Valuing early-stage companies that aren’t yet profitable can be complex (to say the least).
When startups are still on their journey to profitability, traditional valuation methods, such as price-to-earnings ratios, can't be applied.
Why?
Because early-stage companies often lack a key component of traditional valuation methods: profit.
Revenue multiples, also known as sales-based valuation methods, bridge this gap by considering a company's sales rather than its profit, enabling startups to attract investors and secure funding.
These sales-based valuations offer a glimpse into a startup’s market value, sidestepping profit and asset considerations.
In this article, we take a closer look at revenue multiples and answer questions like:
- What are revenue multiples?
- What are the advantages and limitations of these sales-based valuations?
- What are the revenue multiples formulas?
- How do you calculate revenue multiples?
Starting with the basics, let’s dive into what revenue multiple valuations are and what they’re used for.
What Are Revenue Multiples?
Revenue multiples are a type of valuation metric that compares market value to annual revenue. This metric—favored by early-stage businesses—determines the worth of a company based on its annual sales instead of assets, cash flow, profitability, earnings, or any of the other metrics found in a typical CFO report.
Because of their simplistic view of a company's success, revenue multiples are considered relative valuation methods and are used only in specific situations—like the ones we’ve outlined below.
What Are Revenue Multiples Used for?
Revenue multiples are mainly used to value startups and early-stage businesses. Since many of these companies are yet to achieve profitability, sales-based valuations are an alternative way for founders and investors to assess a company’s worth—by focusing on revenue and not profit.
They enable investors to compare companies to industry benchmarks, previous success stories, and current competitors. When applied to the right companies at the right time, revenue-based valuation methods offer a lot of benefits to startup founders.
However, there are some drawbacks.
Shall we?
What Are the Pros and Cons of Using Revenue Multiples?
Using revenue multiples valuation methods has plenty of advantages when it comes to deciding the value of early-stage companies. However, they can be less useful due to the limited perspective they provide for established companies.
Let’s talk about the pros and cons of revenue multiples.
The Pros of Using Revenue Multiples
The key advantages of using revenue-based valuation methods include:
- Easy to calculate: Revenue multiples have simple formulas, enabling you to calculate a startup's value quickly and easily
- Relevant for startup valuation: Because they overlook financial metrics that startups may have yet to generate, revenue multiples have become the go-to valuation method for early-stage companies
- Facilitate cross-industry comparisons: Revenue multiples valuation offers investors a common comparison scale, enabling them to evaluate same-stage companies across multiple industries
- Emphasize growth potential: Traditional valuation methods overlook high-growth potential startups due to their reliance on profitability metrics. Revenue multiples bridge this valuation gap by emphasizing future opportunities rather than historical financial records
The Cons of Using Revenue Multiples
The limitations of revenue multiples are tied to their neglect of profitability, variability, and reliance on market conditions. Christian Rasmussen, the CFO at Cledara, clarifies the cons of using revenue multiples:
“Simplicity: They are overly simplistic and may not provide an accurate valuation without other metrics
Lack of adjustments: They do not directly account for profitability, industry variability, market conditions, management quality, non-recurring revenue and capital structure
Crudeness: Without adjustments for the factors mentioned above, revenue multiples can be a crude measure of a company's value”
Put simply, revenue multiple valuations are useful tools when used for their intended purpose: gauging the value of early-stage companies that lack a long and compelling financial history. For other businesses that don’t face this challenge, traditional valuation metrics are a more convincing option.
So, with the what and the why out of the way, let’s get into the how. Here’s how to determine the value of your company using two common revenue multiple variants.
How to Calculate Revenue Multiples: The Revenue Multiples Formulas + a Step-by-Step Example
The most common revenue multiple variations are price over annual recurring revenue (P/ARR), enterprise value to revenue (EV/Revenue), and price to sales ratio (P/S).
For early-stage companies selling software as a service (SaaS) or other subscription-based products and services, P/ARR is the preferred formula for valuation because it accommodates the volatility and short financial history typically connected to younger businesses.
Instead of considering annual revenue (the total income of a company over a fiscal year), P/ARR uses annual recurring revenue (such as income from subscriptions) to calculate revenue multiples.
But, why?
Because ARR can be calculated with data from a few months and doesn’t necessarily require a year’s worth of monthly revenue records. This works better for early-stage businesses as they often don’t have a long financial history. Some of these companies may have only started to see success in recent months, meaning looking at annual revenue doesn’t paint an accurate picture of their success.
For example, to calculate the ARR for a company that started generating sales only over the last six months, you can multiply the average monthly recurring revenue (MRR) from those months by 12 to get ARR.
This is important because ARR provides a more accurate estimate of what part of a company’s revenue is likely to be stable and predictable over time. Because it disregards one-time sales and short-term fluctuations, P/ARR offers investors a clear view of a business's long-term growth potential.
Let’s take a look at an example.
P/ARR Example for Calculating Revenue Multiples
P/ARR divides a company's market capitalization (the number of shares purchased by investors x price per share) by its recurring annual revenue.
To calculate P/ARR, you first need to calculate the components of the formula.
In this case, the P stands for price and refers to the value of the company based on outstanding shares. In other words, the price indicator is, in fact, a company’s market capitalization or market cap.
Your market capitalization comes from this formula:
- Market Capitalization = Share Price x Number of Outstanding Shares
A share of your company trades for $14. Out of the 10 million shares you authorized upon launching your business, investors bought three million. The shares you authorized and sold are called outstanding shares. Now, to calculate market capitalization, you just have to multiply the price per share by the number of outstanding shares.
Market Capitalization = $14 x 3,000,000
Which gives you:
Market Capitalization = $42,000,000
Now, your next task is to calculate your annual recurring revenue.
- Annual Recurring Revenue = Average Monthly Recurring Revenue x 12
Say your company sold recurring subscriptions worth $350,000 per month for the past six months—minus one month when the business took $400,000 in revenue, and another when it dropped to $300,000. To calculate the average MRR, you’d have to add up the monthly recurring revenue for the past six months and divide the sum by 6.
Average MRR= ($350,000 + $350,000 + $350,000 + $350,000 + $300,000 + $400,000) / 6
Average MRR = $350,000
Of course, in real life, your data will be different. You will likely discover larger fluctuations in your MRR from month to month. But to keep this example easy to understand and follow, we’ve simplified the data.
Next, you can determine the ARR. You do this by taking your average MRR and multiplying it by 12.
ARR = $350,000 x 12
ARR= $4,200,000
Finally, plug the calculated values into the formula to find your P/ARR ratio.
P/ARR = $42,000,000 / $4,200,000
P/ARR = 10x
The current average of P/ARR is around seven. A ratio of 10 and above signals investors that the valued company has a high growth potential.
Although they provide an understanding of a company’s value, revenue multiples are just one of the factors that influence an investor’s decision. To get the complete picture, valuation methods should be considered in the context of the broader environment, which we explore below.
What Other Factors Impact Revenue Multiples as a Valuation Metric?
Ultimately, revenue multiples enable early-stage business founders, finance teams, and investors to get an idea of how much a company is—or, more importantly, could be—worth.
However, it’s not the only consideration when evaluating a business. The amount of money investors are willing to put forth is not solely determined by the calculation of revenue multiples.
Let’s take a closer look at some of the other factors that investors consider alongside revenue-based valuations.
Industry
Industry-specific factors, like industry growth, innovation, and scalability, influence whether investors are willing to invest based on revenue multiples.
For example, startups in industries like technology have a higher expected growth rate and higher chances of achieving scalability. On the other hand, early-stage companies in sectors such as manufacturing may have more stable and predictable cash flows but slower growth prospects.
As a result, fast-growing tech startups will generally have higher revenue multiples than a slow, steady-growth manufacturing business. Investors know this, and assess them in the context of the industry they come from: what’s considered a great ratio in one industry may not be considered great in another.
Market
Overall market sentiment influences investment strategies. During times of economic uncertainty, investors often adopt a more conservative approach, favoring less risky investments that offer stability over potential high-growth opportunities.
Investors consider this valuation method in the context of the current market. A business that’s thriving in a tough market could be a strong bet, so revenue multiples are considered alongside the market the company operates in.
Growth Stage
In addition to market sentiment, investors take into account the company’s growth. An early-stage company that’s showing strong signs in the first six months is favorable to a company that’s showing stable or lower expansion across a longer period of time.
“For revenue growth, investors are looking at both growth in the company’s revenues and the growth in the market in which the company operates.” — Christian Rasmussen, CFO at Cledara
Profitability
Profit metrics can help dictate a business's revenue quality. While it’s by no means a must-have for early-stage companies—that’s where revenue multiples step in—it’s a nice-to-have where possible.
Higher profits signal higher operational efficiency, which increases a company's chances of future earnings growth. The high earning potential makes these businesses more attractive to investors.
As Christian explains, the impact profitability has on investor consideration depends on the company’s growth stage:
“For profitability, it depends on the phase the company is in. For start-ups and early-stage companies, gross margin is the key metric and for more mature companies, the focus is on operating profit margin and for late-stage companies net income and cash flow margins are the key focus.”
Competitive Landscape
A competitive landscape often makes it challenging for businesses to stand out and make an impact.
Companies that don't develop a unique enough product or service to differentiate from competitors may be less attractive to investors, and, consequently, have lower funding opportunities because they face higher competition.
Investors not only look at the existence of competitors, but also at their revenue multiple valuations. If other businesses are displaying much weaker revenue-based valuations, investors are more likely to make a positive investment decision in your business.
Revenue Multiples for Startup Valuation + Funding
Valuating a startup based on revenue rather than earnings is crucial for young companies trying to attract investors. Revenue multiples offer founders the opportunity to demonstrate their business’s growth potential and market traction while still working toward becoming cash positive.
Getting investment in early-stage companies can be one of the trickiest tasks a founder can face. Revenue multiples provide an industry-approved way to highlight the opportunity your company provides to investors.
