As a startup matures and sets out to raise its Series B round, the way that an investor underwrites a company changes. The investment decision no longer relies solely on the story that’s being told. Instead, it increasingly shifts toward the quantitative aspects of the company’s performance.
In this article, we explain the changes that occur as a startup matures and how investors value a growth-stage company.
Key due diligence criteria for growth-stage investors
When a company is first starting out, an investor’s due diligence is primarily focused on the promise of what the company could be — the team, market potential, and early validation, to name a few factors.
Over time, the company finds product-market fit and develops a repeatable customer acquisition strategy to grow its revenue.
As new data points are made available, an investor's due diligence shifts to focus less on the qualitative elements that suggested promising growth at the early stage, and more on the proven performance of the company — as well as financial return scenarios based on the expected growth rate and earnings potential of a company.
Here’s what you should expect growth-stage investors to analyze while reviewing your company:
Growth rate
Growth is important at this stage in a startup’s life. Investors will analyze a company’s month-over-month growth in customers and revenue. Actual target growth rates vary by industry, but investors want to see a consistent positive growth rate each month. With a higher growth rate, founders can attract a higher valuation because investors expect greater future cash flows.
Financials
Investors spend more time at this stage analyzing the financial health of the business. This is a key factor that informs an investor’s valuation in the growth stage.
Financial considerations include a company’s revenues, expenses, accounts receivables cycles, burn rate, and cash runway. Not only will investors analyze the current financial performance, but they will also forecast future financial performance to help inform their valuation of a potential investment opportunity.
“Price or valuation is the present value of the future cash flows of the company,” says Jamie Melzer, managing partner of HF Scale Partners. “What this company is worth today is all of the future earnings of the company discounted back to today.”
Customer acquisition and retention
Can you acquire new users with a repeatable and sustainable process?
This relationship is often cited as lifetime value (LTV) to customer acquisition cost (CAC), and is an important consideration in evaluating your company’s unit economics and scalability. In order to keep growing without running out of money, a company must be able to acquire customers inexpensively and keep churn low and retention high.
Product expansion
Investors want to see signs that your team is thinking about how to expand, both to better serve your existing customers and to widen your addressable market with new offerings. Which complementary products or services can you develop and launch that will enable you to verticalize a segment of the market, or stand up new verticals?
New products introduce revenue diversification into a company’s business model, and subsequently, less risk. This becomes increasingly important as a company moves from the growth stage to the late stage and begins IPO planning.
Valuation methods growth-stage investors use
As your startup matures and establish more of an operating history, it outgrows a lot of the initial risk or unknowns that existed in its earlier stages.
Growth-stage investors think less about what you could become, and instead, turn to underwriting your current business. What could your company be worth in the future given your earnings potential, and what is the appropriate amount to pay today for that future earnings potential?
With these questions in mind, investors might use one of the following valuation methods to underwrite growth-stage startups:
Market multiple approach
This valuation approach compares the key financial metrics of your startup to similar companies that trade in the public markets.
Specifically, a company might be valued using a multiple of enterprise value (EV) to revenue, EV to operating income, or EV to free cash flow (FCF). This comparison analysis allows investors to value an investment opportunity in line with how publicly traded comps are valued.
Why would a growth-stage startup be compared to publicly traded companies? Because an IPO in the public markets is considered the ultimate liquidity event for many companies.
“I think the closer that the company gets to IPO, the more it matters how the public markets would price that company,” Melzer notes.
After running a comparison analysis of similar companies, investors then adjust their valuation multiples up or down depending on the unique characteristics of the company they are analyzing.
Discounted cash flow analysis (DCF)
In a DCF analysis, an investor is aiming to value a company based on its intrinsic value — that is, the company’s ability to generate future earnings.
Now, this isn’t always easy to do at the growth stage, especially if a company is growing rapidly and generating little to no earnings.
But as a company raises each subsequent funding round, a DCF analysis becomes increasingly important as the company moves closer to a potential exit through an IPO. This is because the DCF analysis is the core financial model used to evaluate companies in the public markets.
Performing a DCF analysis can become complex, but the general steps are as follows:
- Forecast the company’s future free cash flow, as well as the company’s “terminal value.” — the estimated value of the company beyond the initial forecast period in the model.
- Discount the future cash flows using the investor’s required rate of return. This rate is typically high for VCs given the risky nature of investing in startups.
- Add the net value of any non-operating assets the company has on hand, like cash, to the present value calculation of expected future cash flows.
This analysis is an important exercise in valuing companies, but can have its limitations for startups that are in hyper-growth mode and generating little free cash flow. Therefore, this is just one data point in a financial analysis of a growth-stage startup.
Venture capital valuation method
The VC valuation method is a strategy to “back into” the current valuation of a company based on how much capital a company is looking to raise, the expected exit value, and the investor’s required rate of return (IRR) on the investment.
First, an investor will estimate a company’s exit timeline and expected valuation at the time of an exit (derived from a market multiple from a publicly traded peer).
Then, the investor will determine their required rate of return which is used to discount the future exit value back to the present. Investors will generally expect a different return profile for growth-stage investments than they do for early-stage investments. This is because, for growth-stage investments, there’s less risk that the company will go to zero, so an investor can accept a lower rate of return given that more of their portfolio will return capital than in the early stage.
“For later-stage, you're typically looking for [roughly] 2-5x,” says Melzer on target investor returns. “For growth stage, it’s probably 7-10x depending on where you sit in that growth stage — maybe 5-10x if you're a little bit later, or 10x if you're a little earlier.”
This results in the investor’s post-money valuation for the investment, which can be used to determine the company’s pre-money valuation and the investor’s ownership percentage.
Growth-stage startups can be a mysterious group to underwrite for investors. These companies are too mature to simply “sell their vision” while fundraising, but often too young for investors to confidently value future cash flows.
Therefore, investors use a mix of both strategies that early-stage and late-stage investors would use to underwrite companies with the goal of achieving a successful exit outcome for all stakeholders involved.
Tucker McKay