In the world of venture and B2B software startups, we often hear or read about a company raising “X” million at “Y” million valuation which is “Z” multiple of ARR. What does the valuation really mean?
This article will explain the distinction between Enterprise Value and Equity Value, and how this topic relates to the inherent friction between founders, VCs, and venture lenders.
What does Enterprise Value and Equity Value mean?
Enterprise Value represents how much a business is worth today. In theory, this is what all shareholders (i.e. founders, operators, VCs, and venture lenders) should maximize at all times. It is calculated by adding Equity Value to Debt and subtracting Cash.
For a startup, we often refer to Pre-Money and Post-Money Valuation like so:
Post-Money Valuation = Pre-Money Valuation + Invested Capital
Pre-Money Valuation = Post-Money Valuation – Invested Capital
For a venture-backed startup raising money for the first time, the Post-Money Valuation represents the Equity Value of the business based on growth expectations and operating margins. The Pre-Money Valuation reflects the Enterprise Value of the business today.
Equity Value = Enterprise Value + Cash
Enterprise Value = Equity Value – Cash
Enterprise Value (“EV”) measures the true value of a startup, as it ignores the type of external funding in place (i.e. equity, debt).
So when a VC says “our fund will invest €5 million for 20% of the company”, the Post-Money Valuation (or Equity) is €25 million, whereas, the Pre-Money Valuation (or EV) is €20 million.
For sub-scale venture-backed B2B software businesses that are not yet profitable (typically less than 100 to 250 FTEs or €10–30 million ARR/revenue), investors and lenders value a business based on the EV to Annual Recurring Revenue (“ARR”) or EV to Forward Revenue (typically 12 months from now) as it allows the software startup to be compared to other private startups or public software companies that operate in related markets and have similar business characteristics and/or metrics.
When an established company (e.g. Salesforce, SAP, IBM, Oracle, Microsoft, Amazon, Twitter, Google, etc.) buys a startup or when a software business decides to IPO, strategic and public investors focus on EV. This is the fair way to compare ‘like for like’.