Why some start-up valuations are higher than others
Globally the combined value of tech companies — at $35tn — is higher than the US GDP in 2020. It is no wonder then that valuations capture the imagination.
And, when it comes to founders, rarely is so much emotional value placed on a single number. It is intoxicating.
But why do some companies achieve eye-watering figures, whereas others seem to underperform? From the outside, it seems like a black box.
Let’s have a look under the hood & explore just how to secure a large valuation.
1) The Size Of The Prize
Not every good idea is a great idea. And not every great idea makes for a great business. If every spark of brilliance started a tech giant investing would be child’s play.
But it’s not.
Investors need the sizzle & the steak. An exciting idea & evidence there is a ready market for it. A tantalizingly large Total Addressable Market (TAM) for the business to feast on.
A word of warning though. Claiming a huge TAM is not going to cut it. You need to be able to defend the TAM you claim. It must be credible. A simple way to build credibility is to position Total Addressable Market (TAM) vs Serviceable Available Market (SAM) vs Serviceable Obtainable Market (SOM). This gives you a framework for demonstrating both the long-term vision & the short-term viability.
- Total Addressable Market (TAM): Total market demand for you product or service
- Serviceable Available Market (SAM): The proportion of your TAM you can reasonably reach taking into account constraints such as geography or target demographic
- Serviceable Obtainable Market (SOM): A reasonable estimation of the market you can capture in a given timeframe given challenges like competition or budgets
In short, visionary ideas attract attention; credible business models open wallets.
2) Team On The Ground
An investor has to believe that the founding team has what it takes to get their idea to market, ride out the challenges & grow into the role of leader.
Whilst every investor-founder relationship begins with a leap of faith, there are some key indicators investors look to.
- Do you understand your market? Premium valuations are often inspired by a compelling demonstration that the founders know the category back to front. Remember, investors & buyers themselves are often stepping into the unknown themselves.
Do you have the required skills?
Do you have start-up experience?
Do you have a positive growth culture?
3) The Journey So Far
Certainly, in the case of tech companies, nothing gets investors more excited than the proven ability to grow. There will of course be an analysis of how responsibly growth is being driven but here are a few rules of thumb investors use to begin benchmarking the appropriate valuation for a tech company.
- Revenue Growth: Expected rates of revenue growth depend on the maturity of the business. In the first three years revenue growth should be 3X, in the following years approximately 2X
- Gross Margins: Investors are often willing to overlook profitability during the growth phase if you can maintain high gross margins. Higher margins & a stronger cash flow mean greater scope to invest in both product development & sales.
- Annual Recurring Revenue (ARR): For SaaS companies in particular scale does matter. For SaaS companies with a sub-$10M ARR, there will be a focus on profitability but above $10M ARR at the increasingly popular ‘Rule of 40’ applies.
The Rule of 40 was first developed by Susquehanna Growth Equity, a private equity & venture capital firm with a strong focus on SaaS. The calculation is captured as ‘Growth Weighted Rule of 40 = (1.33 * Revenue Growth Rate) + 0.67 * (EBITDA margin)’ & operated as a great valuation tool for investors.
4) The Competition & Market Maturity
First mover advantage sounds like it should be every investor’s dream. A chance to shape a category. The time to develop economies of scale. The opportunity to build a loyal customer base before competitors barge in.
But, first-mover advantage is at best a half-truth. Being first means that there is no proven market for the service & no established business model demonstrating profitability. Google was not the first to market. Facebook was not first to market. Sometimes it is what is often termed ‘Improvers’ who end up dominating a category.
So, if you are first to market you will have to persuade investors that there is not just a gap in the market, but also a market in the gap. Conversely, if you are entering a more established category you will have to convince investors that you are more than a copycat; that there is still massive room for growth. Remember, to determine the valuation investors will look to comparables in adjacent categories & markets to off benchmarks.
5) Evidence Of Product-Market Fit
Investors are excited by great ideas & always engage with prototypes, but they will never assume a market for them. They will demand a level of third-party validation.
If you have stress-tested your proposition you are always better placed to secure a higher valuation. If possible you should present tour MVP to prospects and then build a community of early adopters. When users are fully engaged in the Build-Measure-Learn loop, & if the passion of these users matches your passion, it can be very compelling for investors.
6) Frequency Of Capital Infusion
Momentum plays a huge role in valuations. Money follows money.
If a start-up seems to be attracting more & more funding the temptation for investors to engage is almost irresistible. No investor wants to risk passing on the next unicorn.
Buzz amongst investors grows with each round. Even if some of these deals might in part be a function of the founder’s ability to close a deal, the effect is the same. It is a matter of social proof. The valuation process won’t become any less rigorous but each element will be considered in a more positive light if you seem to have the trust of the investor community.
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The desire for a high valuation is understandable. The dollar figure attributed to your fledgling business is more than capital, it is validation. It recognises your passion & your vision. Your hard-work & your commitment.
BUT…Big is not necessarily better.
- The higher the valuation…the more aggressive the demands for terms like preference shares, fixed dividend payments, information rights & bankruptcy liquidation
- The higher the valuation…the further it has to fall with investor preferences later driver it down
- The higher the valuation…the more limited your exit options become with investor expectations being for a >5X return or more on successful startup bets
- The higher the valuation…the faster you will grow which will put pressure on you as a leader
Furthermore, as many recent IPOs show, a private investor valuation doesn’t necessarily stand for much when the company wants to go public.
Look out for the best investors, not the biggest investors. People who can add value to your business not just attach a large valuation. Do they have expertise in your niche? Will they be good for further investment as you scale?
Hope you enjoyed your peek inside the black box. Good luck with your next valuation & make good decisions!