Create fast startup valuation for investors with the help of ARR

Understanding Annual Recurring Revenue (ARR)

ARR represents the normalized, recurring revenue that a startup expects to receive (or receives) annually from its customers. Generally, it is income from the startup’s main activity before excluding any expenses.

Why is ARR Used for Startup Valuation?

This metric is particularly relevant for businesses with subscription-based models, such as Software-as-a-Service (SaaS) companies, where customers pay a recurring fee for access to services and products.
However, this approach is also applicable for estimating the value of any startup based on annual revenue calculation.

Why focus on startups? When considering established companies operating in the market for a considerable period, traditional company valuation methods can be employed due to the availability of extensive historical data.

Moreover, startups and established companies have different financial objectives. Established companies typically aim to increase their profits, which reflect their earnings from business activities, whereas startups prioritize increasing sales, market share, and revenue.

Startup financial indicators tend to be quite volatile as they endeavor to penetrate new markets and refine their business models to drive sales growth.

Consequently, the primary goal of startups is to achieve sales growth, leading to increased revenue and valuation. Therefore, sales performance and revenue growth serve as the most reliable financial indicators for fast startup valuation.

Who uses ARR Startup Valuation?

Understanding and implementing the estimation of startups using ARR is crucial for a range of stakeholders.

Investors rely on ARR to assess the revenue potential and growth trajectory of startups, aiding in investment decisions and valuation analysis. It helps to assess the startup’s attractiveness as an investment opportunity.
If you plan to invest in startups as a private investor, you can find information about ARR and its growth trends in the startup pitch deck. 
However, if this information is absent in the pitch deck and you are interested in investing, you can request ARR details from the startup founders separately. 

Entrepreneurs need to grasp this valuation method to accurately assess the value of their startup. This understanding helps them avoid undervaluing their business and potentially selling shares too cheaply in exchange for investment. Conversely, overestimating the startup’s value may hinder receiving offers from investors. The very important process here is accurate revenue forecasting. It is the base for fast startup valuation.

Steps of ARR Fast Startup Valuation

Step 1. Calculate ARR

 Start by calculating the company’s ARR, which involves aggregating the recurring revenue generated from active subscriptions over 12 months.

To calculate ARR based on subscription price, you need to consider the total revenue generated over a year from the subscriptions. Here’s the corrected formula:

ARR =Monthly Recurring Revenue (MRR)×12

Alternatively, if you want to calculate ARR directly based on the subscription price and number of subscriptions, the formula remains:

ARR=Subscription Price×Number of Subscriptions×12

Let’s use an example to illustrate this formula. Suppose the subscription price is $20 per month, and there are 1,000 active subscriptions:

MRR=$20×1000=$20,000 per month

ARR=$20×1000×12=$240,000 per year

Note: If your startup has no subscriptions, but provides other types of services, calculate annual revenue instead of ARR for fast startup valuation.

Annual revenue = Total number of services performed for 12 months * Their prices

Step 2. Assess the Growth Rate of ARR

 Analyze the company’s ARR growth rate to gauge its expansion trajectory. Higher growth rates often correlate with higher valuation multiples. A good ARR growth rate starts from 100%.

To calculate the growth rate based on Annual Recurring Revenue (ARR) for the previous year and the current year, you can use the following formula:

ARR Growth Rate (%) = (ARR current year − ARR previous year ) / ARR previous year × 100%

This formula calculates the percentage change in ARR from the previous year to the current year, indicating the growth rate of ARR over that period.

Example:

Suppose a SaaS company had an ARR of $1,000,000 in the previous year and ended the current year with an ARR of $1,500,000. Let’s calculate the ARR growth rate for the current year.

ARR previous year = $1,000,000

ARR current year=$1,500,000

ARR Growth Rate (%)=($1,500,000−$1,000,000)/$1,000,000×100 =

=($500,000/$1,000,000 )×100 = 0.5×100 =50%

Therefore, the ARR growth rate for the current year compared to the previous year is 50%. This indicates that the company’s annual recurring revenue increased by 50% from the previous year to the current year.

Step 3. Apply ARR Multiples for fast startup valuation

  Determine industry-standard ARR multiples based on comparable company valuations and market trends. Multiply the calculated ARR by the applicable multiple to estimate the company’s value. Multiples typically range from 4 to 10, depending on the industry and the ARR growth rate.

Thus, the basic formula for startup value estimation based on this method is:

Startup Value = ARR × ARR Multiple

4. Adjust ARR Startup Valuation Based on Other Factors

Adjust the ARR multiple based on additional factors such as customer retention rates, market potential, operational efficiency, and competitive landscape.

A Simple Example of Fast Startup Valuation

What are investors’ criteria for startup valuation?

Let’s understand startup valuation logic by investors.

For this purpose, the investment criteria of venture capital (VC) firms and angel investors will be described for startups based on official information available on their websites.

Investors’ strategy: Investors earn money from increasing the value of a startup’s equity share, which was bought in exchange for provided investments. During the exit process, investors sell their shares and receive their profit as a difference between the sold and purchased amount of the startup’s share. In addition, operating expenses of managing investment should be excluded from the final calculation of the earnings. 

Investor’s exit value = Amount received from selling the startup’s shares – Amount paid for purchasing the startup’s shares – Operating expenses incurred in managing the investment

Based on the information above, let’s calculate the required annual revenue growth rate to achieve returns of the initial investment (X) at a multiplier of 10 to 20 times after 5 years. We will assume that the company’s value grows proportionally with revenue (Y) growth.

Let’s consider examples of revenue growth rates of 50%, 70%, and 100% to calculate the future revenue after 5 years.

1. If the revenue growth rate is 50% per annum, the revenue will increase by 7.6 times after 5 years from its initial value:

Y in 5 years = Y* ( 1+50%)^5 = 7.6Y

2. If the revenue growth rate is 70% per annum, the revenue will increase by 14.2 times after 5 years from it initial value:

Y in 5 years = Y* ( 1+70%)^5 = 14.2Y

3. If the revenue growth rate is 100% per annum, the revenue will increase by 32 times after 5 years from its initial value:

Y in 5 years = Y* ( 1+100%)^5 = 32Y

Thus, if an investor invests $X in a startup and expects to receive between $10X and $20X in 5 years, assuming that the company’s value grows proportionally with revenue (Y) growth, the minimum annual revenue growth required to meet the investor’s expectations is at least 70%.

This is why investors often focus on achieving a revenue growth rate of 100% per annum to ensure a sufficient margin and attain the desired profitability from investments.

Now, you might be thinking, ‘Wow, such high profitability! Let’s invest in startups.

However, it doesn’t work that way. Investing in startups, especially in the early stages, is very risky, and even experienced investors can’t avoid making bad investments.

The goal is for 1-2 out of 5-10 invested startups to become unicorns, generating desired profitability and offsetting losses from unsuccessful investments.

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