For SaaS or PaaS startups, valuation is often considered as combination of art and science. In case of B2B SaaS companies, financial metrics make more sense since the target market and pricing strategy has to be defined, which is not always the case with B2C companies, especially social companies such as whatsapp, instagram, facebook. In such cases, valuation is often based on “eyeballs”- number of users acquired by platform.

In the event of valuation, startup can be roughly categorised in two categories. First is the seed stage, second is the growth stage. Each phase implies different ways of valuation.

Seed stage

Startup valuations are fundamentally different from valuations of established companies because of risk involved. This phenomenon can be nicely explained using cone of uncertainty. As the time progresses, risk involved with startups go down. Since initially there is no revenue or even actual product in some cases, important factors for valuing early stage companies are (but not limited to):

• Product market fit
• Founders’ credibility and Team
• Market size, competition and opportunity
• Revenue and Cash flow projections

At an early stage most of the valuation is dependent on how well the product solves a particular problem and is the problem big enough to build a successful business. After the idea validation, it is important to assess if the team can deliver product or not. Idea alone is not sufficient, it has to be coupled with appropriate execution strategy to make an impact.

Financial metrics based on projected cash flows such as NPV can be used to determine value of the startup at seed stage.
An example could be $2.1M funding in seed round for zenefits. zenefits has a great product idea, credible team with some prior startup experience and big opportunity. All these factors have contributed heavily in getting seed funding.

Growth stage

At this point, the product has been validated and startup is getting some traction. In such cases, financial metrics help in valuations. For example, number of customers, customer growth rate, revenue growth rate, customer retention rate, churn rate and so on. Customers tend to favour first comers in the SaaS market and thus acquiring more and more market share becomes crucial.

The crux of valuation is a simple question - “Are they making more money than they are spending?”. However, this question has to be asked in conjecture with “how much more?”. Since software companies tend to have higher margins than traditional businesses, investors expect 5x-10x average return.

Revenue of the company is an important factor as it aptly describes growth of company. But revenues often do not tell the whole story, high revenue does not necessarily mean the company is profitable. Hence it is always a good idea to check net profits to get a better picture. Classic example of this case is amazon.

Since growth of the company is highly dependent on number of customers. Metrics which identify customer growth and retention are the most important ones. Insights from these metrics could be used to fine tune marketing strategies for upselling/cross-selling to generate more revenue per customer. Customer acquisition cost and lifetime value of customer can be taken as examples for such metrics. Again, the bottom line is to make more money per customer than spent in acquisition. Ideally, this period of recovering CAC should be less than a year. In case of companies such as uber or lyft, the cost of customer acquisition is recovered in few months. All the marketplaces have relatively low CAC as compared to LTV. If the balance is flipped, that means startup is losing money and is not scalable.

Another powerful way of valuing startups is by analysing historical data for similar companies. Investors can look at exits of similar companies and come up realistic predictions on how much the startup in question is worth. But the comparison has to be sensible, comparing duckduckgo to Google is probably not a good idea.

All of the above factors provide information so a startup can be valued pragmatically. However, in some cases, investors have to take leap of faith and envision the future. Because founders are selling what future might look like and not what currently exists.