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Foresight Startup Q&A Blog Series: Modeling Unit Economics

Posted on Modified on by Foresight Valuation Group

 

The Foresight team regularly spends time answering our startup clients’ most pressing questions regarding Financial Modeling, IP Strategy, Valuation, and more. We’ve decided to share some of these important insights in our Startup Q&A Blog Series. This article deals with modeling Unit Economics for your early stage business.

Question:

How Do I Model My Unit Economics? 

One of Foresight’s startup clients approached us asking for advice on how to model the Unit Economics for 2 different business models that the company was considering. The client was launching an Airbnb-type venture and weighing the pros and cons of a Subscription model and Commission model. Although the 2 business models are very different, the Unit Economics modeling is fairly similar, with the largest difference being the Monthly Recurring Revenue (“MRR”) component.

Answer:

  1. Identify the Unit 

The first step to modeling Unit Economics for a majority of (if not all) businesses is to identify the Unit. The Unit is the revenue generating component of your financial model. For a Consumer Software/Subscription business (i.e. Spotify, Microsoft Office 365, etc.), the Unit is likely a single subscriber. Conversely, for Enterprise Software-as-a-Service (SaaS) businesses (i.e. Salesforce, Workday, etc.), the Unit may be an entire organization with many users. In any case, the best starting point for thinking about your Unit may be identifying your “average customer.”

In the case of our client’s Airbnb-type business, the answer is somewhat counter intuitive. The Unit in both cases, Subscription and Commission, is not the end-consumer (the people using the platform to rent). Instead, the Unit is the “Host” – the owners of the assets that are listing their property on the platform. This is because the Hosts are ultimately driving revenue for the business, either through monthly subscription fees or by sharing a portion of their rental proceeds.

  1. Determine Your Customer Acquisition Cost (CAC) 

Once you’ve identified your Unit, the next step is to determine how much it will cost your business to “acquire” them. By definition, for your Unit Economics modeling it is important that you isolate the cost to acquire and onboard a single Unit. There are commonalities among almost all businesses that will be included in your CAC, such as sales expenses, marketing expenses and salaries, but it is also important to consider less-obvious costs that may be more unique to your business, such as data hosting expenses, legal fees, etc.

Again, since the Unit was consistent for our client across both business models, the components of the CAC were also consistent. However, differing business models have significant implications for the CAC that are important to consider. In this case, the Marketing Expenses required to acquire a Host under the Commission model are likely much less than the expenses under the Subscription model. At the most basic level, this is because the costs to acquire a paying user is typically far greater than the costs to acquire a free user.

  1. Calculate Monthly Recurring Revenue (MRR) 

The MRR for your Unit Economics model is another critical input that looks at the amount of revenue that your business collects from each Unit on a recurring basis. The simplest determination of MRR is for a subscription business with a single subscription tier. If the business only offers 1 subscription level, to 1 type of customer, then the MRR is equal to the monthly subscription fee. The MRR calculation becomes more detailed as you begin to add additional subscription tiers, different types of customers, add-on features, etc. In these cases, you should again undertake the exercise of determining the characteristics of your average customer, and calculate the recurring revenue generated based on these features.

For our client, MRR is the component of the Unit Economics model that differs the most between the 2 business model options. For the Subscription model, the determination of MRR is again fairly simple – it is equal to the monthly subscription fee that the average Host will pay to list their assets on the platform. For the Commission model, however, the calculation becomes much more involved. Because the revenue generated from the Unit under the Commission model is not uniform or guaranteed, many assumptions need to be made about the transactions. These assumptions include Average Transaction Size, Average Number of Transactions per Month,  Average Number of Listings per Month, etc. From this example, it is clear how quickly the MRR calculation can complicate.

  1. Know Your Industry Benchmarks (Churn Rate) 

Particularly in the early stages of your business and Unit Economics modeling exercise, it is important to be acutely aware of your industry benchmarks. For inputs such as CAC and MRR, although each business will have unique values, it should raise a “red flag” if your inputs are orders of magnitude away from what similar companies are reporting. If solid justifications exist for your deviation from industry norms, proceed with your modeling but be prepared to answer questions about the abnormalities.

While CAC and MRR are determined using internal inputs and assumptions in conjunction with industry benchmarks, Churn Rate (“Churn”) will come exclusively from benchmarks for all new companies. Churn is defined as the percentage of customers that you lose each month. In the early stages of your business, you simply lack the operating history to know how “sticky” your service is, so instead you should turn to the market to tell you how frequently customers leave (unsubscribe, cancel, become inactive, etc.) similar platforms.

Using these 4 steps as a starting point, you should be well on your way to constructing a solid Unit Economics model. This will become the foundation of your Financial Model as a whole, and help you determine your specific funding requirements among many other key details about your business. For a more in-depth explanation and example of Unit Economics modeling, check out Foresight President, Efrat Kasznik’s talk titled “Telling Your Story with Numbers,” and register to attend one of our upcoming talks!

Startup Q&A Blog Series: Valuing Early-Stage Startups

Posted on Modified on by Foresight Valuation Group

The Foresight team regularly spends time answering our startup clients’ most pressing questions regarding Financial Modeling, IP Strategy, Valuation, and more. We’ve decided to share some of these important insights in our Startup Q&A Blog Series. This blog deals with valuing an early-stage startup when dealing with seed investors.

Question:

How Do I Value My Seed Stage Startup?

A Foresight client was preparing for a seed funding round, and asked us the best way to value their business. Because early-stage companies lack operating history, and in a majority of cases lack any form of revenue, assigning value to the startup cannot be done with “traditional” methods such as a discounted cash flow analysis or a revenue “multiple” approach. The client is launching a smart wearable health tracking device, and looking to substantiate a $12M pre-money valuation.

Answer:

  1. Know the Current Market Comps

Because early-stage startups cannot be valued on cash flows, investors often turn to the market to determine the “going rate” for businesses in any given sector. This is where the entrepreneur should start as well. Undervaluing your business in negotiations with investors means you will likely give up greater ownership percentage than is necessary – something that should be avoided at any stage of the business, not just the seed stage. Conversely, overvaluing your business could kill the deal before it even starts. When both the investor and entrepreneur are educated on current market conditions, the starting point of valuation negotiations can at least begin in the same ballpark. The ColleyGO publication is a great resource for starting your market research. Below is a sample chart from this report:

Not only can we gather the median pre-money valuation for seed companies of which was $16,725,000 in 2024 according to this chart, but we can also observe trends in seed stage valuation over time. Various public sources are available for valuation research by country, market, etc. As a starting point, Foresight’s client knows that they within the median range with the targeted $12M valuation.

  1. Know What Matters to Early-Stage Investors

Although it is a great starting point, most investors will be a bit more sophisticated in their valuation process than simply taking the market median. In particular, there are certain characteristics of a business that investors will consider when assigning value to an early-stage company. In 2011, Dave McClure, founder of the accelerator 500 Startups, shared insights on his methodology for valuing such companies. McClure said that each of these 5 components of a business were worth $1M in value:

  • Market
  • Product
  • Team
  • Customers
  • Revenue

The value assigned to each point can change over time, and would probably be more than $1M today given the sharp increase in pre-money valuations since 2011.  Each investor has her or his own heuristics.

When developing your pitch deck for the seed round, it is important to keep these factors in mind, and highlight those that are strengths of your own business. If you have existing, brand name customers, make sure to call them out. If you operate in a particularly large or “hot” market, emphasize this and quantify it in any way possible. Our client happens to have a particularly strong founding team with experience working with and launching products in similar industries. This will be a great point to emphasize when negotiating for their target valuation.

  1. Efrat’s “Bonus Point”

One component that is noticeably absent from McClure’s list, and that is particularly pertinent to Foresight, is Intellectual Property. IP gives companies an inherent advantage over the competition, and as such, such advantages should be considered in the valuation of the business. Traditional valuation methodologies often overlook the true value of IP to a business – something that Foresight tries to combat. For this reason, entrepreneurs should be acutely aware of the business’s  IP value from the early stages and understand how it impacts the value of the business as a whole.

When considering your company’s IP and the value it adds to your business, make sure to consider all forms of IP,  not just patents. A granted patent is undoubtedly something to hang your hat on when negotiating valuation, but remember to also highlight things like a strong brand, customer relationships, trade secrets, customer data, etc. Even the potential to develop these strong IP assets is something to be considered for your pitch (for example, the potential of amassing customer data even though you may only have a small number of subscribers at this stage). With 2 design patents and 4 provisional patents, our client certainly has some increased leverage in the valuation discussion.

  1. Bonus Note for Hardware Startups

Hardware startups are still very viable businesses, although they come with a number of inherent challenges that software or service startups do not face. Because of this (and because hardware is not the most trendy space), some early-stage investors may shy away from hardware deals.

For those entrepreneurs dealing with hardware, Foresight recommends a few things. First, be creative when developing your business model. One of the main drawbacks of traditional hardware businesses is that revenue is restricted to a single transaction. Modern business models, like we see in software, integrate things like subscriptions or upgrade plans to increase the recurring nature of the company’s revenue. Second, think about how software can work with your product. Even something as simple as a mobile application can open many more possibilities for your hardware business (customer data, premium content, community building, etc.). Finally, be mindful of your audience when pitching your business. Knowing that the word “hardware” might raise some red flags, be creative in how you present your idea to keep investors engaged. For our client, we suggested simply replacing any mention of the word “hardware” with words like “device,” or “delivery mechanism”.

Lessons learned from 2 years of startup surveys: Key observations about founders and the companies that they build

Posted on Modified on by Efrat Kasznik

In 2016, we launched a startup assessment survey, aimed at analyzing startups that approach us for services and scoring them on the Product/Execution Quadrant map.  This analytical tool provides a useful framework for early stage startup assessment (Pre-Series-A) and for identifying areas of weakness on either the Product or Execution side that should be addressed in order to take the company to the next level.

More on the Product/Execution Quadrant map can be found in this article.

 With over 2 years of data, we have seen some interesting trends in the responses we get to our 20-Question assessment survey.  Below are a few observations that can shed light on early stage founders’ motivations, products, competitive advantages and other factors critical to success:

  1. Founders who are experts in their industries are often targeting problems based on personal pain

There is strong evidence in the market that in instances where entrepreneurs are addressing a personal pain in an industry they know well, they are more likely to succeed.  Our survey results show a high concentration of founders who fit this profile, and we believe that the two are actually correlated: the more experience you have in an industry, the more likely you are to stumble upon a problem that is rampant in that industry.  When asked about the problem they are trying to solve, 50% of respondents indicated that the ‘Idea came from personal frustration’, and 53% further responded that it is a ‘Problem in an industry where I know the customer needs’.  These answers bode well with the responses to another question about relevant industry experience, where 58% of respondents indicated that they have ‘Significant experience (over 5 years)’, and another 18% indicated ‘Some experience (under 5 years)’.

  1. Most founders in the software industry have self-funded a product to minimum viable product (MVP) and beyond

Software products are easier to self-fund to a relatively advanced stage of product development, as opposed to products in hardware, materials or life sciences which require large amounts of R&D and depend on grants or other type of early stage funding. This correlation is clearly supported by our survey results:

  • 76% of the respondents identified their product as ‘Software’ related, while close to 50% specifically identified a Software-related industry (Mobile, Social media, Enterprise software or FinTech).
  • 65% of the respondents characterized their stage of product development as MVP and beyond (31% at the ‘MVP/Proof of Concept built’ stage, 24% at the ‘Initial Release’ stage, and 10% have already released a product to the market).
  • Finally, 88% of respondents have self-funded their venture to-date (29% each also indicated Friends & Family or Angel Funding), and only 2% took in VC funding.
  1. While many founders have some form of patent protection, an overwhelming majority mention ‘Superior product features’ as their competitive advantage

While approaches to patent protection vary in our survey, there is almost a unanimous consensus about ‘Superior product features’ being the most important competitive advantage. This finding makes sense in light of the large concentration of software companies in our survey.  Software companies grow in valuation by gaining user traction, and user metrics are often the most important metrics analyzed by investors.  It is therefore no surprise that 92% of respondents indicated a user-facing metric such as ‘Superior product features’ as their competitive advantage (some of these may be overlapping since there was more than one possible answer to this question).  The next popular answer, at 50% of respondents, was ‘Intellectual property’.  When specifically asked about methods of protecting their idea, founders’ answers seem to be all over the place: about a third of respondents (34%) indicated having a pending patent, 27% of respondents indicated they have not protected their idea at all, 15% had a granted patent and 12% had a portfolio (more than one) patent (some of these may be overlapping since there was more than one possible answer to this question).

  1. First time entrepreneurs seem to overestimate their addressable market and/or underestimate the competition

As we have learned throughout our work with hundreds of startups around the world, many founders (especially if it is their first venture) are overly optimistic in that they overestimate the addressable market, and/or underestimate the competition.  Both of these biases are present in our survey results: when asked about the size of their addressable market, 67% of respondents indicated the market was larger than $2 billion, and another 17% indicated the market was between $500 million – $2 billion.  When asked about the state of competition, 68% responded that there was only ‘a handful of competing products’, and only 12% felt like they were entering a ‘crowded market’.  We expect these biases to be correlated with lack of experience, and indeed, when looking at the makeup of our survey respondents: 38% of respondents are first time entrepreneurs, only 19% have raised money before, and only 10% have had a previous exit.

  1. While most founders operate as a team, the definition of a ‘team’ is subject to interpretation

A strong team is a critical factor in our Execution score, and we collect a lot of information about the startup’s team and its makeup.  59% of our respondents reported having a full-time team working on this project, and 35% of them also reported that they have worked with key members of the team before.  This combination is highly sought after by investors, as past work experience is a factor likely to reduce personal frictions in the team, a problem that is considered one of the top growing pains of early stage ventures.  Having said that, perceptions of what constitutes a team varies among founders, and could be subject to interpretation: while 7% of our survey respondents reported that they have no team, 29% of them indicated in a different question that they are ‘Sole entrepreneurs’.  This seemingly conflicting answer is actually typical of startup founders, especially those with little experience, who sometimes include in the team people who are contractors (17% indicated their team is comprised of independent service providers) or advisors (38% reported that they have an advisory board).  While these two groups can fill in the gap in the early stage, they are often only a temporary substitute to a real, dedicated team.  Finally, while 43% of respondents indicated that they were looking to build their team, only 19% indicated ‘Access to talent’ as a major challenge to scaling the business in a different question.  We attribute this pattern to lack of experience, as seasoned entrepreneurs fully understand the challenges involved in putting a team together.

Conclusion

We will keep monitoring the trends as more startups take our survey.  As previously mentioned, our sample of survey respondents over the last 2 years constitutes primarily of early stage ventures developing software products.  We use this survey to map each company on a Product/Execution quadrant map to figure out their readiness for Series A funding. Founders in our survey often fall into the ‘Rookie’ quadrant (scoring low on both Product and Execution) or ‘Visionary’ quadrant (scoring high on Product and low on Execution). This seems consistent with both the industry they are in (Software) and their stage of funding (seed, pre-Series A).  Our goal is to move them to the ‘All Star’ quadrant (high on both Product and Execution) and get them ready for Series A funding.

Churn Is King: How SaaS Business Models Affect Software Company Valuations

Posted on Modified on by Foresight Valuation Group
Efrat Kasznik Foresight Valuation
Efrat Kasznik

In 2012 Oracle CEO Larry Ellison announced the availability of Oracle Cloud, declaring cloud computing “a fantastic opportunity for technology companies to help customers simplify IT”. Software vendors across the world are embracing the ‘software as a service’ (SaaS) cloud-based business model in growing numbers. According to San Diego-based investment firm Software Equity Group, SaaS software revenues will likely represent approximately 25% of the overall software market in the next five years. Research firm Gartner estimated that global spending on SaaS will reach $22.1 billion by 2015. Some software vendors are converting their software delivery and revenue models to SaaS, while others acquire SaaS companies to gain access to this market. Adobe is a recent example of that shift: in May 2013 the company announced that it was halting future updates of its flagship product, Adobe Creative Suite, in favour of expanding the subscription-based Adobe Creative Cloud. On the M&A front, SaaS M&A transactions grew 25% last year and the median SaaS exit multiple was more than double that paid for traditional, on-premise software targets, according to the Software Equity Group.

The transition from licensed software models to SaaS subscription models for software vendors is not trivial, due to security concerns and the initial cost of switching from existing corporate IT infrastructures; however, the long-term benefits manifest themselves not only in higher revenue growth rates, but also in higher company valuations. While the majority of software businesses today – especially those catering to large enterprise clients – still generate most of their revenues from traditional, perpetual licences and maintenance revenues, the valuations of SaaS companies are about twice those of traditional licensed software companies generating the same revenues (Software Equity Group, 2013 survey). What is driving these higher valuations and are there real economic advantages to the SaaS model over traditional software licensing models?

SaaS business model
SaaS subscription models are gaining ground over the traditional software licence and maintenance models as enterprise customers become more comfortable accessing their software in the cloud and paying monthly subscriptions, compared with a large upfront perpetual licence fee. As the global computing industry is becoming more diversified in terms of networking platforms and access devices, software delivery is slowly morphing into a subscription service that can be accessed anywhere, at any time, on any device. Users receive timely, automatic upgrades rather than having to wait for the next version to be released and pay an additional fee for maintenance.

The SaaS business model is disrupting the traditional cash-flow pattern associated with a software user: high, upfront payments (with annual maintenance fees of about 18% to 20%) are substituted by a longer stream of smaller, periodic (mostly monthly) subscription payments. This results in a cash ‘squeeze’ in the early period after the launch of a SaaS product and can cause delays in revenue recognition for the SaaS vendor and a cash management challenge to SaaS providers of all sizes, from start-ups with limited resources to public companies managing their earnings. While recurring revenues are usually preferable to providers and investors alike, the nature of the monthly SaaS subscriptions – as opposed to a one-time transaction fee – shifts the emphasis to customer acquisition and retention as key to the survival and success of SaaS companies. This observation is particularly critical in understanding the key SaaS business metrics, such as ‘customer churn’, which is defined as the rate of subscriber attrition (usually measured as a monthly percentage, typically under 2% for a healthy SaaS company).

Churn is king: new SaaS metrics driving success
Churn is one of several key performance indicators (KPIs) that are closely monitored by investors, especially in early-stage SaaS ventures, where they serve as a precursor for survival. These metrics and KPIs have been articulated in a series of popular articles and models by venture capital investor David Skok of Matrix Partners:

Churn = percentage of customers lost every month (can be negative or positive)

In order to sustain profitable growth, SaaS companies need to minimise churn, increase MRR and keep CAC down. A common rule of thumb applied by investors assumes the following ratios between these KPIs:

  • LTV > 3 times CAC
  • Months to recover CAC < 12 months

The old valuation adage ‘cash is king’ seems to have been replaced by ‘churn is king’, as these SaaS models are extremely sensitive to the churn rate. Using a simple set of numbers can highlight this point. Assuming a CAC of $10 per customer, the LTV needs to be at least $30. In order to satisfy both ratios, with an assumed churn rate of 2% monthly, the net MRR needs to be at least $0.83 so CAC is recovered in 12 months. The resulting LTV is about $42, higher than the $30 threshold. However, let us assume for the sake of example that the churn rate goes up only slightly to 3% monthly: on the same MRR of $0.83, the LTV is now at $27, below the required $30. MRR will need to go up, or CAC to go down, in a constant balancing act of these ratios.

Why are SaaS company valuations so high?
According to the Software Equity Group, traditional software companies have an average enterprise value of three times revenue, while SaaS companies trade at a much higher multiple of 6.5 times revenue. There are several explanations for the observed higher valuation multiples commanded by SaaS companies:

  • SaaS companies are growing faster. Data released by venture capital firm Redpoint Ventures show that from 2004 to 2009 the average revenue growth for SaaS companies was around 25%. From 2010, SaaS companies started reinvesting about 50% of their profits in growth, and as a result average growth rates have increased to 35% in the past three years.
  • They have a higher percentage of recurring revenues. David Cowan, managing partner at Bessemer Venture Partners, highlighted this point in a quote from his article on high-growth, recurring revenue businesses, which he calls Technology Service Vendors (TSV):

“Recurring revenue (RR) is the flywheel in the engine that drives value in a TSV. So the primary metric of value must derive somehow from RR. New accounts, higher pricing, lower churn and upsells all contribute to RR, so they simply become components of the primary metric.”

  • MRR increases annually. In order for SaaS companies to maintain profitable, accelerated growth, they must consistently generate higher recurring revenues from the same subscriber base (MRR). It is easier to upsell additional services into an existing subscriber base: Salesforce and Netsuit are two examples of successful SaaS vendors which have been following that path.

The SaaS segment of the software industry is still young and growing, so any empirical conclusions on valuation trends will have to go through a longer observation cycle in order to establish a solid pattern. SaaS companies will need to keep balancing ratios such as churn, MRR and LTV in order to keep their profitable growth and high valuations.

Article published on: iam-Magazine

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