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February 6 2020 - New York, NY

Startup valuations and how they work: Michael Tannenbaum

Thomas M:
Welcome to another episode of Brex in the Black. We have Michael Tannenbaum, CFO of Brex here, and today we're going to talk about startup valuations and how it works. Michael.
Hello. Thank you. I think that this is a super important topic. It's one that people have a lot of questions on because there's not a ton of transparency on how these valuations get said. So I think it's helpful to take a look at the investor perspective and just talk about the different stages of valuation. I'm actually even going to borrow a bit from Andrew Chen who is a partner at Andreessen that does a lot of growth commentary and advice for startups and just kind of use the overall framework that he uses to break down the different stages of a startup and then the actual fundraising and valuation perspective will be my own. Does that work for you?
Thomas M:
That works.
Okay, good. Cool. So pre-seed, which a Chen would call bet on the entrepreneur. In that case, typically you're raising from friends and family or accelerators and a lot of those, the accelerators will actually set their own pricing based on the investment. So for example, YC, they set their standard basically for $120,000 investment for roughly 7% which sort of puts your valuation at 1.7 million, if you kind of do the math. I think that YC, Y Combinator, that sort of in general sets the stage for what valuations for good companies, which YC tends to attract, obtain in the pre-seed market. And so while it is a bit arbitrary, you're typically talking about valuations around 1 million. It's kind of what the entrepreneurs set, but given you have accelerators out there at around one to two, that tends to be the range. Next phase is what you call seed, which is bet on the team, per Andrew Chen. I think here is where you start to think about the 20% ownership rule. That 20% ownership rule carries through throughout the mid stages of a startup lifecycle. And what I mean by the 20% ownership rule is that typically investors that are purchasing and investing into a company, they want to own at least 20% of that company because that is the framework they have in order to at least exert some form of influence over management and leadership and feel like they have a stake, a meaningful enough stake in the company. So that 20% rule tends to be the industry metric. And so what that means is that depending on how much money you raise tends to be where the valuation will shake out. So think about multiplying by five, right? And that's where you can start to think about valuation, when you're at the seed stage. Things that are relevant there start to be the TAM, the total addressable market, the story, possible unit economics. Usually you don't have a business yet, but just looking at what is the profitability and revenue and sort of what are all the metrics for one customer that you're trying to do based on what you think the market will look like. That tends to be what people look at. So a combination of addressable market, what theoretical unit economics are, the team is kind of where I started with, and then that 20% or so ownership. So you're typically looking at you know, five to $10 million post money for seed rounds. They can get higher. You know, second time entrepreneurs, all those kinds of things can push it into, you know, the mid teens to 20 but those are really reaches.
Series A, which you could call or at least Andrew Chen calls bet on the traction. This is typically where there is a business. And so you're starting to see some form of traction, it may not be revenue yet, but engagement, there is a product, you know, people are using this product, you may have what people call product market fit. And at that point you're looking at user metrics and engagement to determine how interesting this business is. And at this point you've also probably have your actual unit economics or at least a lot more clarity. So if you're in a pre-revenue stage, you at least have a sense for what your price, maybe you started with a freemium model, but you know what the paid tier is going to look like and so there's a little bit more specificity and the actual unit economics become relevant. In this phase, you're also still working with that 20% metric. So you have, again based on how much money you're raising, that sort of dictates your valuation. And here you typically see valuations in the 20 to $50 million range, at least in the Silicon Valley standards that I see.
So after series A, of course comes series B. Andrew Chen calls this bet on the revenue. And so here again, the 20% metric that we keep coming back to is still relevant. People are, and just to remind you that what I'm talking about is whoever's investing new money in this round wants to own roughly 20% of it, based on the proceeds they invest and that's what dictates the valuation. At this point, people are looking at the overall P and L and not just sort of the revenue but costs as well. And so people, you're betting on the revenue but you're looking at the overall picture of the P and L. CAC starts to be more relevant, meaning customer acquisition costs. And then this is really where a CFO starts to get very involved by the time you have the series B round. You're talking about valuations and the hundred to $200 million range, significantly more amounts of money here. And so people are expecting to see real numbers, decks, diligence, outputs, and at this point this is where I think a CFO can really shine. I think also at this point you need to start to think about the process because you know you're managing investor expectations and people are sort of underwriting specific returns and that's where what I call market models become more relevant. So you actually want to start to compare, okay, incumbents in the space have this economics, where am I? If I get to this market share in five years, how does that compare to existing industry, stuff like that. So this becomes kind of the more CFO round starts at the series B.
And then later rounds, you start to lose the 20% rule. You start to change the investor mix outside of just traditional Silicon Valley style of venture capital, people with different return thresholds, different liquidity horizons. They may want to see liquidity faster, maybe they're interested in an IPO, stuff like that. So things really change after the B. And so I think there, but, and that's where again, the CFO is going to become increasingly important trying to understand the investor perspective and also help produce materials, insights and storylines about the company and explain that to investors.
So that overview was a lot and I'm happy to answer any questions, but also I think that it's important just to break that down.
Thomas M:
Having this whole overview of funding rounds, is there a big difference in B2B and B2C?
So there's not too many structural differences between B2B and B2C, in the sense that people are broadly expecting, you know, ultimately some form of profitability and growth, some combination of that. I think that there for B2C, the early traction and sort of product and engagement is kind of more relevant. Whereas revenue unit economics tends to come later because there's more precedence and B2C world of people monetizing later.
I think that in the B2B world there is this expectation that from day one you have a clear sense of everything from go to market to unit economics and addressable market. And I think that's because B2B, the TAMs are definitionally smaller. So the, if you think about from a venture perspective, they're playing for as much upset. They're trying to make huge bets and take big swings. And so B2B is a bit more capped then B2C because it's just a smaller market. If you look at the largest tech companies today, really Microsoft being the only one that's, you know, firmly B2B. They have Xbox and a few things. It's a lot of B2B revenue and while it has been doing really, really well, most of the other big, big tech companies are B2C. And so I think there is just that sense that when you're investing there's less room, less margin for error in B2B. Although the downside is also less, right? Because you can sort of build a small business serving businesses where a lot of these consumer things are kind of winner take all.
Thomas M:
Great. Thank you. So you mentioned that a series B is where a CFO really shines. Does that mean that's when you should start looking to bring in a CFO or should you just bring one in from earlier?
Yeah, so I think it depends on your business, the financial sophistication of the founders. There are some founders, actually frankly, like Brex founders who were highly sophisticated when it came to financials. When I showed up here, there was a lot of infrastructure already. I mean, for a company that was based in a kitchen, so I was impressed. But at the same time, I think in FinTech the standards are higher. You're dealing with more sophisticated counterparties, you're raising more money typically, you are trying to get network and regulatory approvals in many cases and so having a CFO adds credibility. But I think for your standard, either consumer or tech or SAS business, I do think series B is about the right time to bring in the CFO, especially if there's some either founder or existing, you know, COO or operator or VP ops, whatever, that can handle kind of the financials up until then. I don't think it will hurt you dramatically in fundraising until the series B. And what can a founding team do in pre-seed seed series A to set themselves up for a series B in the right terms without a CFO? Yeah. I think the biggest thing that they need, I mean, there's a lot of things obviously, but the main thing just in the context of fundraising and getting to that series B milestone is making sure, and I preach this a lot in my talks, is this concept of milestone fundraising, which is when you're fundraising, you want to think about what are the different milestones you need to get to and how much money from a burn perspective do you need to get there? And that's how you plan your capital raises. So the amount of money that you're raising is basically what do you need with some cushion to get to that next either product or revenue or operational milestone. And once you're there, you know, that's when you raise again. And so you're planning how much cash and capital do you need today to get there?
Thomas M:
Great. Thank you so much Michael. And we're out with Brex in the Black.
Thank you, sir.
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