Valuing Unprofitable and Venture-Backed Software Companies


In the world of early-stage tech investing, you might think that valuation plays a crucial role in investment decisions. As a former VC, I’ll tell you that you’d be wrong, at least in a traditional sense.

This is because early-stage venture firms are governed by something called the power law. The power law states that a tiny percentage of investments are going to bring in the vast majority of returns. If you’ve got a portfolio of ten startups – chances are, just one or two companies are going to take off and return 10x, 50x, or even 100x, while the rest will fail or just do okay. Because of this, VCs are more focused on finding outliers rather than obsessing over getting the lowest entry price. It’s all about backing the next big thing, the next unicorn, the next home run - rather than haggling over price in the early days.

But this mindset can create some funky dynamics and misaligned incentives for the founders that are actually doing the work.

As VCs compete to get into the best deals, valuations often become over-inflated and won't match the startup’s current reality. This is fine for the 5-10% of companies that go on to become massive successes but, for the majority of startups, these high valuations can turn into big problems as they try to scale. Founders who originally set out to build solid, successful companies often feel pressured to spend money quickly, scale inorganically, and hit unrealistic growth targets. From their position as a trusted advisor, VCs push decision making that maximizes the likelihood of a company becoming a Unicorn often at the expense of the same company becoming a sustainable $10M, $20M, or $50M business.

At no time is this misalignment more evident than in a small exit event. Although not what any founder envisions when they set out to build a VC-backed software business, a $2M exit could represent a solid return for an entrepreneur that still holds meaningful equity in their business.

On the flip side, VCs typically encourage the founder to keep going, believing that hope is a viable strategy for the future. In reality, a .25x or .5x return on their capital is essentially the same as a 0x and officially writing these investments off as a loss could impact their standing with LPs. VCs also generally have an ace up their sleeves when it comes to these discussions with founders: the liquidation preference. Liquidation preference is a provision commonly found in VC term sheets that ensures that VCs get their money back first in the event of a sale or exit. While this can protect investors, it can come back to bite founders. If a startup doesn't achieve the high growth expectations, liquidation preferences can mean founders and employees end up with little to nothing, despite years of hard work.

We believe that founders and investors need to be on the same page, setting valuations that reflect where the business actually is and what’s realistically achievable. This way, everyone can work towards long-term success without the pressure cooker of inflated expectations. Unless VCs start getting comfortable hitting singles and doubles, they will continue to strike out more often than not while trying to hit a home run. 

At Curious, we see ourselves as an alternative to both the boom/bust attitude perpetuated by the VC industry and the predatory lowballing so prevalent in traditional private equity. We don’t measure our success by the number of home runs hit, but by the number of companies that we can help turn into long-term successes for the next 20+ years. 

This all starts with our underwriting methodology. It allows us to take swings on the slow-growing businesses that wouldn't typically be attractive to VCs or the unprofitable businesses that would be out of scope for most private equity firms.

We know that valuing companies for what they are (vs what they could be) fails to capture the upside that makes tech companies so attractive. At the same time, making assumptions about a future that is too far away can be speculative and highly volatile. Our model helps us to quickly understand what the current state of the business is and what levers can be pulled to set the company up for sustained success. 

Download The Curious Valuation Spreadsheet

With transparency as one our of core values, we wanted to share our underwriting methodology to shed some light on what we believe to be achievable when you are not restricted to traditional PE or VC ways of thinking. We hope this model will be helpful to founders that are thinking about an exit to simulate various scenarios.

Most buyers in the software industry tend to look at revenue and earnings multiples when evaluating a business. According to the latest market multiples report, software companies are typically valued at around 3-5x revenue or 8-12x EBITDA, depending on their growth rate and, more importantly, their profitability.

We take this evaluation a step further. We make sure we consider a business, not just for what it is, but for what it can be. We input historical P&L data and make assumptions about what the next 24 months could look like under our leadership. This allows us to get comfortable with unprofitable businesses or companies that have declining revenue. We hope that sharing this encourages readers to be more nuanced and open-minded as they think through how to evaluate a company in the tech industry.