Sorry, But Your Expansion Stage Software Business Probably Ain’t Worth $100 million

I continue to be amazed by the number of entrepreneurs that can show a relative lack of sophistication or business acumen in a conversation until the topic of their business valuation comes up. Once it gets to that point, they can rattle off every Andreesen Horowitz deal and how “X” business was acquired at 10x revenue.

For whatever reason, the math always seems to magically work out to a pre-money valuation of around $100 million. Indeed, there are numerous expansion (and some early stage) software companies that have raised outside capital at $100mm+ valuations, but I thought it made sense to share my (and many investors) thought process on valuation.

First, it’s important to note that in most other areas of investing, businesses are valued off of some proxy for cash flow (EBITDA, EBIT, etc). I point this out because I think some people lose sense of the fact that valuing a business as a multiple of revenue is, to begin with, generous.

It should also be noted that valuation is more art than science, or perhaps a more appropriate statement is that valuing a business is art rooted in science. Very simply, I like to take an average of a basket of publicly traded company EV/Revenue multiples, then apply a 25-50% illiquid discount and start there. On top of this, I’ll look at the revenue components and value each of those individually to get a sum of the parts total valuation.

So, for example, if a SaaS business is doing $15mm in total revenues, but $10mm of that is recurring subscription revenue, $2.5mm is professional services, and $2.5mm is maintenance, I might say that recurring part of the revenue stream is valued at 3x revenue, the professional services component is valued at 1x revenue, and the maintenance component is valued at 1x revenue, yielding a total valuation of $35mm. On top of all that we may layer a further discount or premium based on perception of team, risk, market, etc.

The bottom line is that this is one iteration out of many for how a business can be valued and should help explain where a VC may start a valuation conversation for an expansion stage software company.