How To Value Your Startup
We often get the question about how to value early-stage startups. We actually have a pretty defined method that we discuss openly with companies, and felt it useful to share here. Obviously we are not unbiased on this topic. But we generally believe that discussions of this type shouldn’t be as black box as VCs often make them seem. In the interest of transparency and clarity this will be a longer post than most on this blog.
Our point of view on how to value your startup is that you should strike the right balance between minimizing your dilution with a higher valuation, and maximizing your future financing or exit options with a lower valuation.
The one thing that you should not do is go for the highest valuation possible. That typically doesn’t end well as I’ll explain below.
Above all you should find a partner who wins when you win in order to maximize alignment and minimize issues that arise when you’re not on the same page about things like blitzscaling (see my partner Andrew’s checklist on when to blitzscale).
Our guiding principle is that fundraising is a massive time suck, and anything you can do to make it as quick and successful as possible is better for the business. The way to do that is to get investors excited about both the business’ performance AND the stock’s potential appreciation.
The more you can do to make the VC’s internal discussion about the merits of the business itself, and the less “I like the company but I don’t like the terms,” the faster you will get to a yes, and the sooner you can go back to building your business, talking to customers, iterating on your product, and growing the fundamental value of your business.
Obviously if you go to market with a super bargain valuation you may get a lot of interest very quickly, but you’d likely be selling yourself short and taking more dilution than you need, which can hurt in the long-run if you plan to raise more funding.
So where should you aim to value your startup? Our point of view is to look at industry public and M&A exit revenue multiples. You may be thinking (1) the public or exit comps suggest xyz multiple, but your startup is growing faster than the comps so you should get a higher multiple. Or you might (2) disregard exit comps as too far off and instead look to “entry” comps of similar-stage companies, for instance a similar-sized competitor that raised at a high valuation.
A couple responses:
(1) Your startup should grow faster than a big company that’s either public or acquired, but it’s also a much riskier bet. There’s other factors at play, but it’s *roughly* fair to say those two forces of growth rate and risk offset and therefore the public or M&A exit comp is a decent place to start a valuation discussion.
(2) Financing “entry” comps are a different animal than M&A exit or public comps. Who knows why people invest in early companies at the terms they do. While there are plenty of head-scratchers out there, our position is that there is more rationality at the point of sale when companies are bigger and the consequences of bad decisions are greater (losing billions vs. losing millions), than at the point of entry where the VC model of hunting unicorns places less importance on the entry valuation.
That’s why when looking for a capital partner that’s most aligned for the business (they win when you win), the exit multiple is typically the better place to start as it encourages a conversation about the outcome and not just the next round.
Furthermore, some of these high multiple financings in your competitors will end up hurting them…and hurting them sooner than you or they may think…
So why not go for the highest valuation possible?
The ultimate reason has to do with how VCs operate. Due to the long time it takes for VC investments to become liquid, VCs need to see steady appreciation on paper as their “report card” to their own investors who otherwise wouldn’t have visibility on their portfolio performance like they would a public brokerage account. This creates an incentive to get their investments “marked up” on paper through future financing rounds at higher and higher valuations.
These “marks to market” typically require a 2x price per share markup within 12–18 months in order to replicate the return on investment necessary to justify the high risk, long illiquidity cycles, and relatively high failure rates of investing in a private equity strategy vs. the public market or other asset classes.
What a 2x pps markup means for you is that if your last round was done at a $5M post, the next round should be at least $10M pre.
But it doesn’t end there. A key point and quirk of private markets is that the $10M pre is really a price floor — not a price target as analysts would suggest for a public company. Whereas a publicly-trade share will settle where the bid-ask is, a privately-traded share typically doesn’t clear if it doesn’t meet a reserve. That means you could have a failed auction and no round if the private market doesn’t think you’re worth $10M pre when it comes time to raise again.
What if you’ve shown decent progress and the market thinks you’re worth $7.5M pre (1.5x appreciation)? Typically these become known as “bridge” rounds with the assumption that they bridge to a big next round at that 2x PPS step up. But these are tricky to raise as they tend to suggest something didn’t go to plan and that’s why you’re out raising again at less than the typical 2x goal.
To use a more concrete example, let’s say you have a $1M ARR SaaS business growing 100%+ YoY, 100%+ net retention, etc. Public comps as of mid-2020 suggest roughly 10x ARR on a post-money basis. You go out to raise money and — for dramatic illustrative purposes— one group offers you $10M post, and another one offers you $30M post.
You go with the $30M post because it’s a higher valuation and less dilution, right? Not so fast.
You get back to work, continue growing, and after a few months start having conversations with investors for your next round. The sophisticated ones ask you how much you raised in your last round, at what post-money valuation or cap, how long ago, and your ARR then and now. You tell them it was $30M post a year ago and you were doing $1M ARR then and $2M ARR now. Great progress on the business, right?
Then the VCs pass on valuation. This happens happens a few more times until it’s fairly clear from the market feedback that the valuation is too high. Your options at that point are to either “grow into” the valuation (assuming you have the cash runway), raise at a lower valuation that turns into a smaller “bridge” round, or if you’re really out of options, raise a down round. And no one rushes in to catch a falling knife.
What happened is the VCs realized you raised at 30x ARR and assumed you and your investors wanted a $60M pre on this round (the 2x rule). If they don’t think you’re worth $60M pre at that point in time, they often won’t bid rather than bid what they think you’re worth (the price floor effect). Part of it is being polite to your last round investors who marked you at $30M post. They don’t want to be the ones suggesting your investor takes a flat to down mark on their report card to investors. At least not until it becomes fait accompli.
If you had raised at a closer-to-market $10M post instead, the “hurdle” would only be $20M pre for the next round. If you doubled ARR to $2M, you’d still be comfortably within the 10x ARR range, your last round investors would get a nice step up (aka their reward for backing you early at decent terms), and your new investors would feel that there’s enough upside at $20M pre to get excited about working with you. In other words, you’d have a lot more financing options.
A final point regards “paying ahead” for growth. A lot of deals in good times or in very fast growing companies get done at multiples that are up to a year or more ahead of the market multiple. For example, let’s say your $1M ARR SaaS business is reasonably confident in being $2M a year from now. An aggressive investor may be convinced to invest at $15M post, justifying to themselves and their investors that due to growth, they’ll be blended down to a 10x market valuation in due time.
Paying ahead works if the growth actually happens. If not then back up a few paragraphs to the dreaded “bridge” round. A lot of companies got burned here due to COVID and either have to delay their next rounds until they regain the traction they lost or delayed, or else raise tricky bridge rounds or down rounds if they need the cash.
Here at Reformation Partners we’re always thinking beyond the next round to what the long-term consequences are for financing decisions made today (see our Opportunity Cost of Capital post, for instance). One of our mantras is that it’s risky enough building a startup. If you can reduce your capital markets risk and increase your financing optionality, that’s one less thing to keep you (and your investors) up at night.
Let us know what you think!
