The Unusual Relationship Between Revenue and Valuation Over Time

People love to think of a startup’s valuation as readily determinable by a valuation expert based on agreed upon financial formulas. In reality, a startup is only worth what an acquirer is willing to pay. This is true because equity in a startup is an illiquid security that is very difficult to turn into cash, especially in a reasonable amount of time. Of course, valuations are set all the time based on things like public market comparables, multiples of profit (a typical company is worth 4-6x profit), combination of growth rate plus revenue, and other factors.

For startups, there’s an even a more unusual relationship between revenue and valuation over time as there’s no-to-little operating history, no-to-little revenue, and no profits. Here are a few data points over time:

• Month 1 – With a fresh idea and unlimited potential, the startup is actually worth more than when it starts to generate early revenue (e.g. valuation of $2M pre-money for an angel investor)
• $50,000 in annual recurring revenue (ARR) – With a few paying customers and some product / market fit, investors will begin digging into the start of a financial model, and since there’s some revenue, will start talking about multiples of revenue or annual run rate (e.g. valuation of $1.5M pre-money even though the company is clearly further along than month one yet the valuation isn’t better)
• $1,000,000 in ARR – With the magical seven figures market crossed, a whole new class of investors emerge (many VCs won’t invest unless the startup has at least a million in recurring revenue), valuations are discussed as multiples of revenue (e.g. a valuation of $5M pre-money based on 5x run rate)
• $5,000,000 in ARR – With an even more substantial base of revenue, product / market fit clearly in place, and market adoption risk negated, the revenue multiple starts to expand, especially with a high growth rate (e.g. a valuation of $35M pre-money based on 7x run rate)

So, valuation stays flat or even goes down from the initial formation of the company though the first or second year. Then, as revenue starts to grow, valuation grows at an even greater rate and really expands at a few different inflection points. Today, Software-as-a-Service is super hot and the market leaders are often trading at 13x revenue, which isn’t sustainable, but is the current state of affairs. Revenues and valuation don’t have a straight relationship over time.

What else? What are some other thoughts about the unusual relationship between revenue and valuation over time?