Success comes from careful planning and precise execution. This universal law applies especially in business. With that in mind, it’s no wonder why developing a strategy for how you plan to account for startup equity and valuation continues to be fundamental for business founders. The reason for this stems from the fact that the valuation of your startup will ultimately set the trajectory for the whole business itself.
Ideally, you should seek to maximize the value of your startup equity (most efficiently and realistically possible) while considering its dilution effects. Remember, when your company starts to issue new shares to investors, holders of stock options can start exercising their right to purchase stock in your company. This results in a dilution of startup equity. The following is a how-to guide for founders looking for intelligent ways to value their startup and how much equity to give away.
Valuing your startup
Ultimately, valuation is about looking at factors like cash flow, revenue, growth rate, customer acquisition, and retention to understand the startup’s lifecycle stage. Doing this properly will allow you to understand the valuation of your startup based on an accurate analysis of the financial metrics you consider. Doing this correctly is a sure way to come up with a credible valuation of your startup.
A valuation can become more challenging when the startup is very young or exists in a relatively new market. Doing the aforementioned is like going out into uncharted territory. Investors will have to base their idea or reasonable hopes for success not on proven methods and typical financials for a well-established product but future potential.
Analyzing Comparable Companies
Since most startup companies exist in established markets, one of the best ways to value your startup is to compare the valuation of other companies in the same market. While not without risk of error, looking at the valuation of companies in the same market (or at least a similar one) can significantly benefit your valuation analysis. Use existing data, market trends, and strategies of tried and proven companies. Doing so can only contribute to your efforts to effectively and accurately value your startup equity.
Capital needs for investors
It’s essential to have a solid grasp of the amount of money you will need and how much ownership you will have to divest if you don’t achieve targets shared with initial investors. One way to do this is to reverse engineer the entire valuation process by looking at the primary amount needed in conjunction with startup equity your investors would need in return. Note that the more equity you relinquish, the quicker you’ll start to see a dilution of your stake in your company.
Market Opportunity
The market opportunity is the primary metric used by the media to help grasp the financials associated with a company’s startup equity and valuations. This is why analyzing potential market opportunities is critical for investors looking to predict their payout better when they sell their equity. It is not uncommon for investors to seek to generate ten times their initial investment when they exit. The main three metrics used to analyze market potential by founders are TAM, SAM, and SOM — which stand for Total Addressable Market, Serviceable Addressable Market, and Serviceable Obtainable Market.
How much equity to give away
Calculating how much equity to give away can be done by looking at the financial necessity of your company at the particular stage of your company’s lifecycle. You will need enough to pay contractors, purchase necessary equipment, hire employees, and cover marketing costs. These overheads should be considered when calculating how much equity you should give away.
With securing investments capable of funding your startup’s operations for at least 12 to 18 months, it would help if you were also prepared to divest between 10 and 35 percent of your startup equity once you reach your startup’s valuation. If your startup can maintain consistent growth, your investors can expect tenfold on their initial investment four to six years later. However, should your company start seeing downward sales trends, you’ll likely have to secure future funds by giving up more equity.
In conclusion
Focus on having a tight grasp on startup equity, how much you need to raise in funding, and how much equity you’ll need to give away. These factors will not only affect your company’s performance but will also determine its ability to acquire and retain talent in the future.
