Startup Valuation Metrics (for internet companies)

What Are Startup Valuation Metrics (for internet companies)?

Startups, by definition, are the early-stage companies that bring innovations through new goods or services to the market. Founders can build startups in any field or industry. However, startups commonly operate in the technology, software, and internet industries.

Valuation is the most critical process in investing in startups. The valuation of businesses, especially startups, is way different from any other asset’s valuation. 

Moreover, the business valuation varies according to the industry in which the company is operating.

Internet startups have unique valuation methods and metrics compared with companies operating in other industries. Therefore, we will cover them in this article.

We will discuss the internet startup valuation process, how data is collected, and who uses that data. Also, we dive into the valuation metrics of internet startups and their importance.

What is Startup Valuation All About?

The estimation of a newly founded company is more like an art. The startup’s value is based on several assumptions and inputs of the analysts. The problem is that those inputs are subjective. 

Nevertheless, the estimation of the intrinsic value is still necessary because that’s the point where decision-makers will either get profits or incur losses.

Moreover, the investors typically consider the relative valuation with absolute valuation.

The standard type of relative valuation, comparable company analysis, is valuing the company using its closest competitors and industry standards.

For example, let’s consider an internet startup. We can derive the value of that company using the closest competitors. 

We classify the closest competitors by their revenue size, funding stage (seed-stage, round A, etc.), operating industry (internet, e-commerce, software), and geography (US, China, UK, Japan, etc.).

The relative and absolute values of the company are vital for the valuation process. The typical users of startup valuation are VC funds and angel investors. In the next section, we discuss what kind of data is used as inputs for the valuation of internet startups.

Data used to determine valuations

There are several sources we use to calculate the startup’s intrinsic value.

The first thing and the foundation of any valuation are assumptions. The startup valuation is not an exception. We make our assumptions based on valuation metrics such as monthly active users (MAU), monthly unique visitors (MUV), etc.

The following things worth considering are the financial statements of the company. The income statement, balance sheet, and cash flow statement clarify the historical trends and serve as the base of economic forecasts. Based on that, we can derive the company’s intrinsic value.

In addition, the market conditions, intangible assets, competitive advantage, and management’s expertise will redefine whether the intrinsic value addresses the startup company’s reality.

The relative value should be considered together with the absolute value. The reason for that is accuracy. So, combining the two methods helps get the value closer to the real value that should be paid to the company.

We will cover the valuation metrics of internet startups in the next section. The valuation metrics are essential since they serve as the foundation of the assumptions and screening of the business’s health.

Types of Internet businesses

There are several types of internet businesses:

1. Software-as-a-Service (SaaS)

As the name implies, SaaS companies provide software for their clients. The software is usually sold for a specific fee or periodic (annual, bi-annual, monthly) subscription. Companies such as - Microsoft and Oracle use this business model.

2. Universal Apps

The companies in this sub-sector develop universal or “all-in-one” apps. Those apps provide a wide range of services across different specters. Apps such as WeChat are considered super-apps that offer many services, including messaging, social media, and payments.

3. Advertising & Affiliate Business

Advertising companies make money advertising products and services. Usually, they are marketing agencies and other marketing firms. One example of making money through advertisement is providing the product for free and using the customer’s data for ad targeting.

Examples of free services with many ads are Google, YouTube, Facebook, etc. They typically suggest all kinds of advertisements despite the customer’s preferences.

On the other hand, the company might use specific ads to target its audience. For example, the blogging business in the software niche might recommend high-value expensive software products. The blogger might charge high fees for that advertisement.

4. E-Commerce

Nowadays, e-commerce is probably one of the most widespread business models. As the name suggests, e-commerce companies make money by selling goods online. 

They are either the marketplaces for other sellers or selling the goods directly to consumers by themselves. The most popular e-commerce companies are Amazon, Alibaba, and Shopify.

Now we are going to discuss the e-commerce valuation metrics. This type of business model is widespread and inherits almost all of the qualities of other business models (SaaS, universal apps, etc.). 

What are the main e-commerce valuation metrics for internet businesses?

Some of the common metrics are:

1) Monthly Unique Visitors (MUV)

MUV = Sum of all unique visits from all channels on a website/month

This indicator is foundational for all kinds of internet startups. It measures the reach of the company. The high number of monthly unique visitors means that the business has a big audience and high potential. However, it doesn't necessarily transform into higher profits.

As of November 2021, the companies with the largest audience are the following:

• Google - 2.98 billion visitors/month
• Youtube - 1.7 billion visitors/month
• Facebook - 1.53 billion visitors/month
• Wikipedia - 1.39 billion visitors/month
• Instagram - 740 million visitors/month
• Amazon - 580 million visitors/month

2) Customer Conversion Rate (CCR)

CCR = Number of signups per month / MUV

This measure shows how many website visitors have become members, signed up for a newsletter, or somehow interacted with the website by clicking links. The numerator of the equation varies depending on the company's business model.

For example, newspapers use the signup for a newsletter as a numerator in this equation. The online shops use the number of orders per MUV as the CCR.

A high conversion rate does not always mean that all of those customers will pay for the service or product. However, the better the conversion, the higher are chances for a business to turn the potential customers into actual customers.

3) Bounce Rate (BR)

BR = Number of visitors who clicked the back button or closed their browser / Number of site visitors

The rate measures how many visitors left the website without any action. For example, you visited a particular website, but you just closed the browser or clicked the back button. This means you did not take any action.

The BR is negatively correlated with Google rankings. In other words, the higher the Google rank of the website (first three places, for example), the lower the BR is (fewer people will leave). 

The bounce rate ranges from 25-40% for e-commerce and retail businesses and 65-90% for blogs and portals.

4) Average Order Value (AOV)

AOV is calculated in the following way:

AOV = Total Revenue from orders / Number of orders placed in a period

Suppose the total revenue of the company is $10 million in 2021. The total number of placed orders is 100K. The AOV will be equal to $10,000,000/100,000=$100.

Average order value directly affects the profitability of the company. Therefore, the AOV is the key to building pricing and online marketing strategies. For example, the marketing team might want to focus on increasing the AOV instead of the traffic.

5) Monthly Active Users (MAU)

MAU = Sum of all visitors who logged on the website in a month

MAU shows how many people are actively involved in the platform or website. Here active involvement means being logged in to the website or constantly interacting with the platform. It's an essential measure for internet companies and serves as a KPI.

The following social networks have the highest MAUs in the world (as of January 2022):

1. Facebook - 2 billion 910 million
2. YouTube - 2 billion 562 million
3. WhatsApp - 2 billion
4. Instagram - 1 billion 478 million
5. WeChat - 1 billion 263 million
6. TikTok - 1 billion

6)Average Revenue Per User (ARPU)

ARPU = Revenue / Number of active users in a period

People usually use the MAU as the No of active users in a period. Then, they will calculate the average revenue per user in a month.

The ARPU takes into account both the non-paying and paying active users. This measure is usually used among businesses with the subscription model. This is common in businesses such as SaaS companies, telephone carriers, and internet providers. 

7) Monthly Recurring Revenue (MRR)

MRR = Sum (All revenue that automatically renews on a monthly basis)

OR

MRR = (Number of subscribers under a monthly plan) x (ARPU)

This is the revenue that automatically renews every month as a monthly subscription. It is an essential measure for budgeting, tracking performance, and forecasting revenue. The most popular subscription business model is that of Netflix.

8) Revenue Run Rate (RRR)

RRR = Monthly revenue x 12

This is an excellent measure for startup companies. Most startup firms don't have 12 months' historical returns. Had they used actual returns, they wouldn't have fully shown their potential. So the RRR is an excellent way to show the startup's potential to investors.

9) Contribution Margin Per Order/Customer (CMPO/CMPC)

CMPO/CMPC = (Revenue - Direct variable costs) / Number of orders

The contribution margin shows how much gross profit is produced per customer. This is an important figure. The more contribution margin per order the company has, the more money it can spend on fixed costs such as rents or interest payments.

Suppose that the company has $100 million in revenue, COGS of $20 million, and shipping costs of $9 million. During this time, the company received 4 million orders.

The contribution margin per order will be:

CMPO = ($100M - $20M - $9M) / 4M = $17.75/order

10) Customer Acquisition Costs (CAC)

CAC = Marketing expenses / Number of new customers

The indicator shows how much it costs to acquire a new customer. In other words, CAC measures the effectiveness of marketing campaigns. 

There are three types of marketing expenses:

• CPM - Cost per 1,000 Impressions (M = thousands in Latin)
• CPC - Cost per Click
• CPA - Cost per Acquisition

11) Contribution Margin After Marketing (CMAM)

CMAM = (Revenue - Direct Variable Costs - Marketing Expenses)

This measure is the same as the Contribution Margin Per Order. However, there is only one difference, CMAM includes marketing expenses. 

The analyst must pay attention to whether a particular contribution margin includes marketing expenses or not, as this can be crucial in certain cases.

The company's management uses CMAM to make significant production decisions, such as continuing production, improving it, or discontinuing it. 

Investors use those metrics to compare the competitors of the same product. The company with the highest CMAM is considered attractive to investors.

12) Churn Rate

Churn Rate = Number of lost customers / Total Customers (who subscribed to a service)

The churn rate shows us the percentage of customers who "churned out" in a certain period (for example, annual). Typically, that indicator is used in companies with a subscription business model as a customer satisfaction indicator. 

Suppose that the firm had 40,000 customers last year. The firm added 5,000 new customers this year, and this year it has 35,000 customers. The churn rate will be:

Churn rate = (40,000-35,000+5,000) / 40,000 = 25%

It helps businesses to make a customer-retention strategy. Moreover, the churn rate is often used in IT and human resources.

Also, there is one more type of churn rate: the employee churn rate. The employee churn rate is calculated as (Number of employees who’ve resigned) / (Total Employees).

13) Burn Rate (and Runway)

Burn Rate = Average amount of lost cash/month

The burn rate shows how much money the startup is losing per month. There are two burn rates: gross burn rate and net burn rate.

Gross burn rate = monthly operating expenses 

Net burn rate = Monthly cash sales - Monthly cash expenses

The cash burn rate is used in combination with the runway. The runway is calculated as (Total Cash Balance) / (Monthly Cash Burn Rate). 

Usually, seed-stage investors use the runway to know how long the startup can last before generating returns and when to inject cash into the startup.

For example, the company has a total monthly cash balance of $100,000. The monthly operating expenses (burn rate) are $20,000. The runway will be:

Runway = $100,000 / $20,000 = 5 months. (The startup can last 5 months without external funding).

14) Lifetime Value (LTV)

LTV = CMAM (annual) / Churn rate

LTV measures how much profit the company can earn from a customer during the lifespan of the customer interaction. Two factors affect the LTV: churn rate and brand loyalty.

The competitive advantage affects the churn rate. The second one, brand loyalty, depends on customers' preferences. So startups base their strategies on those factors.

The most accurate way to estimate the lifetime value is through contribution margin after marketing per customer/year.

For example, suppose the firm has, on average, $30 of contribution margin after marketing and 30% of the churn rate. In that case, the lifetime value will be:

LTV = $30 / 0.30 = $100

Calculation methods that use other value measures, such as revenue, are unreliable. For example, in the case of the revenue measure, the estimation ignores the variable costs.

15) LTV/CAC Ratio

LTV/CAC = (CMAM / Churn rate) / (Marketing expenses / N# of new customers) 

The next significant rate is the LTV/CAC ratio. This measure shows the return on investment per dollar spent on customer acquisition. Again, the higher the ratio, the better the firm operates its business. Also, the figure helps to compare the firm with its peers.

Suppose that the lifetime value of the customer is $100. Therefore, the customer acquisition cost is $25. Then, the LTV/CAC ratio will be:

LTV/CAC = $100 / $25 = 4x.

16) Payback (# of orders or time)

In most cases, startup companies struggle to recover their initial investment. Therefore, they need to know how many orders or months/years they need to recover their investment. Almost in all cases, one order is not enough to recoup, and firms might need several orders.

Here is the payback period formula:

Payback period = (Initial Investment - Opening Cumulative Cash Flow) / (Closing Cumulative Cash Flow - Opening Cumulative Cash Flow)

For example, the initial investment of the firm is $5 million. The opening and closing cumulative cash flows are $2 million and $3 million, respectively. Then, the payback period is:

Payback period = ($5M - $2M) / ($3M - $2M) = 3 years

17) Viral Coefficient

Viral Coefficient = (Number of existing customers) x (Number of invitations sent per user) x (CCR) / (Number of existing customers)

The viral coefficient shows the rate of aggressive growth a company experiences. This indicator represents how many referrals of existing customers attract new customers. The higher this rate, the better the company is.

The expansion of the customer base through virality is one of the most effective ways for the firm's profitability. The firm leverages the network of its customers to attract new customers.

The importance of the startup valuation metrics

You may ask yourself why some startups are worth a billion dollars even if they don't generate revenue. They have no or even negative cash flows. The answer is simple. Those startups are assumed to make massive revenue within a short period.

You cannot value seed-stage startup companies using traditional methods such as discounted cash flows. Many startup companies, including internet startups, don't have any historical financial statements or other historical figures. 

This is why venture capitalists use different projections under certain assumptions to derive the company's value. First, the value is based on the potential of the company. The most effective way to measure the potential is through the valuation metrics described above. 

For example, the customer conversion rate and viral coefficient are used to derive the forecasted revenue. Then, you use other metrics to derive other items, such as operating and marketing expenses.

Finally, you implement the same discounted cash flows using the forecasted numbers. You use a higher-than-average discount rate to factor in the risk of the startup firm. This is why it is essential to consider the valuation metrics addressing the industry of the startup company.

Researched and authored by Almat Orakbay | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Discounted Cash Flow (DCF)
• Free Cash Flow (FCF)
• Relative Valuation Models
• Gordon Growth Model
• Valuation Methods