The saying ‘live and learn’ probably resonates with most of us in the startup world. It captures our make-it-happen attitude and, in many ways, it serves us well.
But if there’s one thing you don’t want to do that with, it’s startup maths. Or in other words, equity and valuations, which are two things you really need to understand before you start asking people for their money, because ignorance can cost you the deal, or see you short-changed.
Here’s an explainer to help you avoid those fates.
Equity equals ownership
First up, in case you’re not clear on what equity is, it’s ownership of part of your company. For example, if a person or entity has 20% equity in your startup, they own 20% of it.
Equity can be bought (usually by an investor) or earned (usually by a co-founder or team member), or a combination of the two.
It’s important to realise that equity means giving up part of your company, which is why it isn’t right for everyone, and some founders are quite strategic about when they go down this path.
Generally speaking, the upside is that it can allow you to get to the next stage and the downside is that it means losing full control of your business.
How equity works over multiple rounds
If you’re going down the path of raising capital from investors, you need to be aware of the different funding rounds: seed stage, Series A, Series B, Series C and beyond.
At each funding round, you can expect to give up 10-30% of your company.
This can be off-putting and also means you need to be comfortable with who your investors are.
It is also worth asking yourself if you’d rather own 100% of something that’s not worth as much or less of something that is more successful.
An extreme example of this is ‘poor’ Jack Dorsey, who co-founded Twitter. He owned just 4% of Twitter when it went public, which was worth US$400 million. And that’s really what equity investing is all about: keeping a smaller piece of a bigger pie.
You will need legal help
If you’re giving up equity in your company, you need to know how to formalise it. There are a few options, including convertible notes and SAFE agreements, which you’ll need to read up on before you’re at the negotiating stage.
It’s also a really good idea to have a term sheet ready to go, and with all this stuff, it’s worth doing it properly with a good lawyer. There are some startup-friendly ones around these days that understand the startup space and don’t charge top-end-of-town prices.
The art of startup valuations
Startup valuations can be as much an art as a science. Ultimately, your valuation is a negotiation between you and the person you’re convincing to invest in your business. And we all know negotiation is an art.
But there is some science to it too, because you need to understand what factors contribute to a startup valuation so you have a confident base to negotiate from. It’s kind of like knowing the salary range you’re eligible for and why, and then being able to negotiate from there.
What’s wrong with valuing your startup too high?
There are two main problems with this.
Firstly, investors tend to dislike it. But that doesn’t mean you should go too low either, as that sends an equally unlikeable signal that you’re either not savvy or not confident.
Secondly, if you overvalue your company when doing a friends-and-family fundraising round, it will make it hard for an angel or venture capital investor to come in at a fair value (in their eyes) down the track.
So be as realistic as you can about your startup’s valuation from day one. Here are some tips to help you do that.
Early-stage tech startup benchmark
There is a quick way to understand early-stage tech startup valuations in Australia. It’s based on one of Australia’s main tech accelerators, Startmate, which offers $75,000 in exchange for a 7.5% stake in an early-stage tech startup.
If you do the (startup) math — $75,000 divided by 0.075 — this values an early-stage tech startup at $1 million.
This is a very simplified way of determining a valuation, but it does provide a local benchmark of sorts.
It also assumes your tech startup is good enough and the right fit to be accepted into the Startmate accelerator. Take a look at the startups it has accepted in the past and try to understand why — look at what stage they were at, whether they had a partial or full team, what their experience was, whether they had any customers, and any other indicators you can find.
The working-backwards valuation method
Another simple valuation method is to work backwards from how much you need (and then apply a critical eye).
For example, let’s say you’ve put together a plan and financial model that shows you need to raise $500,000 for your early-stage startup. Here’s how that translates into a valuation, based on how much equity an investor would get in exchange for their $500,000:
- At 10% equity, you’re valuing your company at $5 million;
- At 20% equity, you’re valuing your company at $2.5 million; and
- 30% equity gives you a valuation of about $1.7 million
Those valuations are very different. It can be tempting to offer the lowest amount of equity above (10%), but is your startup really worth the valuation that yields ($5 million in this example)? Could you confidently back this in front of an experienced investor?
This method gives you an operating range to begin negotiations. The value you settle on will reflect many factors, including your product, how good it is, how experienced you and your team are, and what traction you have.
The venture capital valuation method
As the name implies, this is about looking at things from a venture capitalist’s (VC) perspective. And bear with us, this is a longer, more technical method, simplified as much as possible. This method involves two steps.
1. Estimating your future value
This involves putting together a financial model of your planned future, to the point where you expect to make a profit.
It also relies on looking at what comparable listed companies price-earnings (PE) multiples are trading at. All listed companies will show their PE multiple (check out Yahoo or Google Finance for starters). Essentially, it’s the multiple that listed companies are trading at (their market cap = number of shares x share price) to their profit.
A listed company’s PE multiple = listed company market cap (valuation) / listed company EBITDA (profit).*
The premise here is that if you’re comparable to a listed company, then when you list or are acquired by a comparable company, the same PE multiple should apply to your future startup company (assuming rationale markets of course).
So you go: your startup’s future value = your startup’s future profit x listed company PE multiple.
2. Estimating your current value
Once you’ve estimated your future value, the next step is to discount that to today’s value so the VC gets the return they’re after (which is usually a ten-times return on any investment to cover the cost of all those other startups that don’t make it).
In other words, it’s about what will make it worth it for the investor to invest in your company.
You can use a discount formula to work out what today’s value should be (essentially the reverse of the compounding formulas you might have learned back at school) or more simply, you can use something like the ten-times expected return principle to go:
Your startup’s current value = your startup’s future value / expected return.
Putting it together in a worked example might help this sink in more. Let’s say you’re a startup that’s a bit like Twitter (or hoping to be acquired by them), and that Twitter is currently trading at a PE multiple of 15. In five years, you’re expecting to make a $2 million profit, and you’ve heard that VCs expect to make a 10-times return on any one investment. This means:
- Your future value is $2 million x 15 = $30 million.
- To make it worthwhile for the investor, your current value needs to be $3 million ($30 million / 10).
Remember, valuations are just a number
It’s worth remembering that your startup valuation is just a figure. It doesn’t mean anything unless you are successful in raising funds.
Even then, raising funds is not the real story despite the headlines we regularly see about it. It’s what you do with the funding to increase your company’s value and ultimately achieve an exit that’s successful for you.