can be valued between 3x and 15x their annual revenue, with the multiplier increasing for more established businesses. However, revenue multipliers are also not standard in the VC yet. US, EU and Asian VCs use different multipliers. They also don’t work on businesses that have hardware components, are project based, or are early stage. In addition, multipliers are inefficient for deep tech/tough tech, or non SaaS startups usually.
💡Ask VCs how they came up with their proposed valuation for you and they will usually tell the multiplier they used, - EBITDA Multipliers
For more established SaaS companies with $5 million in Annual Recurring Revenue (ARR) or above, the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) metric is often used. It provides a measure of the company’s profitability. EBITDA multipliers have been used in traditional businesses as these determine profitability, and not just revenue. Key for those big rounds, and not usually seen in early stages. - Market Comparisons
Comparing the startup to similar companies in the market can provide insights into its valuation. Investors may consider factors such as the company’s growth rate, market share, competitive landscape, and industry trends. This approach can help determine a fair valuation based on market benchmarks. As a founder, you could try and use a benchmark of the vertical in the market, but make sure you understand that investors may look to benchmark revenue or profits as well. However, this does give you an indicator of ball park figures. - Stage of Development
The stage of development of the startup is an important factor in valuation. Early-stage startups with promising prototypes or minimum viable products may have lower valuations due to higher risks. As the startup progresses and demonstrates growth potential, its valuation can increase. For overcoming early stage lower valuations, founders can use convertible loan agreements to postpone valuation conversations to a later market event (investment or revenue number) - Upselling Potential
Showing a high potential for upselling existing customers can positively impact a startup’s valuation. Investors value the ability to generate additional revenue from existing customers, which indicates scalability and customer satisfaction. In short, share your vision on how big this can be. Be optimistic, but pragmatic, without being arrogant or ignorant. - Exit path
Even though a long way away, investors would like to see an exit path for their investment. It might not be set in stone, but they would like to see founders really understanding the end game for both themselves and the investors. Most of the time this is omitted from the valuation, but there are times when such vision can add to the valuation of your company, specially when it is anchored with a similar exit in another industry.
💡Ask investors their fund duration and try and see if your Exit strategy for them fits within the fund duration. - Intellectual Property or Trade Secrets
Having fantastic ideas is one thing, but having solutions to problems, and then knowing you are the only ones capable of making products out of these solutions, is another very highly sought after startup trait. While not limited to Patents and defendable IP, even trade secrets are valuable for investors and can drive up valuations. However, remember, having public patents also lets your competitors know how you are doing things, and this can lead to them developing similar strategies in the future, circumventing your own patents. Make sure you truly communicate the value of your technology.
💡Get a third party to give you a valuation for your technology or patent. - Other Factors
Additional factors that can influence the valuation of a startup include the strength of the founding team, intellectual property, customer acquisition costs, user growth, and engagement metrics.
It’s important to note that valuing a startup is a complex process, and different investors may use different methodologies and considerations. If you are not aligned with the valuation, either walk away or find a way by which you can justify the valuation. If you need the money, the ball will be in your court. However, if the investor has FOMO, they might suggest a mechanism than might close the deal. Tranches, loans or milestone based investments are possibilities, though tend to be complex arrangements,
Remember, valuation is not an exact science, and it’s subject to market conditions, investor sentiment, and other external factors. More importantly, it is up to you. One mans trash is another mans treasure. Find the treasure seekers!
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