The “Burning Math” - a new Startup Efficient Growth valuation model

VC funds have an emerging question when running startup valuations: how can they integrate startup recent efforts to balance growth and cost efficiency into the valuation of the company?

To try to answer this question, Datasset is building a new valuation model “the Burning Math” that tries to reflect these efficient growth efforts into the startup valuation.  

Since we entered the Ice Age of financing in 2022, cash is not anymore pouring into the venture world. Therefore, startups no longer focus only on increasing revenues. They rather work hard on having an “Efficient Growth”, meaning a sustained revenue growth coupled with a thoughtful cost control in order to reduce their reliance on external financings. In a nutshell, “doing more with less”.

This industry shift has a direct impact on startup valuation models. Prior to this venture capital cash shortage, revenue multiple - and more specifically Annual Recurring Revenues (ARR) multiple for SaaS companies - was the key metric used by VC funds to assess the valuation of a company.

Considering the increasing value-added of Efficient Growth during this macroeconomic downturn, valuation models should catch-up with updated models that directly integrate these cost control efforts in the balance.

To determine how VC funds should integrate Efficient Growth into their startup valuation models, we need:

1. first to define what we precisely mean by Efficient Growth
2. determine which metric can better reflect this Startup Efficient Growth
3. Propose a new framework which integrates Efficient Growth into startup valuation

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How to define Startup Efficient Growth?

Startup Efficient Growth means finding the correct mix between revenue growth and cost control that will allow the startup to scale while being profitable in the long run.

Yet, because revenues and expenses are interconnected, finding the right balance between these two indicators is crucial and tricky.

• “Crucial” because at an early stage, expenses growth is not proportional to revenue growth. Therefore, every expenditure must be strategically allocated to bridge this initial gap between expense and revenue growth.
• “Tricky” because expenses are an intrinsic factor of growth. At an early stage, opting for a short-term cash conservative approach may slow down revenue growth and hit profitability down the road.  

Therefore, selecting the right metric to assess Efficient Growth is essential to make sure we capture adequately the startup effort to combine revenue growth and cost control into its valuation.

Which metric better assesses Efficient Growth for startups?

The Rule of 40 - what it is and why it is inadequate for early stage startups

I see an increasing number of startups reporting to investors their own Rule of 40 which is a total nonsense.

The 40% rule is calculated as follows:

Company growth rate (revenue YoY growth rate) + Company profit (or EBITDA margin) should add up to 40%.

It was brought in 2015 by the iconic Brad Feld (see his original article The Rule of 40% For a Healthy SaaS Company) to assess the good mix between revenue growth and EBITDA margin for late stage companies. Brad Feld explicits it clearly - “if you are going to raise VC money, get focused [...] on scale, then start focusing on the 40% rule”.

Indeed, the Rule of 40 is putting an emphasis on being profitable which is inappropriate for most early stage venture and growth startups. At an early stage, startups need first to invest in order to create revenues. Deficit is structural and should not be penalized.

Bottom line: the Rule of 40 was more conceived to fit scale-up rather than startup models. Even worse - trying to apply the Rule of 40 to startups can kill both their growth & profitability.

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The Rule of X - getting closer to Startup Efficient Growth assessment

Bessemer Venture Partners published a great paper in January 2024 announcing the Rule of 40 math is dead wrong. Byron Deeter and Sam Bondy point out that assigning equal weighting to growth and profitability is wrong. Growth should have priority over Profitability and should be weighted between 2 and 3 depending on the company stage.

The Rule of X, which fine-tunes the Rule of 40, has two main advantages:

1. It puts an emphasis on growth over profitability
2. It creates buckets with different weights applying on the Rule of 40 depending on the company stage

Yet, this interesting framework only applies to mid / late stage companies. Then, how can we measure Efficient Growth for startups that are pre-seed to Series-B / C companies? Bessemer Venture Partners advises to look at the Burn multiple. Let’s dig into it.

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The Burn Multiple - the perfect KPI match for Startup Efficient Growth assessment

The Burn Multiple is a very interesting tool for startups. It was put together by David Sacks in his article the burn multiple, largely inspired by the Efficiency Score of Bessemer Venture Partners. It computes as follows:

It has three great interests:

1. It better fits early stage companies as it gets away from a profit driven approach
2. It puts a focus on good use of funds
3. It takes a marginal approach, meaning it looks at the effect of 1 additional dollar spent on extra revenues.

Sacks goes further, by offering a “rule of thumb” to assess what is a “good” burn multiple.

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Burn Multiple by ARR of a16z - a more refined model for Efficient Growth assessment based on ARR level

Andressen Horowitz proposed an even more refined framework based on a16z private data, in an article titled A framework for Navigating Down Markets

It lays-down guidelines on the appropriate Burn Multiple depending on the ARR level, creating different buckets of burn multiple performances based on ARR level.  

There are 3 main advantages to a16z model:

• the expected burn multiple should depend on ARR level and company development
• the more the startup grows, the more it should put a focus on reducing its burn multiple
• it covers a large spectrum of startups, from early stage companies with ARR below $10m up to startups with over +$75m ARR.

Introducing The Burning Math for startup valuation

Datasset proposes a new model for valuation of SaaS companies, the “Burning Math”. The goal of this model is to integrate Efficient Growth into early stage valuation assessment.

How does it work?

1. Set an initial valuation applying classic multiple benchmarks to the current ARR level
2. Calculate the startup average Burn Multiple over the last 3 months to mitigate cyclical expenses
3. Determine in which bucket the startups falls depending on its ARR level
4. Apply a 25% bonus / discount on valuation, depending on whether the startup fall into the good / bad bucket

You finally get a valuation that is anchored into an ARR multiple approach, but that directly integrates Efficient Growth.

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This Burning Math is an initial “rule of thumbs”. It needs to be tested with VCs eager to submit data sets to fine tune these initial hypotheses. We look forward to publishing an upcoming paper sharing our results.

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