What are the pros and cons of using revenue multiples to value a start-up? (2024)

**Pros of Revenue Multiple Approach:**1. Simplicity & Transparency2. Ideal for Early-Stage or High-Growth Companies: Particularly advantageous for startups or firms poised for rapid revenue expansion3. Facilitates Industry Comparisons: Allows for straightforward benchmarking against similar companies within the industry4. Emphasis on Top-Line GrowthCons1. Neglects Profitability & Costs: Overlooks crucial aspects like expenses, profitability, and operational efficiency2. Excludes Non-Revenue Metrics: Fails to account for vital indicators such as customer retention, market share, and competitive positioning3. Doesn't Address Inconsistent Growth Patterns4. Subject to Industry Variances

Revenue multiples are a short-hand way to compare the valuation of similar companies (same industry, same business model) by revenue performance. In recent years, revenue multiples have been applied as a method of valuing companies - for which they are deeply inappropriate. They are, in the best case, a practical way to calibrate a valuation to the market conditions at that time. Revenue multiples fail as a valuation method on two counts: They fail to look at the subject company with any meaningful resolution, due to the focus on comparison.They rely on finding suitably similar companies which is challenging in a market where companies are unconventional by nature.

Revenue multiples are a benchmarking technique, where you value your startup based on the multiples of similar startups in your industry. The key here is to find startups that operate in the same industry, geography, serving the same customer, and possibly at the same stage of growth.Using revenue multiples are one of the best ways of valuing early stage startups, which are not yet profitable, and where other methods like DCF do not work (since cash flows aren't predictable)

Often revenue multiples for start-ups are determined using 'comparable' businesses - businesses that address a similar market, or have a similar value proposition or solution.But keep in mind that early stage valuations are more of an art than a science, and as the paragraph above mentions, fluctuate wildly based on current market conditions.

✅ Stick to the Basics: Revenue multiple is a valuation metric. It is calculated by taking the company's current valuation and dividing it by its current or estimated revenue. It's essentially an answer to the question: "How many times the revenue is someone willing to pay for a company?"✅ Look at Comparable Companies: To find an appropriate revenue multiple, look at the multiples of similar, publicly traded companies in their sector. This gives a ballpark figure, but the catch is that, established companies may have different trajectories and risk profiles than startups.✅ Adjust for Risks: High-growth startups might command higher multiples due to their growth potential. On the contrary, more risk could reduce the multiple.

Calculating revenue multiples is both subjective and precise in nature. As the multiple is an indicator of future earnings or revenue, one has to make assumptions about how much the business is going to grow. The more traction + scalability in a business model suggests a higher revenue multiple, whereas slow growing businesses tend to get lower multiples. Benchmarking using comparables is another way of obtaining a revenue multiple, what other companies have achieved multiple using a similar business model within the same space with similar metrics.

For me, four factors influence the revenue multiple paid:- revenue growth (double or triple YOY growth percentage)- Gross profit margin today- expected EBITDA profit margin when it materializes- market competition today or expected market entrants in the future

4 main factors: Market sentiment: is the industry on a high growth trajectory?Quality of revenue: ideally, scalable recurring revenueAssets: possessing difficult to replicate assets (such regulatory approvals) Revenue growth: 20% + YoY

✅ Simplicity: Unlike some valuation methods, using revenue multiples is fairly simple. No need to dive deep into financial projections (which are subjective). Just look at your current revenue, slap on a multiple, and you've got a valuation! Especially useful when you're in early-stage talks with investors or partners.✅ Benchmarking: Many sectors have established revenue multiples. Startups can easily compare themselves to peers, understanding where they stand in the game of valuation. This helps when negotiating with investors or assessing market position.✅ Focus on Growth: For startups, it's often about top-line growth. Revenue multiples encourage this perspective, rewarding those who can scale fast and efficiently.

As a saas, seed-stage startup CEO turned Chief Growth Officer:-market-driven vs. venture-driven-susceptible to economic trends-susceptible to geopolitical conflicts-forces you to "think like" a venture capitalist/investor-yet you are not a startup fund, usually-FOMO drives revenue multiples up - regardless of whether they "should" or "shouldn't." (everyone ends up being human)-90% of startups fail, and most of the original "projections" you built, will become useless.-Growth > Rev. VCs will "fund growth" (even if you're not profitable)-tacking on someone else's business model on top of yours -fulfilling the vc model on top of your own tend to create conflicts, and expand opportunities for misalignment/poor communication

I'm a Boston-based seed stage investor. At the stage I invest there are often no revenues, so multiples end up being zero. Not a great metric. And basing off projections is highly dependent on the aggressiveness of the entrepreneur. Anyone can show $1B in revenues in 10 years, but believably? I prefer the term "price" to "valuation" in any case. It will be based on the investor's perceived risk and perceived reward, and will be compared to other companies with similar profiles. It is thus a market-dependent number, as can be seen in the higher "valuations" seen in Silicon Valley than in the Northeast. The best way for an entrepreneur to price their deal is by talking to a lot of investors and getting their feedback.

It depends on the stage in the startup lifecycle. In early and pre-revenue stages, its best to go for a convertible, and postpone the game of valuation. According to me the best time to use a revenue multiple is when a decent level of product-market fit, and predictability has been achieved.The best alternative is the DCF approach. This method estimates the value of an investment based on its expected future cash flows. For startups, it can be a more comprehensive look than just revenue, but predictions can be challenging due to their volatile nature. This method is especially relevant today in the era of "find the path to profitability" vs the earlier mantra of "grow at any cost"

My start up experience suggests that tracking initial marque customers is the gateway to understanding the value of early stage start ups.

(edited)

(part 1)I would propose an alternative perspective, linking the metric to the maturity of the business, as I do in my valuation classes.Early on, there is just no basis for forecasting profits, when the business is just starting to have revenue. At that stage, there is no reasonable alternative, and even the revenue multiple must carefully leverage the choice of comparables which should be at a similar stage.At the other end of very mature and stable businesses, nothing can be as precise as the P/E ratio, but it still benefits from adjustments for risk, growth and payout ratio.