Valuing your Early Stage Startup
Despite the worsening economic outlook, the valuations of technology and software businesses were soaring up until now.
The impact of the geopolitical conflict and aftermath of the pandemic is being felt hard by businesses and institutional investors. Having to cope with rising energy prices, interest rates, challenging labour markets, higher output costs, and supply chain bottlenecks will result in many businesses breaching their covenants. Downstream, this will inevitably decrease the finance available for investments.
While the market is tougher, investments will still be done – but with an applied market correction. From speaking with several VCs, we are seeing valuations coming down by 60-70% (at least for new ventures). This will, if not already, start to promote better discipline and focus on delivering sustainable profitable revenue and business growth.
While software technology businesses have proven their agility during the pandemic, they are also not immune from market instability and price volatility. Accepting these headwinds, the technology sector by virtue is more agile – and of course, plays a key role in enabling digital transformation and optimisation for other businesses and sectors.
The eternal principle of buying low and selling high. Challenging times create opportunities for institutional investors. When fundamentally sound businesses seek investment, investors can capitalise on economic events to negotiate favourable commercial terms — giving greater returns to their shareholders.
So how do you assess your company valuation?
Ultimately, it is the market that determines the valuation of your company – and it’s a case of supply vs. demand. However, there are approaches that investors consider – and how you may want to carry out a “self-valuation”. This kind of due diligence should not be seen as a one-time exercise. Leading indicators like these are a useful way to track the ongoing health of a business.
Early-stage start-ups
Early-stage or pre-revenue businesses are hard to value for the simple reason that there is little or no historical data to go on. Instead, investors must assess the value of unproven capabilities, business models, executive teams, technology roadmaps and financial projections.
Here are two approaches investors might use to assess early-stage businesses:
Revenue multiple
In this approach, value is estimated by comparing a company’s current (and potential future) state to other companies within its industry, ideally with similar commercials, products, and services. By assessing the valuation of peer companies, you can apply a similar revenue multiple to estimate the value of your business.
You may still need to apply caveats to account for risks, because your revenue, product and hypothesis will be based on forecasts.
Berkus
The Berkus method provides a framework for assessing pre-revenue businesses. The Berkus method attempts to solve the problem of quantifying something, which is not yet possible to quantify, by using both qualitative and quantitative factors.
Rather than focusing on unproven projections, Berkus assigns a base value to the core business idea and compares that to the ‘cost’ of a standard set of risks faced by technology start-ups. These include:
● Valuable business model (base value)
● Available prototype (reducing technology risks)
● Ability of the founding or management team (reducing implementation risks)
● Strategic relationships (reducing market risks)
● Existing customers or first sales (reducing production risks)
● Usage (demonstrating product stickiness and churn risk)
More mature valuations
Although proven businesses can be measured by the methods above, investors are more likely to rely on historic data to support their forecasts.
The typical assessment will look at recurring revenue, total contract value, accounts receivable billings, margin and profitability, assets, liabilities, competition, market, intellectual property, industry, leadership, pipeline, customer retention, product usage etc. Some of these will have a greater weighting, but to help CEOs and founders filter out the noise, the following options can be employed:
Rule of 40
The most common approach for software companies is to use the ‘rule of 40’. VCs embraced the rule to do a high-level and relatively simple health check, which assesses the combined growth rate and profitability.
Rule of 40 = Y/Y revenue growth (%) + EBITDA margin
Customer lifetime value: customer acquisition cost ratio (LTV:CAC)
As a business moves beyond product development and early-stage growth, the focus shifts to acquiring and retaining customers. The LTV:CAC ratio is one of the most critical indicators used by investors to determine valuation.
How you interpret these results will give you a reasonable indication of the health and value of your business.
Mitul Ruparelia is the founder and principal of Citius Partners. He has over 20 years of experience in delivering exponential revenue and margin growth.
