How Venture Capital (Ab)Uses Revenue Multiples

The deeper you get into venture capital, or equity investment generally, the more familiar you will become with the concept of “multiples” as a tool for quickly analyzing company value.

However, there is a divergence of views about the role multiples play in venture capital investment decisions. A generational divide opened up over the past decade, with a younger cohort of investors using multiples more aggressively.

So, what is the purpose of multiples, and how should investors apply them?

First of all, let’s consider the origin: public markets.

When looking at public market stocks, you have a wide range of data available thanks to the associated reporting requirements. In search of alpha, traders will analyze multiples such as EV/revenue, EV/EBITDA, EV/FCF or P/E.

Each metric provides a slightly different perspective on performance relative to the share price, and is used to understand whether or not the company is currently underpriced by the market.

Multiples are also used to understand public and private market trends, more broadly. Two recent examples of this are Mark Suster’s conversation with Harry Stebbings about recognizing inflated valuations, and Bill Gurley, Brad Gerstner and Aaron Levie talking about the market for software companies.

In that second example, Gurley also comments on the contemporary application of revenue multiples, which we’ll explore further: “Silicon Valley has the crudest, least intelligent view of valuation. They always rush to price to revenue because it’s easy, and quite frankly it’s easy to be optimistic.”

Over the past decade, driven by the brisk pace of deals during ZIRP, revenue multiples have become understood as a shorthand tool for valuation. In theory, you find a similar company which recently raised capital, derive its revenue multiple, and apply that to the revenue of another company to determine the relative valuation.

It’s certainly easier than a typical valuation process, but does it work?

Fundamental problems

First, there’s just not enough data in private markets. Finding similar companies is challenging; getting a good picture of their financial performance and deal terms which produced that valuation is often near impossible.

It’s procyclical. Relative valuations work when your comparable companies are priced with some underlying rationale for intrinsic value. Unfortunately, pricing with multiples is now so prolific (e.g. 71% of European VCs) that there’s a tenuous connection between price and value — which makes venture capital more vulnerable to inflationary cycles.

It’s a bad way to look at outliers, which are fundamentally what venture capital is all about. What multiple did Mistral AI use for its seed round? What about Anduril? The logic quickly falls apart when you look at the category-defining startups that investors should be chasing.

They don’t actually calculate valuation. Finally, pricing with multiples may seem appealing due to its convenience but, much like pricing based on ownership targets, it isn’t actually a valuation exercise. In reality, multiples are used as a way to justify assigning a number that feels right (or voiding a deal entirely) based on a roughly intuited view on value. Most of the time, it’s a lie.

The role that multiples should play, as demonstrated in the earlier examples, is understanding trends and providing context.

That generally means two things: comparing terms to the broader market to see how a startup is positioned relative to its peers, or analyzing trends in the fundraising market more generally, such as how expectations shift over time and between stages.

Fundamentally, multiples are a tool to compare and analyze valuations, not a shortcut for calculating them. Crude comparisons that lack specificity will continue to generate bubbles, damage returns and do a disservice to the outliers.

Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation, and a venture partner at Social Impact Capital.

Illustration: Dom Guzman