When it comes to determining your company’s valuation, a thorough understanding of your numbers is critical. In his highly informative session, Tomasz Tunguz, the Managing Director at Redpoint Ventures, shares the essential benchmarks you need to track your company’s valuation and where to look to make improvements.
Revenue Design: Valuing a Software Company
Generally, companies are split into different valuation types:
- Value Investing: Based on the company’s profits.
- Growth Investing: Based on revenue growth.
“The truth is all startups are valued as growth companies. That’s because they are some of the fastest-growing companies in the world,” says Tunguz.
Yet often growth companies are not generating profits. So how can you assign a value?
Investors look at a number called a growth multiple to determine a growth company’s value. To find your growth multiple, you’ll want to use the following formula:
Estimated Value (EV)
[Market Cap Minus Cash, Plus Debt]
[Projected Revenue for the Next Twelve Months]
Seems simple enough, right? But there is more to it than this single number. If you want to discover ways to increase your valuation, pay attention to the five major components behind this multiple.
The Five Metrics to Help Increase Your Value
# 1 Revenue Growth. Not every company grows in the same way. There are two approaches to increasing revenue:
- Unprofitable, but high revenue growth. Consider the example of the software company Snowflake: This business raised lots of capital and invested it in efforts to grow revenue. Yet because of this decision to focus on growth instead of profitability, they achieved one of the highest revenue growth metrics at the time of IPO of any software company.
- Profitable, with a slightly slower growth rate. Atlassian, another software company, was founded in the year 2000 before the modern VC landscape developed into its present form. Atlassian did not take any capital but managed to grow at a decent pace and has become profitable.
You will need to assess factors like your product, target market, and current competition to determine which growth strategy is right for your business
#2 Gross Margin. To calculate gross margin, use the following formula:
Gross Margin = Revenue – Cost of Goods Sold (COGS)
What goes into COGS for software companies? It typically includes things like cloud computing costs, professional services, customer success, and licensing.
#3 Sales Efficiency. While there is no standard way to calculate sales efficiency, Tomasz recommends the following formula:
Sales Efficiency = [Gross Profit Period 2 – Gross Profit Period 1]
Sales & Marketing Period 1
So what is sales efficiency telling you about your performance? Sales efficiency reveals how much gross profit you generate when you invest in sales and marketing efforts. The greater the sales efficiency number, the better the business performance.
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#4 Net Dollar Retention (NDR). To find your NDR, you’ll want to divide your present cohort value by last year’s cohort value. “At a high level,” says Tunguz, “the whole idea of NDR is how quickly is my bank account growing? How quickly are my customers going to pay me?”
If you’re looking to improve NDR, consider devoting your efforts to the following areas:
- Products & Pricing: Understand your customer segment of the market, ensure you can efficiently cross-sell adjacent products, and finetune your pricing structure.
- Customer Success: Stay proactive with account planning, encourage upsells, and cross-departmental sales.
#5 Cash Flow Margin. The more cash your business generates, the more you can invest in growth. Less cash means more equity investment and more dilution.
Cash Flow Margin = Cash Flow From Operations ÷ Revenue.
- To improve your valuation, look beyond the growth multiple. There are metrics that you can track and improve upon to increase your valuation.
- Before adopting a growth strategy, assess your specific business needs to determine whether to pursue a high revenue growth model or a profitable model.
- To improve NDR, dedicate your efforts to cross-selling, upselling, an effective pricing infrastructure, a deep understanding of your customer segment, and top-notch customer support.
- Ensure your business is at peak performance by tracking whether the money you spend in sales and marketing generates any gross profit in return.