Venture Capital Valuations and Multiples
Although creating or assessing the valuation of a startup is an art with a splash of science — there are norms that founders and emerging investors should be aware of. This post is meant for founders that are fundraising from venture capitalists and angels investing in startups.
In setting expectations, you are not going to learn everything you need to know about company valuations from this post, but it will give you principles to keep in mind and links to resources to deepen your understanding.
1. Valuation is the current or projected worth of a company
The valuation is the ‘price’ of the business. A founder has a product to sell (their company), investors want to buy that product, and the valuation is the price the investor agrees to pay now for shares (a ‘piece’ of ownership) in a company. The investor may pay more than the company is worth today, but that depends on the investors preferences and alternatives. Active investors constantly review investment opportunities, compare them to each other, and select the most competitive deal that they anticipate will yield the highest return (i.e. return the most capital) and meets their investment objectives. The valuation (i.e. ‘price’) and other characteristics must be competitive to be selected for investment.
2. Your valuation as mature company is your future goal
For mature companies, that have been operating several years with consistent revenue and stable cashflows, there are standard evaluation techniques. Four of the most common techniques include (1) comparable analysis, (2) previous transactions, (3) discounted cashflow and (4) P/E ratio. In generating a valuation for a company it is common to use several methods and compare the results of each to determine a reasonable valuation.
As an early stage founder you may be wondering — why do I have to know these methods? No seasoned investor will pay a higher price today than what they expect the company will be worth tomorrow. It is quite the opposite — investors expect a steep discount for the risk they are taking today in order to achieve an attractive return tomorrow. How a company will be valued in the future creates a clear ‘valuation’ goal for your startup.
The comparable analysis reviews similar companies and determines the valuation as a multiple of revenue or EBITDA. E.g. valuation = revenue or EBITDA x average multiple of an existing company.
The previous transactions analysis reviews similar companies and determines valuation based average multiple the similar companies were acquired for revenue or EBITDA. E.g. valuation = revenue or EBITDA x average multiple previous companies paid for a similar company.
Keep in mind, as you assess or estimate valuations there are expected multiples for types of companies and industries. Example from Fred Wilson’s blog, e-commerce businesses are expected to be 1–2 x revenues and SaaS businesses 6–8 x revenues. Know the multiples for your industry.
The discounted cash flows method estimates valuation based on estimated future revenue. Estimates are based on years of historical results (i.e. ‘actuals’) and discounted to a present value.
The P/E ratio is one of the most common for mature companies that make it to the growth stage where the valuation equals a multiple of earnings. More information on that method here.
A common mistake I have seen startup founders make that have no revenue, or a limited history of consistent revenue, is using the discounted cashflow method and estimating their valuation based off lofty projections without years of historical results. Years of historical actuals is ‘evidence’ that the startup can deliver the product and customers are willing to pay — proving two core assumptions for early stage startups. Discounting projections based off of projections without historical actuals ignores execution risk (i.e. the assumption that the team can execute the vision) and unrealized customer demand. Investors contributing capital today should pay closer to todays value, and in certain cases a premium that accounting for any evidence of future revenue such as a signed contract with a clear value — not the full value of what the company is going to be worth years from now. The increase in valuation over time (the future valuation minus today’s valuation) is the upside potential that founders and investors both benefit from to account for the risk they both take today.
3. Early stage companies have an expected valuation range and raise amount
The valuation on early stage SaaS (Software as a Service) companies raising for the first time, with no revenue traction or limited history of consistent revenue, in the U.S., tend to be from $2M–6M today (note date of post) for competitive companies. The size of the round (i.e. amount of money you are raising) is usually between $250K-$1M. This round is usually called a ‘pre-seed’ and typically does not count as a proper equity round since the funders are usually less sophisticated investors and include family, friends, accelerators, and angels.
[Note: How did I get the lower bound of the valuation? Competitive accelerators are (think 500 Startups, YC, Techstars) give $100–180K for 5–10% of a startups company. That estimates valuation for a competitive company to be from $1M-$3.6M. Granted these accelerators are providing more value than cash, but for the sake of simplicity, I estimated $2M.]
The next round is referred to as the Seed round. For the same type of company valuations tend to be from $4M–11M. The size of the round is usually ranges from $500K-$2M with the average being closer to $1.1–1.6M. This is regarded as the first ‘institutional round’.
What accounts for the valuation range? They differ by industry of the company, by the stage of the company, by the location of the company, and can change over time.
How do I come up with a valuation for my early stage startup? The Berkus Method valuation is dated — but gives an example of a framework. It looks at each characteristic of a business (e.g. team, market, product development, stage of business, sales channels, market size) and gives a value to each and adds the values up to give you a total valuation. The Seraf Investor gives an example of a few methods that follow this framework.
The short answer is, a founder should use multiple methods — the Berkus or Seraf method to look at valuation by characteristics, the comparative method to understand the appropriate multiple of current revenue, the previous transactions method to understand what similar companies are being purchased for, while keeping in mind what the norms are for your next stage of fundraising given your level of traction. Compare all those and determine what your valuation range should be.
Unsolicited advice: Founders are by nature ambitious, but aiming for a valuation far outside expected range leaves the investor do deduce (1) the founder is uninformed (which is the point of this post! to help founders!) or (1) attempting to advantage of an uninformed investor — which may be advantageous, but then, should a founder really want this person as an investor?
Additional reading: Public Comps, Startups.com, Codementor, Arkenea, Seraf Investor, Envato, Damoodaran Online, Upcounsel, Parisoma, Berkonomics, Seedcamp, Humble.VC, Fred Wilson
4. Expectations of traction and valuation range exist for each round
In estimating the valuation range, it is important to keep in mind the traction expectations at each round of fundraising.
Traction refers to concrete measures of progress. Examples of these measures include number of partnerships, product development (e.g. is the product live yet?), number of users, percent of active users, growth rates, but the the most important is revenue.
Revenue is evidence that people see value enough to pay, you can deliver a product, and they trust the startup enough to pay them. It is magnitudes stronger than surveys or quotes from potential customers — because what customers say and do are usually different. Month over month growth of this revenue, normalized for marketing spend, is one of the next strongest indicators. Below is an example table of traction expectations related to valuation, funding and round size specifically for SaaS companies (in 2019).
The traction expectations and other attributes will differ by industry, product type, and over time.
Also keep in mind the norms for round size and timing between rounds in alignment with the traction founders are achieving. Rounds are created in order to de-risk the investment and create checkpoints for fundraising activity. Capital in a single round are meant to last from 12–18 months, provide enough capital to achieve critical milestones, and test core assumptions to determine if the venture should receive additional funding.
Additional reading: Data Driven Investor, PitchBook
5. Each round founders sell ~15-25%
Every round the founding team is expected to sell 15–25%, usually 20%, of their company. This can decline slightly in later rounds. It is just a norm. For more background you can read Sam Altman’s post on YC here. What does this mean for you? It means with each round the percentage of ownership the founding team owns is diluted (i.e. reduces).
As a simple example lets say two founders each own 50% of the business. If they sell off 20% in the fundraising round there new individual ownership is 40% (50% x (1–20%)). In the next round if the founders fundraise for 15% of the company their new individual ownership is 34% (40% x (1–15%)) and so on.
Most founders are concerned with selling too much of the company too quickly or loosing control, as they should be, but they should keep in mind that if you are deviating from the norm, there should be justification beyond the founders personal interests — but also balancing the investors interests.
Example if a founder is pre-revenue and raising $750–1M at a $4–5M valuation, assuming they are competitive in all the other categories, that fits within a norm for early stage SaaS companies. If the founder wants to be valued at $6–10M, holding the raise amount constant, the increase/deviation needs justification, such as revenue, strong revenue growth, strong user activity, strong user growth or other evidence of traction that de-risks the investment.
6. The probability of being a Unicorn is extremely slim.
As founders and investors are estimating valuations and shooting for ‘unicorn’ status (i.e. a valuation of $1B USD or more), they should know the odds of reaching that status are about 1% for companies that received seed funding. For the pre-seed stage it is even less.
I share this as a sanity check for investors and founders. Founders fundraising are optimistic and audacious by nature, but as we all get starry-eyed — price (valuation) paid today should be closer to value today and the appreciation of startup valuation between now and then is the upside founders and investors share by taking risk today.
5. It is all relative
“A startup becomes a company and eventually, that company gets valued on real value metrics. Someday it will have customers, and revenue, and profits. And investors will think “how many years of profits will I be willing to pay for that company?” A PE ratio will be applied and it will be valued on the business fundamentals and not what can or could be.
Venture capitalists and seed funds and angel investors make or lose money on the journey from hypothetical value to real value.”
-Fred Wilson, Union Square Ventures, Hypothetical to Real Value
At the end of day, the norms stated in this blog post will change and a startups valuation is relative what the market will pay. A startups valuation is relative to other startups that in the same space at similar stages. Founders, remember, investors are looking at a large number of deals and will select what is most competitive at the given point in time. Investors, remember, look at the entire picture and compare to your alternatives. For both parties assessing or estimating a valuation for a startup — remember these are relationships — be nice, play fair, and lets create value together.
If you have feedback, write a comment, and if you know a founder that would benefit share.
Best,
