The Art (And Science) Of Valuation: Here's How Venture Capitalists Value Your Startup From a range of detailed financial metrics to market experience and gut feel, the final valuation can come down to a mixture of science and art.
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If you're an entrepreneur and keen to attract investment in your high-potential startup, you are probably thinking about venture capitalists (VCs). But what do VCs want? What information should you provide? And how exactly do they value your company?
From a range of detailed financial metrics to market experience and gut feel, the final valuation can come down to a mixture of science and art. The good news is that our region continues to attract the attention of VCs. According to the Emerging Venture Markets Report published by MAGNiTT in early 2021, MENA startups received a record US$1 billion in funding in 2020, up 13% from 2019.
Here, we take a closer look at how VCs arrive at a startup valuation.
So, what are high-potential startups?
The kind of startups we are talking about here are high-potential tech companies with products or services in untapped markets. Those products or services will solve problems, and the startup, already generating revenue, will have the potential to grow rapidly over the next three to five years.
So, although we are not talking about unicorns like Careem, Bayut, or Souq.com, startups in this context refer to high-potential ventures with high percentage revenue growth of between 100% and 200% year-on-year that could be in-line for unicorn status. They will be in a disruptor-type market, and they may have received their first round of funding from angel investors or even friends and family.
Well, what are VCs looking for?
There is no easy way to assess the value of a startup. Of course, the more mature a startup, the easier it is to make the calculation. This is down to the fact that the revenue data and growth figures are already established.
But even with these figures in hand, it is still not black and white. Each startup is unique, and concise valuations are the result of more than just financial metrics. They are usually reached by a mixture of evidence and gut instinct based on market experience.
First off, VCs will want to check out the management team and the background of the company founders, and assess what level of confidence they might inspire. If a founder has a track record in previous successful tech startups, for example, then that's a big tick in your favor. But they will also be alert to any red flags: are you overstating your presence, or are you as strong as you say you are?
As for the financial metrics, monthly recurring revenue (MRR) and annual recurring revenue (ARR) will be examined closely. Because ARR and MRR only express recurring revenue, they allow VCs and startups to understand if an increase in revenue comes from anomalous one-time purchases or sustainable growth of reliable income. In short, they produce a more accurate picture of future income than just using the revenue metric.
Naturally, VCs will want to see upward trends in the monthly and yearly revenue. They will be particularly interested in revenue generated after the first six to 12 months, because a period before that would not paint an accurate picture. After 12 months, sustained revenue growth of 15% month-on-month is a positive sign VCs can value the company as a fast-growing startup.
Once information from the financial metrics is established, VCs will compare your company with others in the same market to see if your product, service, and business model stands out from a crowd sufficiently to make it a viable investment opportunity. If there are none in the market, the VC will look for other comparable startups.
They will also want to understand whether your business or product can be replicated easily by another startup. Once they've ascertained whether it's defensible, they will examine what the market trends are in your industry to try and work out whether they're too early or too late in the process.
In addition, they will be keen to see if you have already attracted other investors -a good sign for future rounds as far as a VC is concerned- and any strategic investors or board members. The more experience you can bring onboard from successful tech startups, the better the valuation for you.
And what do they need from you? As a startup owner, you should give accurate revenue data, growth rates, and information on total value of transactions. In addition, they'll need signs of accelerated growth in your venture's evolution and historical trends, as well as your key performance indicators (KPIs) and data on customer retention and the number of active users.
But how do VCs decide on a valuation?
VCs will use a range of methods, but they will likely first look at comparable transactions. They will examine comparable companies in your sector as well as other startups with similarities to yours and compare their ARR multiples using different key ratios. In the same exercise, they'll also look at revenue multiples and KPI multiples, such as churn rate, burn rate, dollar revenue retention (DRR), and customer lifetime value (CLV).
The venture capital method helps determine a range of exit values based on potential revenue multiples in five to seven years. These, in turn, are discounted at their desired return on investment, taking into account subsequent rounds and dilution. This is often used in scenarios where it is easier to estimate a potential exit value after achieving certain milestones.
Some may also use the scorecard method. This compares your startup to typical angel or VC-funded startups at the same stage of development, and adjusts the average valuation of recently funded companies in the region to establish a valuation of your business.
The scorecard method, in reality, is used in support of the two methods mentioned above. VCs will look at an average valuation from the scorecard method alongside the comparable ARR and revenue multiples from similar ventures to see how closely the two valuations match.
Although a mixture of science and art, it's likely that a range of VCs would come up with very similar figures for the same startup, even if that figure might not match the founder's own valuation. In short, any valuation will be the result of a detailed process in which the science is cross-checked against market experience.