The Basics of Equity - Part 1: Valuation

Alongside the challenges of actually getting a company up and running, the issue of equity often becomes a key concern in the life of entrepreneurs. After all, the startup is their baby and they are hoping to be rewarded for their hard work in the end. But many new entrepreneurs may not have a full handle on how a company should be valued and how equity should be distributed. So in the next couple of posts we will examine these questions.

Recently I’ve had a number of entrepreneurs pitch their company to me followed by the question, “Do you think I can ask for a pre-money valuation of $X million?” The short answer to that is, “Yes, you can ask but that won’t be much of a factor in the actual valuation.”

When you deal with traditional industries or later-stage technological companies, you can call on a set of established measurements – such as discounted cash flows and company assets – in order to establish a valuation. These help provide investors with a valuation that is relatively objective and takes into account the current state of a company and its future prospects.

Unfortunately, early stage tech companies usually have no revenues and few real assets, so the normal tools don’t really apply. This means that the valuation for early stage companies is strongly subjective. It is influenced partially by the quality of the team and the hype surrounding the space, but much more by the immediate financial needs of the company and the investor.

What does this mean for the entrepreneur? In short, it means that the valuation of the company is based mostly on what the investors are willing to give you, which in turn is based on how much you are looking to raise.

VCs (early stage ones at least) have a set investment model which is generally based on holding a 20-25% equity stake in a company. In the case where two VCs are investing, each one will want to hold 20-25%. This dictates the valuation we are willing to consider.

Let’s put it into numbers. You are looking to raise $1 million. Your friendly VC wants to hold 25% of the company post money (in other words, after the investment). So, if we divide $1 million by 25% we get $4 million dollars post money (i.e. the $1M put in is now worth 25% of the company). If we subtract the money investment from the post-money valuation we get $3 million.

This means that your company is worth more or less $3M.

Let’s take a second example, where two VCs are involved. You want to raise $5 million from two VCs. Each will want 25%. Therefore your post-money valuation is $10 million ($5M/50%) and your pre-money valuation will be around $5M.

These figures are not set in stone. But they are the basis for negotiations. Obviously, if you have a number of investors fighting over your company, you will be able to demand a higher valuation. But this will give you a ballpark figure about what you can expect your valuation to be.

Also, it should be noted that this rule does not necessarily apply to angel investors. Angels have their own goals with regards to the revenue they will see from your company and will offer you a valuation accordingly. One well-known angel investor I know has a standard model of taking 20% of the company in return for $100K seed money. Some are less generous, others more so.

To reiterate, your valuation is directly affected by the amount you want to raise. Next time, we will tackle the issue of how much do you need to raise.

Comments

[Boaz Kantor]

Very nice post, thanks Shai!

[Eli Ken-Dror, Treezer]

I enjoyed reading your post, looking forward to reading the next one!

[SurferGirl]

Shai,

It's great to see a VC be honest about the valuation game.

While it may work this way in reality, isnt it pathetic that as an entrepreneur I've created more value (ie higher pre-$ valuation) if I target a higher raise? Nothing has fundamentally changed with the company, yet according to your methodology I'll have a $3M pre$ if I raise $1M or I'll have a $15M pre$ if I raise $5M.

Doesnt this encourage entrepreneurs to raise more than they need and then invest in golden toilets?

[cheap caps]

It's great to see a VC be honest about the valuation game.