The drivers of revenue multiples

The revenue multiple, or in other words the ratio of a company’s valuation to its revenue, is a commonly used metric to value startups. The reason is that most startups have negative EBITDA and net income, so it isn’t possible to value them based on these metrics.

However, it isn’t possible to simply take one company’s revenue multiple and directly apply it to value another company.

Specifically, different companies demand valuations which reflect different revenue multiples. The reason for this is that a company’s revenue multiple is driven by numerous factors. The most important of these are:

  1. The company’s growth rate: Companies that are growing faster command higher revenue multiples.¬† Since it’s easier to grow fast off of a small base, earlier stage companies tend to command higher revenue multiples than later stage ones.
  2. The size of the company’s addressable market: Companies targeting larger addressable markets have more room to grow their revenue by capturing more of their addessable market. As a result, they command higher revenue multiples than companies targeting smaller addressable markets.
  3. The company’s margin structure: Companies with superior margin structures (higher gross margins, contribution margins, EBITDA margins, net income margins, …) will have more money left over from each dollar of revenue that they make. They will therefore command higher revenue multiples. Although most startups have negative EBITDA and net income margins, many have positive gross and contribution margins. It’s therefore possible to value them based on gross margin and contribution margin multiples, which are better reflections of the fundamentals of the business than the revenue multiple.
  4. The company’s long-term defensibility: Companies with business models that are difficult for competitors to challenge will be able to retain their revenues and profits for longer periods of time in the future, and will therefore command higher revenue multiples.

Fundraising for the existing average business and the new and promising idea

After a startup raises money, three things can happen.

The first is that it performs well, either with its initial business idea or following a pivot, and goes on to raise more funding based on this performance.

The second is that its business does not grow, attempts to pivot do not either, and the business therefore fails.

The third case lies in the middle. Specifically, the startup ahieves some growth in its initial business idea. However, this growth is not high enough to raise more funding based on the company’s performance, and it’s not low enough to declare the business a clear failure.

Startups that experience this third scenario often come up with a new business idea that is adjacent to the initial business, and try to raise money for the new idea. When this happens, they need to decide whether to stop working on the initial business to focus on the new idea, or to continue working on both in parallel. Many decide to work on both at once, and therefore pitch new investors the combination of an existing average business and a new and promising idea.

When this happens, interested investors want to invest in the new and promising idea. However, they don’t want to pay for the existing average business, and they don’t want the team to spend any time on the existing average business.

As long as the existing average business continues, this makes it challenging for the startup to raise money.

If you don’t want to raise money, you can keep working on both businesses in parallel.

However, if you want to attract investors, you’ll very likely need to close the existing average business and raise solely for the new and promising one.

One day at a time

“The best thing about the future is that it comes one day at a time”

This is a quote attributed to Abraham Lincoln, and I have two takeaways from it.

The first is that you can’t do everything at once. If you have a goal, you have to make patient and consistent progress towards it on a daily basis.

The second is that most goals that seem very far away are actually more achievable than they appear. The analogy of climbing a mountain is helpful in explaining this.

Specifically, when you’re at the bottom of a mountain, you can’t see its peak. With each step of the climb, you see parts of the mountain that were previously inaccessible to you. To get to the peak, you must traverse through these intermediate parts. You can’t climb further than your reach at any particular step allows.

Similarly, when you first start working towards a goal, it’s difficult to envision achieving it. By making steady daily progress towards the goal, you unlock new levels that take you closer to your goal, until you can eventually see yourself achieving it.

And just like when you’re climbing a mountain, there’s no short cut. You have to go through certain places before you can get to other places.

The rules that aren’t widely known

There are a set of rules which govern how our world works. In the physical sciences, these rules are precise and map directly from inputs to outputs. In the social sciences, these rules are approximations and produce a general mapping from inputs to outputs.

For example, force = mass * acceleration is a physical science rule, while the input of being kind to others making them more likely to like you as an output is a social science rule.

If the rules that govern a particular context are widely known, there are a lot of people who will be able to apply those rules. As a result, the returns to applying the rule will decline due to competition.

It’s the rules that aren’t widely known that produce the greatest returns for those who identify and apply them.

Distance = speed * time

What you achieve in life can be thought of as the distance that you progress. Distance, in turn, is speed times time.

Speed is how fast you’re progressing, and time is how much time you put in.

This is why you’ll make more progress if you’re working on something that you’re naturally good at, by working with a capable team rather than alone, and by raising external funding rather than relying on internally generated profits. These are examples of ways to increase your speed.

It’s also why you’ll make more progress if you’re spending the majority of your time on one goal rather than pursuing multiple goals at once.

Meeting a founder’s team

Most investors state that, together with the market, founders are one of the two key determinants of a startup’s success. While this is true, a founder is only as good as the team they’ve built. As a result, meeting a founder’s team, consisting of the founder’s direct reports and any other key team members, is a great way to evaluate the founder and their startup.

The first benefit of meeting a founder’s key team members is that they reveal¬†how good the founder is at identifying and attracting talent. The more impressed you are with a founder’s key team members, the more impressive the founder who built the team.

The second benefit is in observing the interactions between the founder and their key team members. Who speaks more often on issues pertaining to the team member’s responsibility? How does the founder address their team and vice versa? Do the founder and team members seem perfectly aligned, which is usually a sign that they are not expressing their differences in viewpoint, or do they point out where their perspectives are different and how they’ve decided to move forward to either test out the different hypotheses they hold, or despite their different perspectives?

Meeting a founder’s team in a series of one on one’s, together with holding a group session in which each key team member participates, is a half to one day exercise that greatly improves the quality of an investor’s investment decision.

Cynicism

The dicitonary defines cynicism as “an inclination to question whether something will happen or whether it is worthwhile”.

And indeed, many attempts fail, many promises are broken, and even successes are, on a long enough time horizon, impermanent.

But these are just reflections of the scientific laws which govern the world we live in. When you attempt to do something, by definition, there is a chance that the attempt fails. Promises are broken, either because people never intended to stick to them, or because circumstances changed such that it is no longer possible to keep them. And even successful outcomes are soon hopefully superceded such that the earlier foundations which paved the way for better outcomes are eventually forgotten.

However, these are the laws of the world we live in. As such, we cannot change them.

We can only decide whether to be cynical because of these laws or to accept the laws and push forward regardless.

What the founder will do

One of my first learnings as an investor was to focus not on what you can or would do with the company, but what the founder will do.

It’s a continual work in progress to take this viewpoint because, when you’re excited about the promise of an idea, your natural reaction is to think of all that you could and would want to do with it.

However, if you decide to invest, you often soon discover that the founder takes the company in a different direction than what you imagined.

If you formed your view of the company’s future without carefully listening to the founder before investing, this direction can be radically different.

If you listened well, although there will still be surprises due to the experimental nature of startups, hopefully these changes will be for the better and the general direction of the company will remain as you envisioned.

Aggregating user reviews across online services

In the offline world, you often don’t know the background of who you’re transacting with. To gain insight into this, you perform reference checks by asking people who you do know whether they know the person you’re about to transact with, and if so what their past experiences in dealing with that person have been.

Many online services allow for anonymity. This makes it more difficult to transact on such services than in the offline world.

However, an even greater share of online services, often based on real world identities, offer a more trustworthy environment for transactions than that provided by the offline world. They do so by aggregating and displaying the collective transaction reviews of a particular person for the viewing of future individuals who are considering transacting with that person. They effectively make available the references provided from people beyond your own network, and this makes it easier to reference check the person you’re about to transact with.

User reviews on sites like Amazon, Uber, and Airbnb are great examples of this.

The shortcoming of the user reviews made available by current online services is that these online services operate in siloes. When transacting on Amazon, you can only see the Amazon reviews of the person you’re transacting with. You cannot see the reviews of the same person on Uber. The same is true for other services.

So existing services miss the opportunity to reflect a more comprehensive and therefore representative view of the online trustworthiness of their users, new services miss the opportunity to jump start their service by reflecting the track record of their new users from the existing services that these users use, and individual users of one service either miss the opportunity to benefit from their good track record on other services, or are able to hide a poor track record to potentially abuse a new service.

This presents an opportunity for a company, likely new and independent but also potentially an existing company with a large number of reviewed users and user reviews, to aggregate people’s user reviews across online services, and make available this complete picture of an individual’s online trustworthiness.