When you are raising capital from an investor, they will likely be basing their tech startup valuation of your company not on what it could possibly become at a later date, but instead, on how they need to measure the metrics that will allow them to meet the investor's expectations of their required ownership percentage for their investment in your company.
For example, if you are looking for a 2021 revenue multiple in 2026 without providing sufficient retention and growth data to support such a claim, it is likely that your investment proposal will be rejected without a second thought.
Resetting Your Ownership Table
It was once the case that every software company was routinely assigned a ten times revenue multiple, however, this is no longer the case; as evidenced by current statistics, the seed funding market has seen a decline of 40% from its all-time high, while Series A funding has fallen by 30%.
The median enterprise value to revenue multiple for publicly traded software companies is currently 6.7x, and as such, private software valuations are typically discounted by 30-40% from the public multiple, resulting in a typical private software valuation between 4.8x - 5.3x.
It is imperative that you eliminate any and all old data from the last decade; in order to determine the value of a tech startup, you must be 100% disciplined across the various stages of the growth phase of your company, as well as have a thorough understanding of the mathematics regarding the dilution of an ownership interest by an investor.
Valuation Methods for Your Growth Stage
The most common reason that founders destroy their negotiating power with an investor is because they are using the wrong valuation methodology for the stage of growth their company is currently in.
For example, you cannot apply a discounted cash flow method to a startup that has not generated any historical cash flows; likewise, you cannot apply market comparison methods to a startup that has not experienced growth.
Investors segment their mathematical methodologies into pre-revenue, early revenue, and rapid growth phases of a startup.
Pre-Revenue Companies
Investors will only work with companies that have not yet generated any revenue if they are able to develop a comprehensive risk assessment plan. The two most commonly used methods to assess pre-revenue companies are the Berkus method and the scorecard method.
The financial models do not consider the actual cash generated by your business; specifically, they evaluate the structural issues involved in executing the business model and hence the potential risks associated with that execution.
The Berkus method evaluates specific risk areas of execution through a dollar valuation, which includes the valuation of the business idea itself; the valuation of a working prototype; the valuation of a quality management team; the valuation of the ability to develop strategic partnerships; and the valuation of the ability to roll out the product.
In addition, if a working prototype does not exist, the potential investor will reduce the pre-money limit by the valuation of the business.
The scorecard method uses an average comparison of your startup to the average funded startups within the same classification and geographic market. The potential investors define a base average pre-money number for the sector you are in.
This average number is adjusted up or down based on weighted criteria, the most heavily weighted of which is the management team, which is typically thirty percent; next is the opportunity, which is typically twenty-five percent.
If there are no prior exits on the management team, then the multiplier for the thirty percent will be less than 1, resulting in a downward adjustment of the entire pre-money figure.
The methods used by the investors serve to isolate the risk of failure; therefore, if you make the argument for a high pre-money number without the complete management team, the scorecard math will instantly eliminate your argument.
Valuing Companies With Revenue
When a company has achieved actual recurring revenues, the method for calculating the tech startup valuation of such a company changes dramatically. Once recurring revenue has been established, the venture capital method and the first Chicago method are the most common operational methods.
The venture capital method is mechanical; the process begins with the exit. Investors will project the company valuation in five to eight years, on projected revenues and others in the same industry. The investors will determine the return on investment that they are expecting.
A limited partner's requirement to obtain ten times the capital they invested in a fund means that the fund should take the projected exit amount at some future date and divide that amount by 10. This figure represents the maximum value the fund can accept as post-money today.
The Risks of Predicting Future Cash
Also included in this stage of the valuation process is the use of discounted cash flow analysis, which works best on cash flow models where revenue patterns are highly predictable.
In situations where customer attrition is highly variable, a discounted cash flow would be practically irrelevant and an investor will heavily discount the projected future cash flows of the startup in order to adjust for the high failure rate of startups. As a start-up, an investor may apply a discount rate of between 40% - 50%.
Using Market Multiples to Find Price
Investors will apply some form of multiple to the market when determining the value of a startup during due diligence.
This multiple could be anywhere between four and seven times the company's annual recurring revenue (ARR), but this depends on how closely the investor feels a start-up company can replicate the performance of the best-performing public companies. This could be even more of a stretch if the investor believes the start-up to be in direct competition with many other companies.
The most commonly used multiple is the price/earnings multiple, which compares a company's stock price to its earnings. However, startup funding negotiations are often based on the comparison of market multiples used to determine the price of a startup.
While comparing your business to a public company that generates $2 billion in ARR with a $2 million ARR is not going to provide you with very meaningful results.
In order to properly use comparables for your tech startup valuation, you will need to find the most relevant private market transactions that occurred in your specific industry and have high-growth potential and gross margins that are comparable to yours.
If your competitor raised their capital at a multiple of eight and maintained a net retention rate of 130% but you only achieve a net retention rate of 90%, you should not expect an eight multiple.
If you're looking for a quick way to find out how to calculate the post-money and cap table valuations based on the numbers found in your own internal reports, when preparing a report for investors, don't use any data that are from three years ago as a foundation or basis for determining the valuation of your deal.
Investors will simply replace your outdated figures with their current figures when evaluating your potential valuation.
Figuring Out Investor Ownership
Also, it's important to keep in mind that while the pre-money value of a company is often important to the founder, the only value an investor cares about is their target ownership percentage.
In fact, tech startup valuations typically start with an investor's anticipated equity requirement (i.e., the ownership percentage they want) and then move backward through simple math to determine the post-money valuation.
At seed stage, lead investors want to pick up between 20%-25% equity of a new company; they will drop their desired ownership percentage to around 15% for companies that are private at this level of investment but still will want to hold on to at least 30%.
Additionally, this remains an extremely hard operational floor for most venture capital firms; therefore, if an investor has due diligence to perform on a company and determines that in order to achieve a specific return, they will have to invest $2,000,000 and receive at least 20% ownership of the company, the amount invested and the pre-money valuation numbers will be extremely regimented to meet that criteria.
In this example: $2,000,000 / 0.20 = a post-money valuation of $10,000,000. Subtracting $2,000,000 from that amount results in the pre-money valuation of the new company being exactly $8,000,000.
The pre-money valuation will not change, regardless of what the discounted cash flow projections or market comparables indicate; instead it will change due to the inability for the investor to reach their target equity percentage based solely on the dollar amount of their investment. If you do not accept the pre-money offer, the deal will likely be given to another investor.
The Danger of Pricing Your Seed Stage Too High
Negotiating a post-money valuation of $20 million when your company produces only $1 million in ARR puts you in an incredibly dangerous position. You will be creating an irrational value that creates a huge structural challenge to secure your next round of funding.
Series A investors today require aggressive growth to support a high multiple. If you manage to grow your ARR to $2 million by the time of your next round, and Series A investors are willing to give you only an 8x multiple of your current ARR, the post-money valuation will be $16 million.
This is a significant decrease from your previous round and is considered a down round. The impact of a down round on founders' equity, anti-dilution clauses for prior investors, and overall company morale can be traumatic. To mitigate this risk, you must project your future growth needs before you accept a high valuation.
Models cannot be sent out immediately. Whether you use traditional SAFEs or convertible debt instruments, you will delay the formal pricing event; however, you will still mask the potential future dilution until conversion takes place.
How Specific Revenue Levels Control Tech Startup Valuation
The current private software market relies heavily on specific revenue bands. Several data sources including Software Equity Group, Carta medians, and others illustrate the type of return investors will receive based on different stages of company growth.
The One Million Dollar Revenue Mark
Once a startup reaches $1 million in annual recurring revenue, valuations will fluctuate dramatically between companies. The range of transactional multiples runs extremely wide, starting at 3x and going all the way to 25x.
The range of multiples for every point in between is directly attributable to differences in growth rates. Companies that are experiencing more than 100% annual revenue growth and have demonstrated high levels of operational capital efficiency will generally be able to find venture capital financing providing between 10 and 25 times their annual revenues for the initial capital.
Conversely, for companies that have experienced stagnant growth, or are operating in low-margin businesses, such as traditional marketplaces, valuations are significantly reduced.
For companies that incorporate a marketplace business model, the mid-range valuation for a business at that stage is averaging approximately 3.9x seller discretionary earnings. Micro-private equity and search funds will only pay between 2 and 4 times the annual revenue for an asset that doesn’t exhibit rapid growth at that stage.
When a company has $1,000,000 in annual recurring revenues, that company is selling their expected growth rate, rather than the actual revenue number.
Reaching Five Million in Revenue
Reaching $5,000,000 in annual recurring revenues significantly alters the profile of the corporation’s prospective buyer(s). Corporations that achieve that size typically face stringent financial metric thresholds to be able to raise capital.
The basement pricing multiple for privately held software companies in that range is between 4.8x and 5.3x. Bootstrapped corporations typically settle toward the lower end of that range.
To achieve a premium valuation multiple, between 7x and 9x the annual revenues of the company, a corporation needs to pass through two independent operational hurdles. First, a corporation must achieve a score above fifty on the rule of 40. Second, the corporation’s net retention rate must be greater than 120%.
If the company meets both criteria, it will create a clear separation from the average market participants. Companies in the $10-50 million range of revenues that show exceptional growth and low levels of revenue churn (e.g., high levels of customer retention) often fall into the 10-12x valuation range.
However, companies with average performance metrics will remain at the baseline of 5.3x for their valuation multiple.
Reaching Ten Million in Revenue
Companies generating $10 million in annual recurring revenue (ARR) represent a clear demarcation point in terms of the company’s stage of growth. Companies within this range include a wide variety of both healthy, stable businesses and companies that are high-growth venture targets.
Typically, a healthy software company will price themselves at 5 to 10 times revenue, whereas bootstrapped operations that are growing more slowly will be priced at 3 to 5 times revenue as acquirers factor in costs to get to those growth rates quickly.
High-growth stage companies in this revenue tier may realize an 8-15 times revenue multiple based on the market’s perception of their potential future growth. Additionally, niche vertical software platforms are likely to receive a premium at the $10 million ARR level with their valuation based on average growth metrics (with a 7-9 times revenue benchmark).
At this level, investors will be betting significantly on both the ability to execute upon the current concept, as well as the operational machine behind the company. Inefficiencies within the company’s sales and/or customer success processes will have a very negative impact on the valuation multiple a company is able to achieve at this tier.
Reaching Fifty Million in Revenue
Once a tech startup has achieved $50 million in ARR, there is no longer a price range associated with valuation; the median multiple for this cohort will be 6 to 8 times revenue.
Tech startups of this size have now become large enough to attract large strategic acquirers (e.g., public software companies) and large private equity rollup funds, both of which will pay a 10-15 times revenue multiple to acquire these assets to increase their portfolios.
When a firm is totally immersed in the realm of predictive analytics and machine learning, the multiples associated with this level of business will be very extreme. AI systems with $50M+ in annual recurring revenue (ARR) will receive between 18 to 25 times their revenue.
The Q1 index indicates the current median value of the enterprise-value-to-trailing-twelve-month-revenue multiple for all private companies at this level, and private firms at this size have been impacted substantially by the multiples associated with the public equity markets and are therefore trailing the public and have a standard discount on their private liquidity.
Important Metrics That Determine Your Price
Key performance indicators (KPIs) are vital metrics to establish the tech startup valuation a company will receive from potential investors. Investors do not estimate the value of a startup based on multiples alone but rely on objective operational KPIs to support their determination of where a startup falls within a multiple band.
There are four primary KPIs that will ultimately decide whether you will receive a premium multiple or a significant discount on your valuation.
Keeping Customers and Protecting Revenue
Net retention rate (NRR) is used to measure the amount of revenue generated over time by your existing clients, factoring in both account expansions and account churns. NRR is the most important performance metric for valuing software companies.
If NRR is greater than 130%, you are typically in the highest multiple tier and typically receive between 11 and 15 times revenue.
High retention rates indicate a high degree of product integration into the customer's workflow; therefore, they cannot easily extract themselves from their operations without significant damage.
On the contrary, an 80% retention rate indicates an inherent flaw in your business model and suggests you are losing a significant portion of revenue annually and are constantly in need of acquiring new clients to remain financially stable.
If your retention rate falls below 100%, you won't be eligible for a premium multiple no matter how aggressively you are growing your top line; thus, investors perceive it as a leaking bucket.
The Rule of 40
The rule of 40 is a very simple, yet brutal, calculation. To calculate the rule of 40, simply add your year-over-year revenue growth percentage to your profit margin percentage.
If the total is more than 40% you will have passed the test. Currently, the overall average displays that only about 23% to 26% of all public software companies today are passing this standard.
The rarity of passing the rule of 40 results in a premium. Companies that score more than 60% on this rule will easily receive multiples of 12x or more. Companies scoring under 30% will receive severe multiple compression.
Investors will cut a company's valuation multiple to the 3.0x-4.5x range in a very short time frame. The rule of 40 drives founders to weigh the need for aggressive growth against the need for fiscal responsibility. Founders may invest burn rate to grow, but their growth rate must far surpass their burn rate in order for them to maintain an acceptable valuation.
Earning Back Marketing Costs
The customer acquisition cost (CAC) payback cycle is a way of determining how quickly your business can recover the expense(s) associated with the sales and marketing of a single user. For example, if your CAC is $5000 and your user pays $500/month, your payback period is 10 months.
Although companies are generally expected to have payback periods less than 12 months in order to achieve a premium valuation, the faster the payback cycle can occur, the better it is for the company because it recycles cash.
Scaling operations requires significantly less outside capital than companies with long payback periods of 18-24 months. A prolonged payback period results in a company's inability to operate efficiently within its current cost model, thus resulting in a company's valuation being reduced immediately to the low 4-6 times range.
As a result, lifetime value to customer acquisition cost ratios must also significantly exceed 8 to 1 in order for companies to be competitive. Companies with lower ratios are likely experiencing a far too "expensive" sales process to warrant long-term revenue from its customers.
The gross margin of a company impacts the overall valuation multiples of all the companies in that industry; therefore, gross margin percentage should ideally exceed 80% before investors are willing to consider investing in a company at an 8-10x multiple.
Investors will generally only consider investing in companies at a 4-6x multiple if they have a gross margin percentage less than 55%, as this typically means that the cost of production of a company's product has eaten up a significant amount of its profits.
Revenue concentration acts as a major detractor during the due diligence stage of a company’s life cycle, as investors look closely at the company's customers to determine revenue risk.
If a company's top 10 customers generate in excess of 40% of the company's overall revenue, investors view this as a major concentration risk, as the departure of just two of those customers could result in the company’s demise, resulting in very low valuation multiples for that company.
There are a few different types of concentration risks that could potentially impact a company’s total valuation immediately upon the occurrence of a concentration risk event. It is strongly recommended that you diversify your revenue base before attempting any institutional fund raising activity.
Extra Value for AI, Product-Led, and Specific Industry Software
Not all software is valued equally in the marketplace. The technical architecture of your software product and the specific market strategy you are utilizing determine how the software product will be categorized into a valuation model. Investors are willing to provide a premium for those software products that use a particular business model to generate revenue.
The Extra Value of Artificial Intelligence
Artificial intelligence has completely destabilized the standard tech startup valuation models that were historically utilized by private equity investors. AI native platforms command a very significant multiple of revenue—typically anywhere from 14x to 18x—compared to traditional non-AI baseline software companies which typically trade at multiples of revenue (typically between 8x and 10x).
The additional premium of 80 to 100% that AI is able to create is based on the belief that AI platforms will have far greater operational leverage and market share potential over the long-term.
To claim this premium your company must meet certain very strict technical criteria. You can’t simply take your legacy software product and wrap it in a basic language model and claim the huge premium. Investors will view that as being a "shallow integrated" software solution.
AI integrated companies are only able to command 10.0x to 13.0x revenue multiples if their core workflow and data processing is built entirely off machine learning technology and continuously improving. Investors pay the premium because they believe that these types of AI platforms have the potential for far greater operational leverage and future market share potential than any other type of software product.
Product-Led vs Enterprise Sales
How you sell your software product is a foundational difference in respect to the value of that software product to the purchaser. Product-led growth relies entirely on the product itself to generate user acquisition, activation, and retention, whereas enterprise sales relies heavily on sales representatives closing larger deals over longer sales cycles.
Companies that sell their products under a product-led growth model have a valuation premium of approximately 20-30% compared to traditional enterprise sales models. Current multiples for companies that utilize product-led growth models are in the 9.5x to 12.0x ranges.
The valuation premium arises from the dramatic difference in user acquisition costs. A product-led growth company can spend between $500-$3000 to acquire a user automatically, whereas an enterprise sales company may spend between $10,000-$50,000 to close a single deal.
The significantly lower user acquisition costs for companies that utilize product-led growth enables them to achieve quicker payback periods and therefore generate significantly higher valuation premiums.
The Extra Value for Industry-Specific Software
Software specifically developed for use in a single industry (e.g., healthcare operations, construction management, etc.) is classified as vertical software. Vertical software companies can achieve high multiples in the current market by generating aggressive valuations of 12x-15x multiples.
The reason vertical software companies receive such high multiples is largely due to the extremely high switching costs associated with vertical software. Once a medical practice uses a vertical software platform to manage all its patient data and billing, chances are they’re not going to switch to another platform because the pain of removing the software is significantly greater than the financial costs of keeping the software.
For this reason, vertical software companies nearly always achieve nearly perfect retention rates. Investors are willing to pay a 15x multiple for a business that never loses a single customer.
Conversely, horizontal software (i.e., software that is built for everyone and anyone) must always compete on features and price and therefore has lower rates of customer retention compared to vertical software and therefore will have lower valuation multiples as a result.
Concrete Assets and Founder History
Defensible assets and a team are abstract concepts for many investors to value. For an investor to value the investment, concrete historical records must exist that support the valuation of the investment.
Judging a Founder's Past Success
Financial success has a direct impact on company value. In calculating the risk associated with a deal, an investor looks directly to the previous performance of the founding team. Take, for example, two identical start-up companies.
Company A is a start-up run by a founding team with two prior successful businesses sold for a total between $50 million and $200 million, while Company B is a start-up operated by a group of educated individuals who have not previously exited a business.
Investors may gladly invest a $2 million investment in Company A at a $12 million post-money valuation, but that same investor may only be willing to invest $1 million in Company B at a $5 million post-money valuation.
The two software products may be identical, but the execution risk is significantly divergent. Proven founders do not have to demonstrate their ability to hire and manage an operating team, handle cash flow, and sell the business; first-time founders carry a significant financial discount as the investor is effectively funding the founder's education.
How Patents Change Tech Startup Valuation
When companies have pending patents, investors will typically apply a 15% premium to the standard valuation during due diligence. After a patent is issued and legally protectable in the courts, the valuation premium goes up by about 30%.
Operationally defensible businesses with proprietary databases, direct access to exclusive information, and monopolistic positions in very narrow markets have premiums of 40% to 60%.
These premiums exist because defensible moats protect profit margins that would otherwise be lost to competition. If the software product being developed can be duplicated by a larger company within two months after commercialization, the valuation will remain dense.
Avoid Thinking Only About the Short Term
Rather than obsessing over achieving a maximum pre-money valuation, you should focus on creating a cap table that allows future investors to easily establish the price for their next capital inflow without creating a down round. Are the current operating metrics supporting what you are demanding or are you simply creating a negative carryover effect through debt to raise additional capital?