Ever wondered how investors make funding decisions regarding startups?
In the initial stages, a startup only rides on a brilliant idea and a fabulous team-leading the execution. They do not have reliable, progressive data to show, especially about their profitability.
In this situation, how do you think investors gauge the merit of ideas? How do they know which startup would fetch them massive returns in the future?
A revenue multiple is the answer.
This category of multiples is part of a wider umbrella of company valuation techniques known as valuation multiples. Let’s discuss it one by one.
Any valuation multiple is a ratio of one financial metric to another. Over the years, as the startup marketplace evolved, investors realized that the usual valuation techniques used to measure the profitability of established businesses do not work for startups simply due to the absence of sufficient data. Among many multiples, the ones based on revenue calculations turned out to be a good fit.
What are Revenue Multiples?
As the name suggests, revenue multiples are valuation metrics based on company revenue. This works best for startups because revenue is the only stable value compared to all other factors. These multiples provide an opportunity to bypass complicated company valuation calculations based on earnings and cash flows. Mostly, startups do not have sufficient data to support such analyses. Thus, multiples derived from revenue values work best in this case.
Revenue multiple is derived by dividing the enterprise value by the total revenue generated by the startup. We will get into the calculations at a later stage, but for now, it is good to know that by using the enterprise value, this multiple provides a realistic estimate of a startup’s long-term profit potential. Enterprise value not only accounts for the market cap but also a startup’s outstanding debts and cash reserves. This gives a holistic picture of the current financial health of a startup.
Importance of Revenue Multiples in Startup Valuation
If you have spent some time analyzing investment processes, you will realize that one of the popular valuation tools is EBITDA and multiples derived from it. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. Early-stage companies are just starting their business process, and it is difficult to account for all the components of EBITDA. Thus company valuation based on EBITDA is not possible in the case of startups. A feasible solution is revenue multiples for startups.
Use of Revenue Multiples in Startup
Revenue multiple is a reliable valuation tool. But it can only function well in the hands of an experienced analyst. As a simple value, this multiple indicates nothing unless compared and analyzed with a strong foundation or working knowledge of the business and operating industry. In the hands of experienced analysts, revenue multiples serve the following purposes:
How do Revenue Multiples Help Tie Back Expenses and Cash Flow?
A realistic company valuation multiple must account for expenses and cash flow. In the case of startups, though this is difficult and revenue is used as a reference point, it must circle back to analyses that justify expenses and cash flows. This can be done by using the Gordon Growth Model or the Dividend Discount Model. As per this model:
This is the basic Gordon Growth Model. It is based on the concept that the true worth of a business is the present value only after discounting all future dividend payouts. But in the context of startups, especially tech startups, the concept of dividends may not work as their business model does not involve dividend payouts. In this case, the same Gordon Growth Model is adapted to account for the established cash flow into a startup. In this case, the following formula is used to calculate revenue multiple using the Gordon Growth Model:
Revenue multiple = Profit margin*Profit payout* (1+g) / (r – g)
This formula can only work if the startup has a constant growth rate and profit margins, and profit payouts. At times, this could be difficult for a startup as the business is just growing, and there might be some bumps on the path. This should not be taken as a negative in company valuation. Experienced analysts know that these ups and downs are part of a startup growth cycle. If nothing works, then the standard formula for revenue multiple is always reliable for a quick scan of comparative companies in the industry.
What is a Reasonable Revenue Multiple?
Revenue multiples for startups can have a straightforward interpretation. A high multiple indicates high growth and high-profit margins, while a low-value multiple indicates the opposite. But to think of it, this is a vague reading. How high is high, and how low is low? Also, in the initial stages, a startup can have a sudden growth spurt and show very high multiples to the range of 200 – 300x. But this will change and stabilize over time. Thus, analysts with true industry experience can provide a realistic picture of the true meaning of revenue-based multiples. Here is a basic range guide:
1x – 5x:
This is the base range. Startups with revenue multiples in this category are growing slow, approximately 10% per year. If this range is explored further:
6x – 10x:
This range of revenue multiples is usually found in companies with a growth rate of below 50%. Investors are choosing companies in this range usually fund startups growing at a rate of 30 – 40% per year.
10x – 20x:
This is considered a high-range multiple. Such a high range is usually seen in companies growing at 300 – 400% per year.
As we have seen so far, revenue multiples are, on the one hand, extremely helpful, especially in the context of startups. But, like every other valuation metric, they have their limitations as well. Here is a brief summary:
Pros of Revenue Multiples:
Cons of Revenue Multiples:
Revenue multiples may seem extremely simple and conversational. Investors and analysts could speak in terms of these multiples over a cup of coffee. It is that convenient. But, to an inexperienced eye, solely revenue multiple based judgments can be misleading. Here are some factors to be considered while revenue multiples:
The revenue multiple formulae is very simple. It is derived by dividing the enterprise value by revenue.
Revenue multiple = Enterprise value / Revenue
Enterprise value = Market cap + Debt + Preferred shares + Minority interests – Cash and cash equivalents
Revenue = Total annual revenue
Let’s approach this with an example:
Enterprise value = A + B + C + D – E
= $50,000,000 + $10,000,000 + $50,000 + $1,000,000 – 20,000,000
Enterprise value = $41,050,000
Revenue multiple = $41,050,000 / $25,000,000
Revenue multiple = 1.6 x
As per this calculation, it can be said that this company is trading at a 1.6x
Valuation multiples as a group can be categorized into two types:
Revenue multiples per se belong to the category of enterprise multiples. The various types of enterprise multiples are:
These were some basic ideas about the concept of revenue multiples. Take time to understand how these multiples are used in valuations for startups and how you can benefit by using them for your company.