Working for a tech startup that wants to go IPO is an exciting opportunity. You get to be a part of something new and innovative, and you have the chance to make a real impact on the company's success. You also get to learn a lot and grow your skills in a fast-paced environment. It also comes with quite a bit of risk. According to the Startup Genome Report, about 90% of tech startups fail within the first five years.
As a way for pre-IPO organizations to attract and retain top talent and cope with this level of risk, they offer up equity to their employees. These shares in the company are a powerful incentive for employees to join and stay with an organization because it gives employees a stake in the company's success which can motivate them to work harder and help the company achieve its goals.
The outcome of an exit (a sale of the company or Initial Public Offering) can be life-changing money for some folks, especially executives part of a "Big IPO." For example, I was part of the Okta IPO back in 2017 and CEO, Todd McKinnon is now worth $1.2B from the success of going public. Charles Race who led our Field Operations racked up $170M in net worth in just 4 years and is since retired. He's now spending his mass amounts of free time farming, cooking, and brewing beer. At the Account Executive level, I had many Okta colleagues of mine that paid off their homes (one of my friends bought a home on wheels), got completely out of debt, and bought some toys with the leftovers. One of my coworkers bought each of his kids a horse! And those ain't cheap...
Now that I likely got your attention, how does all this work? Let's break it down.
When a company goes public, it is essentially selling shares of itself to the public. The price of these shares is determined by the company's valuation (the process of determining the worth of a company pre-IPO) which is a bit tricky to determine.
There are a number of factors that go into determining the valuation of a pre-IPO tech company. These factors include:
The company's financial performance: This includes the company's revenue, profits, and growth prospects.
The company's competitive landscape: This includes the company's market share, its position in the industry, and the threat of competition.
The company's management team: This includes the team's experience, track record, and ability to execute on the company's business plan.
The company's intellectual property: This includes the company's patents, trademarks, and other intellectual assets.
The company's overall growth potential: This includes the company's ability to grow its revenue, profits, and market share over time.
Valuation is often done by a team of investment bankers. The investment bankers will assess the company's financial performance, competitive landscape, management team, intellectual property, and growth potential and then they will use this information to determine a fair price for the company's shares.
Fun Fact: If a pre-IPO company is valued at $1B or more, it's called a Unicorn. $10B or more? A Decacorn.
There are lots of different methods used to get to the number. Here are three of the most common:
Comparable Transactions Method - You’re simply answering the question, “How much were startups like mine acquired for?" For instance, imagine that Rapid, a fictional shipping startup, was acquired for $24 million. Its mobile app and website had 700,000 users. That’s roughly $34 per user. Your shipping startup has 120,000 users. That gives your business a valuation of about $4 million.
Revenue Multiple Method - Revenue multiples are calculated by dividing the market value of a company by its annual revenue. For example, if a company has a market value of $500 million and annual revenue of $50 million, its revenue multiple is 10x.
Venture Capital Method - This reflects the mindset of investors who are looking to exit in the next several years, i.e. IPO. There are two formulas VC's use to get to the valuation:
Anticipated ROI = Terminal Value / Post Money Valuation
Post Money Valuation = Terminal Value / Anticipated ROI
First, you’ll calculate your startup’s Terminal Value (aka Exit Value), or the expected selling price after the VC firm has invested. You can find this using estimated revenue multiples for your industry ($500M in the example above under #2).
Next, determine the Anticipated ROI such as 10x, then plug everything in to find the Post Money Valuation. From there, subtract the investment amount to get the Pre-Money Valuation.
Fun Fact: SaaS startups are currently seeing between a 4.6x revenue multiple (traditionally we are seeing 5x-7x revenue multiples).
Metrics That Matter (in SaaS companies):
Churn - Churn is an essential metric for investors. The typical SaaS business model relies on monthly subscriptions. The churn metric calculates how many of these subscribers cancel the service, either monthly or annually.
Churn is vital because acquiring customers is expensive. You're leaking money if you're just mashing new customers into a business with high churn.
A low churn rate implies customer satisfaction and loyalty.
Customer Acquisition Cost - CAC refers to how much it costs you in sales and marketing to acquire a new customer. For example, if you spend $200k on marketing which gets you 1,000 new customers, your CAC is $200 (200,000 / 1,000).
Lifetime Value - LTV is a metric that expresses the average amount of revenue you can expect from a customer. Obviously you want a LTV that is greater than the CAC :)
Annual Recurring Revenue - ARR is the amount of revenue over an annual period.
Net Revenue Retention - NRR is a metric that measures the percentage of recurring revenue that a company retains from its existing customers over a period of time. It is calculated by dividing the total recurring revenue from existing customers in a given period by the total recurring revenue from existing customers in the previous period x 100.
Fun Fact: Rubrik's NRR is 140% which is one of the highest in the tech industry. NRR speaks to the quality of service, level of customer satisfaction, and the effectiveness of the sales & marketing team.
MARKET CAPITALIZATION (Post-IPO)
For public companies, valuation is referred to as market capitalization where the value of the company equals the total number of outstanding shares multiplied by the price of the shares.
To calculate market cap, you take the total number of a company's shares outstanding and multiply that figure by the company's current stock price. For example, if a company has 10 million shares outstanding and its current stock price is $30, it has a market capitalization of $300M.
Market capitalization is important for a number of reasons, including:
Measuring the size of a company: Market capitalization is a measure of the size of a company. A company with a high market capitalization is a large company, while a company with a low market capitalization is a small company.
Tracking the performance of a company: Market capitalization can be used to track the performance of a company over time. A company with a rising market capitalization is performing well, while a company with a falling market capitalization is performing poorly.
Comparing companies: Market capitalization can be used to compare companies in the same industry. A company with a higher market capitalization is generally considered to be more successful than a company with a lower market capitalization.
Fun Fact: Apple (AAPL) has the largest market cap in the world which currently sits at $2.8T
It is important to note that valuation and market capitalization are not the same thing. Valuation is an estimate of a company's worth, while market capitalization is the current market value of a company's outstanding shares.
Here is a table to help you understand the basic differences:
HOW ARE SHARE PRICES DETERMINED?
Share prices are determined by supply and demand. When there are more buyers than sellers, the price of a share will go up. When there are more sellers than buyers, the price of a share will go down.
There are a number of factors that can affect supply and demand for shares, including:
The company's financial performance: A company with strong financial performance is likely to have more buyers than sellers, which will push the price of its shares up.
The company's prospects for future growth: A company that is expected to grow rapidly is likely to have more buyers than sellers, which will also push the price of its shares up.
The overall state of the economy: When the economy is doing well, there is more money available to invest, which can lead to higher share prices.
Investor sentiment: Investor sentiment is a measure of how confident investors are in the market. When investor sentiment is high, there is more demand for shares, which can push prices up.
Share prices can fluctuate wildly, and it is important to remember that past performance is not necessarily indicative of future results.
Here are some additional factors that can affect share prices:
Dividends: Companies that pay dividends are often more attractive to investors, which can lead to higher share prices.
Mergers and acquisitions: When two companies merge, the share prices of both companies may go up.
New product announcements: When a company announces a new product or service, the share price may go up.
Negative news: If a company experiences a negative event, such as a product recall or a natural disaster, the share price may go down.
It is important to note that share prices are not always rational. Investors may sometimes buy or sell shares based on emotion or speculation, rather than on fundamental factors such as the company's financial performance.
Fun Fact: Berkshire Hathaway (BRK.A) currently has the highest price per share which sits at $511,800.
Hopefully this article helped you get clarification on how valuations work, how they are calculated different from market capitalization, and some of the major differences between pre-IPO organizations and public companies.
If you liked this article, be sure to read: Is My Company Ever Going to IPO?