Whenever a startup closes a new funding round you practically immediately read and hear a lot about it on various websites like TechCrunch, Newsletters, or your personal LinkedIn, however, the underlying valuation at which VCs and other investors value the company is basically never disclosed in more detail. There are a number of reasons for this information disparity - among others, funding is a vital marketing tool for startups and their valuation is always evolving and built on confidential information. Therefore, it is of great importance when trying to break into VC, to understand how to value a startup when looking outside-in and to be able to assess current valuations.
But how do you actually do that? Do you actually use the valuation methods that are taught in university? To answer these questions, we will outline the most common methods used in practice to value startups from Seed to Late-Stage in the following.
Pre-money valuation
As the name suggests, pre-money valuation does not include "new money" as in the latest round of funding. It can be seen as the valuation of a startup before investments are made. The pre-money valuation is that portion of the post-money valuation attributable to stock held by founders, employees, and previous investors.
Pre-money valuation = Post-money valuation - Investment
Post-money valuation
Contrarily, post-money valuation refers to how much the startup is worth after it received the "new money".
Post-money valuation = Investment / % stake received
Comparing metrics is vital in assessing a startup's potential and health. While some are more useful than others, a16z compiled a list of the most common misconceptions and metrics used to analyse the state of a startup and its Product/Market fit, some of which can also be used as standalone proxies for valuation.
Business and Financial Metrics
Bookings vs. Revenue vs. Billings
Bookings represent the value of a contract between the startup and its customers. However, unlike Revenue, it is just a contractual obligation and does not reflect whether the service has already been provided. In this case, the startup is able to recognise it as Revenue. Billings add the change in deferred revenue of the previous time horizon to revenue. If Bookings increase, Billings will increase likewise.
It is especially important to track the conversion of Bookings into recognised Revenue. A high conversion ratio indicates an effective sales and product delivery process.
Additionally, for SaaS companies it is common to rather look at Billings as a proxy to measure the growth of a startup, as it is a better forward-looking indicator for customer value than Revenue.
Total Contract Value (TCV) vs. Annual Contract Value (ACV)
Total Contract Value (TCV), as its name suggests, is the total value of the contract, thus including non-recurring items as well.
Annual Contract Value (ACV) likewise measures the value of the contract over a 12-month period for better comparability. Investors assess the size of a startups ACV compared to the competition and the development of ACV over time. A growing ACV is a positive sign that indicates that the offering is becoming more valuable to customers.
Recurring Revenue (ARR, MRR) vs. Total Revenue
Startups which have a high share of product revenues vs service revenues are typically preferred. Product revenue is what the startup generates from the sale of the product/software, and unlike service revenue, is recurring.
Annual Recurring Revenue (ARR) hence excludes one-time items like non-recurring fees. When looking at ARR/Customer it is important to look at its growth. A growing metric indicates that the startup is able to upsell or cross-sell its products.
Monthly Recurring Revenue (MRR) is the startup's ARR divided by 12. Importantly, as mentioned, the figure should not include Bookings or non-recurring items.
Gross Profit/Gross Margin
How profitable are the startup's operations and is the profitability increasing over time?
This metric is extremely important and powerful in comparing different startups. A higher (sustainable/recurring) Gross Margin is logically associated with a higher valuation.
Life Time Value (LTV)
Life Time Value (LTV) is the present value of the future net profit from the customer. LTV helps startups and investors to assess the long-term net value of the customer after accounting for Customer Acquisition Costs (CAC).
High LTV showcases either high retention or a high contract value, both of which are great indicators for Product/Market fit.
Customer Acquisition Cost (CAC)
Customer Acquisition Cost (CAC) should ideally reflect the full cost of acquiring users, including indirect costs like referral fees, credits, or discounts.
Often it is the case that it gets more expensive to acquire customers when startups try to reach a larger audience, hence it is important to assess it on a per-customer basis.