Startup Valuation: Making the Math Work

A Shift in Venture Capital Dynamics

Traditional venture capital price discipline appears to have diminished. Funds are now prioritizing quicker, earlier-stage investments.

Furthermore, the number of unicorn startups created in the last three months has surpassed any previous quarterly record.

This creates a particularly active period for startups and their investors. As July progresses, 2021 is increasingly likely to establish a new benchmark for venture capital investment.

Investors anticipate that this accelerated pace will continue.

The Exchange: Startups, Markets, and Funding

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Deal Volume vs. Investment Amounts

While investment dollars reaching global startups are at an all-time high, the number of deals isn't mirroring this extreme growth.

Global deal volume did reach a record in the second quarter, but the increase was marginal compared to several quarters in 2018 and the first quarter of 2021.

This influx of capital, coupled with a relatively stable deal flow, has contributed to rising startup valuations and larger deal sizes.

Rising Valuations Across Stages

Data from CB Insights reveals a significant increase in median Series A valuations in 2021, reaching $42 million.

This is considerably higher than the $33 million median valuation observed in 2020 and exceeds the previous record of $39 million set in 2019.

The same data indicates that Series B, Series C, Series D, and Series E rounds have also achieved new highs in 2021, when compared to data from 2015 onwards.

Earlier Funding for Larger Checks

Startups are now securing larger investments at earlier stages of development.

This raises the question of whether many startups are receiving funding despite having revenues lower than typically expected for their stage or capital base.

The answer is affirmative.

Unicorn Valuations and Revenue Multiples

In a recent public discussion, Shomik Ghosh of Boldstart Ventures shared observations consistent with what other investors have indicated privately.

Previously, The Exchange estimated that a relatively small percentage of unicorns valued between $1 billion and $2 billion generated $100 million in revenue.

Ghosh acknowledged this approximation and provided further insight:

This suggests that investing in startups at a valuation equivalent to 40 to 50 times their annual recurring revenue (ARR) is becoming commonplace.

“LTM” refers to the last 12 months, focusing on current performance rather than projected figures.

“NTM” signifies next 12 months. Ghosh’s statement indicates that some startups are even securing funding at multiples of up to 100 times their ARR for the coming year.

Implications and Future Outlook

These trends raise important questions. For instance, Christopher Mims of The Wall Street Journal questioned whether the discrepancy between low startup revenues and high valuations indicates an unsustainable situation.

While a correction is possible, it isn't necessarily probable. The underlying mathematics can still support startups with limited revenues, substantial funding, and strong growth potential.

Analyzing Valuation Metrics for Contemporary Startups

Numerous investors, including Ghosh, are currently observing substantial valuations being assigned to startups, even in instances where revenue generation is minimal. Reports indicate that Series A funding rounds are frequently secured with annual recurring revenue (ARR) in the low hundreds of thousands, contingent upon demonstrating robust growth and the potential for sustained or accelerated expansion.

Several elements contribute to these funding decisions. These include a thriving open-source community, suggesting a substantial future developer base for monetization, a rapidly expanding target market driven by external factors, and founding teams with proven track records of building successful enterprises, as well as ventures in the fintech sector.

Consider Sourcegraph as a concrete illustration. The company recently completed a funding round led by a16z, achieving a valuation of $2.6 billion. Prior reporting indicated an ARR of approximately $10 million. This translates to a present-day ARR multiple of around 260x. While the company’s revenue may have increased since then, potentially reducing this multiple, it remains a comparatively high valuation.

This raises a pertinent question: Why is this significant? The reason lies in the increased risk assumed by startups when securing capital at valuations that deviate from historical precedents. Accepting substantial funding at a premium valuation introduces several potential challenges:

• Failure to achieve projected revenue growth, hindering future fundraising efforts at favorable terms.
• Attracting well-funded competitors to the same market, creating a 'halo effect'.
• Prematurely raising excessive capital, potentially leading to a lack of strategic focus, relaxed financial controls, and overconfidence.

Currently, these concerns are often downplayed in the prevailing risk-tolerant startup environment.

Investors also face specific risks when investing in startups at historically inflated prices. These include:

• Stagnant or declining valuation marks resulting from unmet revenue growth expectations.
• Extended fund lock-up periods in underperforming investments, compounded by increasing round sizes.
• A signaling effect that drives up founder valuation expectations, potentially diminishing returns on future investments.

Despite the potential pitfalls associated with richly valued startups possessing limited revenue history, significant success is also possible. Therefore, it’s important to examine both scenarios: what occurs when startups thrive, and what happens when they encounter setbacks and experience slower progress.

The Optimistic Scenario

A favorable market condition, or "bull case," allows startups securing funding at elevated valuations to bolster their financial reserves. This increased capital provides an extended operational runway, potentially spanning several years.

This extended runway offers startups valuable time to navigate challenges and rebound from setbacks. For instance, a company initially experiencing 300% year-over-year growth, which then decelerates to 100% before recovering, can regain momentum without immediately seeking additional funding.

The availability of greater capital, obtained at a higher valuation, can also facilitate rapid team expansion. Startups may be able to secure top-tier talent and invest more aggressively in marketing and sales initiatives, gaining a competitive edge.

Essentially, larger funding rounds can grant startups the breathing room needed to justify their increased valuations. With prudent financial management, this, combined with access to skilled personnel, can aid recovery from temporary growth slowdowns.

Ultimately, this allows the company to reach its projected milestones, ensuring returns for investors. These returns are often supported by favorable valuations in the public markets for comparable revenue streams.

Benefits of a Strong Financial Position

• Increased operational flexibility.
• Ability to attract and retain high-quality employees.
• Enhanced marketing and sales capabilities.
• Greater resilience to market fluctuations.

A robust cash position allows startups to weather periods of slower growth and maintain their trajectory. This is particularly important in dynamic markets where unforeseen circumstances can arise.

The Current Landscape of Tech Valuations

Despite current optimism, the valuations of venture capital portfolio companies are heavily reliant on robust public market multiples for expanding technology businesses. A decline in these multiples could quickly alter the investment climate.

The Impact of Public Market Multiples

Currently, recurring software revenue, or SaaS, is valued at approximately 21.3x its revenue according to Bessemer’s cloud index. However, should this multiple decrease to 15x, startup valuations would inevitably follow suit.

Investors acquire equity in startups anticipating a substantial return upon exit. Consequently, diminished exit values, driven by lower public market comparisons, will lead to reduced investment in current startup shares.

Revenue Growth and Valuation Defense

In a scenario with lower multiples, startups would be compelled to generate more revenue simply to maintain their existing valuations. This necessitates faster growth rates.

This increased pressure could negate the benefits of larger funding rounds. The flexibility for startups to experience periods of slower growth between funding rounds would be significantly reduced if they must consistently demonstrate accelerated expansion to justify their valuations.

Increased Investment Risk

The inherent risk associated with these investments would correspondingly increase.

The current financial model for expensive startups functions effectively as long as growth remains strong and public market multiples remain high. A decrease in the latter requires an improvement in the former, and vice versa.

A Delicate Balancing Act

Investors are navigating a complex situation, seeking promising deals while avoiding excessive overpayment. This inherent risk is why it’s termed venture capital, distinguishing it from more conservative banking practices.

The Next 24 Months: A Critical Period

Numerous companies that secured substantial funding in the past year will soon need to seek additional investment. This will provide a clear indication of the success, neutrality, or failure of current investment strategies.

With low interest rates and high stock values, ample capital remains available, fueling the belief that these investments will ultimately prove successful.

Only time will tell if these expectations are justified.