Nothing seems to grab headlines more than a company that raises, say, $50 million and is valued at $2 billion. No revenue? Doesn't matter. Then there's the promising young company that actually has $20 million in sales but ekes out a valuation of $200 million. (Sounds like an episode of VCs Gone Wild, doesn't it?)
But when you look deeper, it's all about metrics. And that's why business owners have to know how venture capitalists think. Nothing is more important than coming up with an appropriate valuation for your company.
Most entrepreneurs think the correct valuation is the highest one they can get. Nope; it has to be realistic and match the results you can actually produce. Here's the deal: Traditionally, revenue and profit have been the gold standard metrics. But those rarely reveal what really makes the most promising startups tick. That's because capital-hungry companies are in expansion mode and will be operating at a loss and burning cash.
In addition, the metrics VCs focus on have evolved over the years. And the competition for good deals can drive prices up. To help you sort out all this voodoo, here are some of the most popular models VCs consider.
Investors will pay a premium to hear the sound of the cash register ringing with predictability. The subscription revenue model was once the exclusive province of magazines and pay TV. Now the entire software industry has moved in this direction with the introduction of software as a service, where you pay a monthly fee and get free updates.
The beauty of this model: Once the costs of acquiring a subscriber are established, and the cancellation rate, or churn, is figured out, investors can calculate how each dollar invested will increase the value of the business.
If they come, we will fund it
Audience growth is VC eye candy, especially for Internet companies. The presumption is that if you have something that the masses are flocking to, the company will figure out a way to make money from it. The social trinity--Facebook, LinkedIn, Twitter--all garnered nosebleed valuations this way.
Freemium is a go-to-market approach that allows customers to try a product before buying. Then, if they like it, they buy the whole thing or maybe some extra features (common in games such as Candy Crush). This model often goes hand in hand with recurring revenue. That's because the free version may convert into a subscription. VCs also focus on conversion rates: what percentage of free users ultimately start paying.
So there you have it--three popular models VCs love. But consider this: Expansion-stage investors care most about the growth rate of the metrics most relevant to your business model. Surprisingly, how fast you get profitable may not be the most important. Dramatic growth is the real gold standard. And if you can establish that, buckets of cash may end up on your doorstep.