Valuing Your Startup: How Much Equity To Give Away
One of the trickiest decisions you will have to make as a founder will be about the valuation of your startup and how much equity to give away. Even when you’re busy developing your product or service, you will need to make some decisions about startup equity.
Startup equity, valuation, and how much you want to part are fundamental questions all founders have to think about. Remember that the valuation of your startup will decide everything else. Your goal should be to realistically maximize the value of your startup equity, keeping in mind its dilution. To make it easy for founders, here’s a how-to guide on valuing your startup and how much equity to give away.
How to value your startup
The valuation of a startup primarily depends on its lifecycle stage. Understanding the valuation of an established firm is easy since there are financial metrics to analyze. By looking at the cash flow, revenue, growth rate, customer acquisition, retention, etc., it would be easy to arrive at a credible valuation.
Valuing a young company is a challenging exercise. For starters, there may be just an idea without even a prototype. Even if there is a product or service, it may not be out in the market. Without revenue or cash flow, the conventional methods will be insufficient. Since investors will be looking at not the current performance but the company’s future potential, you can use the parameters listed below to value your startup.
Analysis of comparable companies
One of the most effective ways to value a startup is by looking at the valuation of similar companies in comparable lifecycle stages. If you can find companies in your location and sector with a similar potential market opportunity, you would be able to arrive at a realistic value.
The process should be easy considering the online resources you have now, from Crunchbase to PitchBook. Since VC funding reports are available in the public domain, you won’t have to look hard for data sources. You might even find the pitch decks used by similar companies to investors that will help you arrive at your valuation.
Capital needs
Investors also reverse engineer the process to figure out startup valuations. Here, you look at the amount of money you need and the startup equity that investors would need in return for that. For example, if you need $2 million at this stage and the investors demand 20 percent of your startup equity, your company’s valued at $10 million.
Remember that you would need additional funding rounds and will have to divest further ownership. If you don’t achieve the targets that you share with your first investors, you will have to give up more equity in subsequent rounds, leading to faster dilution of your stake in your startup.
Market opportunity
Whenever the media mentions startup equity and valuations, the market opportunity is the primary metric they use to understand the figures. Analyzing the potential market opportunity will reveal to investors their payout when they sell their equity. Usually, investors would be looking at generating ten times their invested money when they exit.
Founders have three metrics to analyze the market potential. These are TAM, SAM, and SOM.
Perception
While not talked about often due to the difficulty in quantifying it, another important factor is the brand equity of the founder(s) and the startup. It would be difficult to create it as a newcomer, which is why you should look at alternative ways to influence investors’ perceptions of your business.
You can get the media and the investor community interested in your startup by placing influential individuals on the company’s advisory board. Your work history and personal brand reputation will also play a key role in the valuation of your startup.
Be realistic
In the startup world, the maxim seems to be that there shouldn’t be any ceiling on valuation. Entrepreneurs are often encouraged to seek as high a valuation as possible since that would get them more funding to develop their product or amplify their marketing. But as a founder, you should be wary of this tactic.
Higher valuation will inevitably bring with it higher targets. If your startup fails to achieve these, you’ll have to give out more equity in later rounds of funding. So, it makes sense to be realistic about your market potential, revenue, and the number of actual users.
Explore other options
Founders aren’t limited by traditional routes of valuation anymore. Suppose you’re still developing your product or service and are unclear about the market size, revenue, or other metrics. In that case, you can go for options like convertible notes or a Simple Agreement for Future Equity (SAFE).
Y Combinator is responsible for popularizing SAFE, which allows firms to raise modest investments from family, friends, or angel investors. There’s no decision on the valuation of the startup at this point. Convertibles or SAFE will be converted into equity when the company raises its first round of investments.
How much equity should founders give away to investors?
One of the most common questions among founders is, “How much startup equity should I give away?” The answer depends, as stated above, primarily on the amount of money you would need at this stage of your company’s lifecycle. The funds you seek should be sufficient to hire employees, pay contractors, buy the necessary equipment, and market your product.
It’s important to also analyze the overheads of your business. The investments should fund you for anywhere from 12 to 18 months of operations. This is because the funding round will take a few months, and you want a safety margin if things were to take longer or cost more than expected.
Once you’ve reached a valuation for your startup, you should be ready to divest between 10 and 35 percent of your startup equity. Keep in mind that this would depend on the valuation and the funding you need. For further funding rounds to happen successfully, your startup would need to double in valuation every year for a minimum of five years.
Such consistent growth will allow the initial investors to get returns of 10 times or more in four to six years and get further investor interest in your company. Any downturn will negatively impact your valuation, and you may have to give up more equity for additional funds.
How much equity should founders give employees?
An effective way to attract and retain top talent in your startup is by offering them equity. As the company’s valuation rises, so will the value of the employees’ equity. This is particularly true for the early stages of a company since employees would also be taking a risk working with an unproven firm.
Offering ownership in the company is not just a way to attract but also retain talent in a startup. This is important for the first few months or years when there may not be any real traction for the product or service. Many startups that offer employees equity keep anywhere from 10 to 15 percent for the purpose. Startups usually offer these in the following ways:
Employee Stock Option or ESOP: The most popular option, ESOP gives a right to the employee but it’s not an obligation. The stock options would depend on vesting, which would require the employee to serve at the company for a specific period.
Restricted Stock Units or RSU: Under this, an employee will have the right to get shares on a predetermined date. But for this to happen, the employee should have met certain conditions, or a particular event should have occurred.
Stock Appreciation Rights or SARs: With SARs, a company would offer cash payments to match its stock appreciation over a particular duration.
No matter what form of equity or related cash payments a company offers, the objective is to give the employee ownership of the firm and a well-earned share of its growth. When they own equity in the company, employees would also understand that the company’s interests and their interests are aligned. This will incentivize them to perform at their best since they would have a share in the fruits of their labor.
In short
Understanding startup equity, how much to raise in funding, and how much equity to share with employees is important for any founder. These will play an essential role in the firm’s performance and its ability to acquire and retain talent.
Originally published at https://forevermogul.com on March 6, 2022.
