Valuing a SaaS business once it’s generating revenue comes down to a number of factors including ARR, growth rate, churn, expansion, unit metrics, size of market etc. But what about if you haven’t even got a product yet, let alone any paying customers? Then what are you supposed to base your valuation on? Ironically, valuing your business before you start charging customers is actually easier than valuing it once you are revenue generating.
If you are looking to raise investment for your fledgling business you will certainly need to build a business plan that includes some idea of future revenues. Depending on who you are pitching to and how much detail you go into, you may also have something in there around how much those customers are going to spend over time and how much it will cost you to win them. But, aside from demonstrating that the model works, those numbers aren’t what determine your valuation pre-revenue. Which is good because the very last thing you want to do with an interested investor is get into a debate about valuation based on future numbers. If you do, they’ll just end up saying that their forecast is more accurate than yours - and that’s a difficult position to argue from.
Before we get into the alternative, let’s consider a typical investment transaction. There are three key elements.:
The value of the business
The size of the investment
The equity that gives the investor
Normally we know the valuation (because it’s largely based on performance) and we know the amount of money we’re looking to raise. And then using those two numbers, we get to work out how much of your business an investor would end up owning.
If my business has a value (based on its performance) of $70m and I’m looking to raise $10m, then to work out how much equity the investor would own we use the following formula:
(Investment Amount / (Valuation + Investment Amount))*100 = EQUITY %
Step 1, I own 100% of the business valued at $70m
Step 2, investors put in $10m, now making the business worth $80m in total
Step 3, investors now own $10m worth of shares in a business worth $80m, or 12.5%
((10m / (70m + 10m)) *100 = x%
or
(10m / 80m) * 100 = 12.5%
That’s all OK where we have some revenue numbers to base a valuation on. But in our case, we don’t have the initial value of the business to start that calculation because we’re so early stage. Instead we have to look at the second two items:
2. The size of investment
3. Size of the equity
Let’s say you want to raise $1m and you are prepared to give away 20% in equity. Can you use the same formula as before? Yes, it’s just that before the equity % was unknown, now it’s the valuation that’s unknown.
(Investment Amount / (VALUATION + Investment Amount))*100 = Equity %
or
(1m / (x + 1m)) * 100 = 20%
or
(1m / (4m + 1m)) *100 = 20%
Using this formula, you can see that if you want to raise $1m and give away 20% of your equity, you will need to value your business today at $4m. Giving you a post-money valuation (ie after the investors’ money has gone in) of $5m. The investor owns $1m of a $5m company, ie 20%.
But how do you work out the size of the raise and the size of the equity?
Good point. If we can’t use current revenue numbers to value the business (because we don’t have them yet), surely that prevents us from arriving at size of raise and equity amount, too? Actually, no. And in fact, those two numbers are much easier to arrive at than a valuation based on multiples of revenue metrics.
SIZE OF RAISE
The size of raise is fundamentally based on what you calculate you need to test a hypothesis. Bear with me on this. You're not asking for money because you need to hire a couple of devs and maybe a marketing person and ‘it’s about time you and your co-founder got a bit of a salary too’. You’re raising money because you believe you have a potentially world-class solution to a problem and you want to prove that, by building and launching a product and winning 20 customers paying you $5,000/month each. At which point you will either raise more money, or borrow money or become profitable. And the cost to the business of you achieving all of that is going to be $1m.
This is absolutely key. You need money to help you get from where you are now to a place in the future at which point something else will happen. Once you’ve spent your investors’ money, the company will be in a different place. Rather than a shopping list of what you want to buy with their cash, instead you are demonstrating how their cash will move the business forward.
Why is this important? Because an investor will prefer to spend as little as possible and own as much of your business as possible. You want to control the debate. You’re saying it’s going to cost $1m to get to 20 customers paying $5k/month. That’s pretty clear. If the investor disagrees he or she needs to explain what part of that they think is wrong and why. Do they know it will only cost $500k? How? Do they think that winning 20 customers is too few for the $1m? Why? What are they basing it on? What do they know about your market that you don’t?
Chances are they won’t disagree with you unless you are saying something absurd like you need $100m to win 20 customers, or you will only win one customer but they will be paying you $1m/month. If the fundamentals of what you are saying seem reasonable, why would anyone disagree?
SIZE OF EQUITY
OK, so assuming you’ve made a convincing case why the business needs $1m and not $500k or even $2m, then that just leaves the Size of Equity. If you’ve watched Shark Tank in the US or Dragon’s Den in the UK, you’ll see investors negotiating on this “I’ll give you all the money you want, but I want 45% of the business”. But the reality is, for an early stage SaaS business looking to be venture-backed, there is a high chance this won’t be your only investment round. Which in turn means that any investor looking to take too large a chunk of the company is an idiot. And that’s because future investors won’t want to invest in a business where the founders aren’t properly incentivised. If you give away 45% of your business for $1m you’ll either find that a future investor will pass, or they will pressure the original investor to give you some of their shares back in order for the business to thrive. And for the original investor, it’s better to own a smaller amount of a successful company backed by some decent investors, than a large amount of a SaaS going nowhere fast.
Any investor worth their salt would ask for 25% at an absolute maximum at this stage. A typical first raise should fall somewhere between 10% and 25% depending on how far the business has got and how large the risks are.
Doing the math
Once you have your story straight about why you’re raising the amount you are raising and pick a number you think is reasonable for the equity you’re prepared to give up for that investment, then you have that final piece of the jigsaw: the valuation.
We’re raising $1m investment at a valuation of $5m (post-money).
And if the investor asks how you arrived at that valuation you just say, it’s based on the money you need to test your hypothesis/get you to a milestone and the amount you’re prepared to give up as equity. Any arguments after that should be in your comfort-zone, rather than an investor’s who might prefer to talk about revenue multiples.