Valuation of Tech Companies: A Comprehensive Guide
The valuation of tech companies is confusing to tech founders - and many technology investors (and even some VCs…). As the leading CPA firm serving VC-backed startups, we advise clients who collectively raise billions every year in VC funding - and work closely with one to two clients a month who are acquired by major, publicly traded technology companies. So we’ve seen first hand how tech companies are valued, and often guide our founders during negotiations around how much their startup is worth.
This comprehensive guide explores the intricacies of tech company valuation, providing insights into methods, factors, and unique considerations that shape the process. We’ll also discuss how different players in the startup ecosystem determine value - their methods are often quite different!
Understanding the fundamentals of tech company valuation
Valuing a tech company involves a complex interplay of financial metrics, growth potential, and market dynamics - and depends on who is “buying” the shares or company. Unlike traditional businesses, tech companies often possess unique characteristics that can make traditional valuation methods challenging to apply. These may include rapid growth rates, initial negative earnings, or significant intangible assets (that can make a company strategically worth a lot to specific buyers).
It’s important to note that different stakeholders may approach tech company valuation differently:
- Venture Capitalists (VCs) often focus on potential future growth and market disruption when deciding how much to pay when they make an investment.
- Acquiring companies may emphasize synergies and strategic fit in their valuation process.
- Public market investors typically rely more heavily on traditional financial metrics and growth projections when they consider how much the stock of public tech companies is worth.
- 409A valuations, required for tax purposes, often take a more conservative approach, considering fair market value without strategic premiums.
These varying perspectives can lead to different valuations for the same company, depending on the context and the party trying to decide how much the company is worth!
Key valuation methods for tech companies
When it comes to valuing tech companies, several methods are commonly used. The choice of method often depends on the company’s stage, financial profile, and the purpose of the exercise.
Here are the primary valuation methods:
Revenue Multiple: This method is particularly well-suited for all technology companies that have started generating sales, especially enterprise software companies. It’s especially useful for companies with recurring revenue streams, as their predictable revenues are expected to continue in the future.
To calculate:
Valuation = Revenue × Multiple
The multiple used can vary widely based on factors such as growth rate, market position, and industry trends. To the extent that VCs use a method to decide how much to pay when they purchase shares, this is likely the one. However, for some businesses, like SaaS companies, the VCs will apply a revenue multiple to ARR, and often they will apply it to projected revenue.
EBITDA Multiple: This method is often used to value businesses for sale and assess their financial health. It’s particularly good for companies with a history of positive earnings. Smaller, bootstrapped tech businesses likely will encounter this method if the founder sells the business; however, it’s not very useful to VCs since most tech startups lose money and have negative cash flow.
The formula is:
Valuation = EBITDA × Multiple
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) provides a view of the company’s operational performance.
Discounted Cash Flow (DCF): This method is not commonly used for early-stage tech companies due to the uncertainty of future cash flows. People who use this method tend to be academics or investment bankers (working with later-stage, slower growing, profitable companies). It involves:
- Projecting the company’s future cash flows
- Determining an appropriate discount rate
- Discounting the projected cash flows to their present value
- Summing these discounted cash flows to arrive at a valuation
Price-to-Earnings (P/E) Ratio: This method is useful for mature tech companies that produce profits. It’s good for public companies, but not very useful for small startups (especially unprofitable ones).
It’s calculated as:
P/E Ratio = Stock Price / Earnings Per Share
A higher P/E ratio suggests that investors expect higher earnings growth in the future.
Comparable Transactions Method: This involves finding and analyzing similar deals in the same industry or sector. While exact comparisons can be challenging in the diverse tech sector, this method can provide useful insights into market values, multiples, and trends. We definitely see tech bankers using this method when they advise on a startup’s sale. We’ll talk more about this in a bit, but most VCs sort of use a method like this, in that they know how much comparable companies are worth and propose the same for companies that they are trying to invest in.
Book Value Method: While often less relevant for tech companies due to their high proportion of intangible assets, the book value method can provide a baseline valuation.
It’s calculated as:
Book Value = Total Assets - Total Liabilities
Liquidation Value: While not commonly used for going concerns, understanding the liquidation value can help investors evaluate the risk of their investment. A higher potential liquidation value typically indicates lower risk. We do see “cost to replace” used sometimes in 409A’s.
Backsolve Method: The Backsolve Method is widely accepted by auditors and provides a quick way for startup executives to check the accuracy of their 409A valuation reports.
It’s particularly useful because it’s relatively simple, cost-effective, and based on actual market transactions. However, it’s important to note that this method may not be suitable if the last funding round was too long ago or if significant changes have occurred in the company or market since then.
How to value a private tech company at a sale
For many private technology companies, the moment when valuation really matters is when the company is sold. Since Kruze is usually assisting on due diligence for several exits any given month, we’ve got a unique view into how acquiring companies actually value the startups that they acquire.
If an exit is not strategic (i.e. the buying company isn’t only motivated by some sort of tech, brand or customer list), then the valuation tends to be based on simple multiples of revenue or EBITDA. This multiple is going to depend on the industry and the company’s growth trajectory. For example, SaaS Capital lists out recent SaaS multiples here. Basically, about 6x ARR, but this will of course change after we publish this article!
One item that founders need to understand is that acquisition agreements negotiate specific terms for what the target company will be worth, and that includes making adjustments for net working capital and debt. You can read about the net working capital adjustments in our article on the topic, but the basic concept is that acquiring companies will adjust what they pay based on the company’s balance sheet.
Capital structure matters too - how the company has been financed. Not only do founders need to think about their preferred shares’ preference stack, but also they need to understand how debt (including credit card debt) impacts what they get in a sale. This is where the concept of enterprise value comes into play. Enterprise value is a more comprehensive valuation that including debt and excluding cash from the market capitalization:
EV = Market Capitalization + Debt - Cash and Cash Equivalents
Basically, if an acquiring company buys the business and gets a bunch of cash, then the startup is worth that cash. It’s like buying a wallet that includes money in it - you’d pay more if the wallet had more money. And the opposite is true for debt that the acquiring company will take on.
How VCs value startups
Venture capital valuations, particularly for early-stage startups, often diverge significantly from traditional valuation methods. This is because conventional metrics like DCFs or balance sheet ratios fail to capture the potential of nascent companies, many of which may not yet have revenue or positive cash flow.
Instead, VC valuations are primarily driven by market dynamics and potential future value. The process is less about concrete financials and more about assessing the startup’s potential to disrupt markets and scale rapidly.
The other item impacting what VCs will pay for shares of a startup is how competitive/hot the company is - the best startups tend to have many investors vying for shares, which can push up the price. Of course, “best” is subjective, and it’s easier to be “best” if you have a pedigree (i.e. Stanford, worked at Stripe, etc.).
VCs also have to take into account how much of the company the founders will own after they make an investment, and consider the ownership dilution from future funding rounds as well. If a founder becomes too diluted, then experienced investors will become worried that they might quit and leave the company. This results in early-stage investors usually paying way more for the shares than traditional valuation methods would suggest.
Key factors that influence VC valuations include:
- Product-market fit and early traction (could be revenue growth, could be user traction)
- Team quality and track record
- Market opportunity size
- Competitive landscape
- Intellectual property and defensibility
- Growth potential
Eric Ver Pleog, a GP at Tunitas Ventures, provides insight into the VC valuation process:
There’s a market rate and if you ask five venture investors, take the name off the company and just give the relevant details, they’d all come up with close to the same number as here’s the market rate for a company in that kind of position, with how much revenue and growth and what level of credibility, the team, and what sector and defensibility business model and size of the market opportunity. You’d be shocked how close the numbers were for all of them. Because they’re all in the market and they’re all seeing what the prevailing prices are on deals that are getting done. The trivial answer is: price is supply and demand.
VC ownership drives valuation
Typically, VCs aim to acquire 15% to 25% of a company in any given funding round. A common approach is to determine the amount of capital the startup needs to raise, then divide this by the desired ownership percentage (often 25%) to arrive at an implied valuation. Not very scientific!
It’s crucial to note that this approach can lead to valuations that seem inflated when compared to traditional metrics. However, the goal for VCs is to identify companies with the potential for exponential growth, aiming for returns of 10x or more on their investments.
Learn more about the importance of 409A valuations for startups
How public stock markets value tech companies
Public stock markets take a different approach to valuing tech companies compared to private investors. While growth potential remains important, public markets tend to place more emphasis on current financial performance and near-term growth prospects. Recent earnings, analyst notes and even competitors’ performance can impact how a public tech company’s stock moves.
For SaaS companies, the Bessemer Cloud Index does a good job tracking the performance of public SaaS companies and their current valuation multiples.
Key factors influencing public market valuations of tech companies include:
- Revenue Growth: Rapid and sustainable revenue growth is often rewarded with higher valuations.
- Profitability: While some high-growth tech companies can command high valuations despite being unprofitable, the market generally favors companies that demonstrate a clear path to profitability.
- Market Share and Competitive Position: Companies with dominant market positions or those disrupting large markets often receive premium valuations.
- Recurring Revenue: Business models with high recurring revenue (like SaaS companies) are typically valued more highly due to their predictability.
- Margins: Companies with high gross margins and improving operating margins are viewed favorably.
- Cash Flow: Strong and growing free cash flow is highly valued, especially for more mature tech companies.
- TAM (Total Addressable Market): The potential market size for a company’s products or services can significantly impact its valuation.
- Innovation and R&D: Companies that consistently innovate and invest in R&D to stay ahead of the competition often command higher valuations.
Public markets typically use a combination of valuation methods, including:
- Price-to-Earnings (P/E) Ratio
- Price-to-Sales (P/S) Ratio
- EV/EBITDA (Enterprise Value to EBITDA)
- Price-to-Cash Flow
It’s worth noting that public market valuations can be more volatile than private market valuations, as they are subject to broader market sentiment, macroeconomic factors, and short-term trading dynamics.
Startup valuation trends: Seed and Series A
Understanding the trends in startup valuations can provide valuable context for entrepreneurs and investors alike. Let’s examine the valuation trends for seed-stage and Series A startups over the past few years; thanks to Carta for publishing these data points on a regular basis.
Seed stage valuations have seen significant fluctuations over recent years. Factors influencing these trends include:
- Overall market conditions and investor sentiment, particularly for specific industries
- Competition among investors for promising early-stage startups
- Sector-specific trends and “hot” industries
- Geographical factors, with tech hubs often seeing higher valuations
It’s important to note that seed stage valuations can vary widely based on factors such as team experience, product development stage, and early traction.
Series A valuations tend to be more tied to concrete metrics and traction compared to seed stage valuations. Key factors influencing Series A valuation trends include:
- Revenue growth and scale
- Customer acquisition metrics and retention rates
- Market size and growth potential
- Competitive landscape
- Macroeconomic conditions
The Series A trends tend to move around more than the seed stage. It’s crucial for founders and investors to understand these trends while recognizing that each startup’s valuation should be based on its unique circumstances and potential. Explore our comprehensive guide on startup valuations.
409A valuations: Their own methodology
409A valuations come into account when a private company wants to offer stock compensation - usually stock options. Named after the section of the Internal Revenue Code that governs them,409A valuations provide an independent assessment of a private company's fair market value. This valuation is used to set the strike price for stock options, ensuring compliance with tax regulations and protecting both the company and its employees from potential tax penalties.
A 409A is not at all the same as a post-money valuation, and usually isn’t at all the price that an acquiring company will pay for a business.
Unlike other valuation methods that may focus on future potential or strategic value, 409A valuations take a very academic approach, considering the company’s current financial position, recent transactions, and comparable public companies. These valuations typically need to be updated at least annually or whenever a material event occurs that could significantly impact the company’s value, and should cost in the low thousands of dollars for most early-stage companies. For startups, understanding and properly managing the 409A valuation process is essential for maintaining compliance, attracting talent, and preparing for future funding rounds or exit events.
Different methods for different events
Valuing tech companies is both an art and a science, requiring a deep understanding of financial principles, industry dynamics, and the unique characteristics of technology businesses. And the methods used vary by the type of company and the reason that it needs a valuation. As the tech industry continues to evolve, so too will the methods and considerations for valuing tech companies.
Key Takeaways:
- Realize that different situations have different methods
- Consider industry-specific metrics and trends
- Don’t underestimate the value of intangible assets, strategic positioning and intellectual property
- Stay informed about market conditions and their impact on valuations
- Seek expert advice to navigate complex valuation scenarios
By leveraging expert advice, conducting thorough analysis, and considering all relevant factors, stakeholders can make more informed decisions about their tech company’s valuation.
Remember, while valuation provides a critical framework for assessing a tech company’s worth, the true value is ultimately determined by what buyers are willing to pay in a competitive market environment. Stay informed, adapt to changing market dynamics, and always be prepared to reassess your valuation methods to stay ahead in the fast-paced world of tech company valuations.
Recent Blog posts for startups
Read our recent blog posts on startup taxes, tax credits, and tax compliance.
