Why Understanding Growth Rates is a Key Skill for Investors

ave you ever seen a public or private company that isn’t profitable, but has a massive valuation?

 If the answer is yes (and we’re sure you know there are many startups out there who fit this bill), then you have encountered a company with massive growth potential.

 Growth rates are a crucial concept for investors to understand. Why? Because they help paint a picture of what the future might look like for a startup, and if that startup can be as big as their valuation portrays.

As many of you reading this know, venture capital is the business of investing in the future. What a startup is doing in the present and what it has done in the past is undoubtedly important, but in VC, you are investing in that company’s future growth, revenue, and hopefully - profitability.

What do Growth Rates Tell us?

The growth rate projects how much a company is expected to increase revenue over a set period of time. Although it can also be applied to other financial metrics like profitability or EBITDA (earnings before interest, taxes, depreciation, and amortization). 

To find the actual growth rate, take two set time periods, like say year 1 and year 2. If revenue in year 1 was $2 million and revenue in year 2 was $3 million, you subtract year 1 revenue from year 2and then divide by year 1 revenue, the starting point.

($3M- $2M = $1M) → $1M/$2M = .50 x 100 = 50% revenue growth rate between year 1 and year 2. 

In the startup world, a founder could take this 50% growth rate to investors and try to leverage it so they get a good valuation, which will of then impact how much equity the investor receives in return for the capital they put in.  

Typically, the startup founder will advocate for a higher growth rate (which as we mentioned leads to a higher valuation),while the investor will push for a lower growth rate because the lower the valuation, the more equity in the company the investor will receive.  

Let’s say a startup shows a venture capitalist the 50% growth rate mentioned in the example above, and the investor and founder agree that the company deserves a multiple of 9x. With current revenue at $3 million, that gives the startup a $27 million valuation.  

Of course, there’s a lot more that goes into it, but that’s a very basic idea about how growth rate can be used in valuing a startup.

The thing about trying to forecast the future is that it can be difficult because, well, it hasn’t happened yet. And no matter how much certainty someone seems to have about something, no one can see or predict the future.

Thus, it’s important for investors to realize this and do their own due diligence when a startup comes in and starts talking about growth rates. 

What are Typical Growth Rates for Startups?

In general, a new startup will typically see their growth rates jump significantly in the early years because they are just beginning, so it doesn’t take too much to grow fast when you are starting with very little revenue.

But over time, those growth rates tend to slow as it becomes more and more difficult to keep building success on top of success. 

As you can see from research conducted by SaaS Capital in early 2020 in the graph below, growth rates are higher for companies with less annual recurring revenue (ARR) and lower with more ARR. 

One thing to keep in mind is that if a company is growing at an astounding rate, it’s your job as an investor to challenge their assumptions and make sure you understand how the startup is arriving at those numbers.

As the saying goes - if something is growing like a weed, it probably is one.

The premiere startup accelerator Y Combinator reviewed startups that have come through its program and eventually raised a series A round, and found that most B2B SaaS companies are growing 300%year-over-year, while most consumer-facing and marketplace startups are growing20% month-over-month. (https://www.ycombinator.com/library/1k-benchmarks)

But again, it will ultimately be up to you as the investor to make sure you agree with a certain growth rate.

What Affects Growth Rates?

Some of the factors that go into the growth rate calculation and assumptions include the size of the market the startup is in, customer loyalty, ease of adoption, and how hard a product or service is to duplicate.

For instance, a startup could have a fantastic product that solves a great problem. But if that problem is not a big enough, you must ask whether there is a substantial enough market to achieve the growth rates needed to make a good return on your investment.

On the other hand, let’s consider there is a huge market, but the customers in that market are not loyal and just go for the cheapest price. Then you must assess whether the startup is capable of maintaining this price advantage over its competitors. 

There is a lot that goes into coming up with a growth rate and evaluating its plausibility. Investors need to make sure they can arrive at or get within the same ballpark of a startup’s proposed growth rates. Your work at this stage will be critical in ultimately determining how much money you make -- or don’t make -- on an investment.

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