Valuing and deciding how much equity to give away of a company that you’ve, no doubt, put your heart and soul into is always going to be a gnarly issue. Unfortunately there is no single answer but here are a few tips that can help you to navigate this notoriously tricky territory.
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Generally when trying to value their company for a funding round, founders will ask one of these three questions:
- How much money should I raise?
- What percentage of the company should I give away?
- What company valuation should I use?
In nearly all cases, the answer is ‘it depends,’ which, let’s be honest, is as useful as a chocolate teapot. With this in mind, it’s a good idea to set out what the ‘depends’ are.
All three questions are intertwined, a decision on one part impacts the others, so it’s best to start at the beginning, which is either:
- Decide how much money you want to raise, and go forward from there; or
- Start with how much of your company you want to give away, and work backwards
Option 1: Decide how much money you want to raise
Some advisors will say “raise as much as you can, while VCs and investors will usually say “you should plan to raise enough to last 12-18 months before you need to raise money again.”
However, raising is incredibly hard, so it’s vital you understand how much you need to hit your KPIs, what would be helpful in terms of a buffer, and that you’re realistic about the deliverables and managing investor expectations.
The reason for a 12-18 month runway is that you’ll need to be on the fundraising trail six months before you’ll have new money in the bank, and you’ll need to show growth between now and then to get new investors interested.
Any shorter than 12 months runway and it’s going to be hard to hit key milestones or show significant traction, which means you are going to be unable to justify your next round valuation. It’s called a runway for a reason — if you don’t have liftoff before you reach the end, things will come to a sudden stop!
So, if your starting point is figuring out the cash you need, then look at your monthly burn rate — add in the team members you plan to hire, marketing spend, dev costs, etc. — and run the numbers again. Now multiply that burn rate by the number of months you need for your runway. Remember to factor in a buffer for the unknown as anything can happen and usually does in startup land.
At this point it’s important to remember that although you have used the above as the calculation, funding your monthly burn isn’t the message your investors want to hear. So when you’re asked about why you are raising £x, remember to correlate your answer to milestones and not survival, the resources you will need to achieve these and the length of time it will take to get you there.
Option 2: How much of your company you want to give away
As much as Dragons’ Den makes for great TV, here in the real world, high growth investment doesn’t happen like that.
The general rule of thumb for angel/seed stage rounds is that founders should aim to give away somewhere between 10 and 20 percent of the equity in the company. These parameters weren’t plucked out of thin air, they’re based on what we see early equity investors looking for in terms of return.
You see it’s all about the investor really. They are placing bets on you being awesome with the clear knowledge that most of you won’t be, resulting in zero return for them. They are exposed to a high-risk/high potential scenario, hence will likely demand a juicy percentage of your startup equity, which if you think about it, seems fair.
So, start by think about calculating your valuation based on the amount you want to raise and the equity you want to give away.
But, despite this principle being around for over a decade now, data reveals a new UK trend — so you should check out your own market — the rise of the Salami Round:
Instead of raising a single large amount in one go which would carry you for 12 to 18 months, an increasing number of companies are opting for a series of smaller raises giving away somewhere in the region of two to six percent equity per raise over shorter periods of time.
In days gone by, this type of raising pattern would have been inadvisable for a few reasons:
- When there’s no break from raising the product and sales can suffer
- Overly complex cap tables can result in errors which lead to problems further down the line
- The shear time and cost of doing all the legals for a funding made short-cycle funding rounds prohibitive
Of course, giving away too much equity is also a big concern. However, tech innovation can and has changed all of this.
There are now new solutions that make cap table management and exit scenario modelling easy. As to the time commitment of closing a round or an extension to an existing round, that now depends on how quickly you can click a button, not how quickly you can find a lawyer.
Whether you start from the amount you want to raise or the percentage equity you want to give away, all roads will eventually lead you to valuation. This number’s sole purpose is to be added into a formula so that the equity percentage which you want to give away, or alternatively, the equity percentage your investor is asking for, can be calculated.
So, how should you value your company to get a number that equates to its real value, rather than one derived from your burn rate?
If you were to ask different VCs, they’ll come up with a pretty wide variety of responses, including:
- We take the amount you want to raise and do the maths from there
- You pitch us a number — if you’re ballsy enough and can justify that valuation based on your product vision, and you and your team’s ability to deliver it, great, we’re in!
- The biggest determinant of your startup’s value are the market forces of the industry and sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money
- Go to Crunchbase, search your nearest competitor, mirror their raise history and take your valuation up or down depending on whether you are pre or post revenue, pre or post launch.
- Multiple the round size by 4X to 5X
Some VCs are led by their head, others by the heart. Either way, there’s no substitute for a data-driven decision, and thanks to available data showing what actually happens across a range of funding round sizes, you’re now well placed to not just come up with a number, but justify it.
UK company valuation indicator
Analysis of UK deal data reveals distinct funding patterns that highlights staged valuation bands. This might not accurately represent your startup environment if you’re outside the UK, but at least this will give you an idea of what’s going on in Europe and outside the US:
Stage: Idea, valuation: £300K-£500K — You’re looking to raise £50K to £100K to get your idea off the ground. New innovation means the legals can be sorted for as little as £750, just add investors and you’re good to go.
Stage: Prototype, valuation: £300K-£750K — You’ve spent six months refining the idea, doing user testing, building a working prototype. You’re somewhere between Idea and Launch, with a valuation to match.
Stage: Launch, valuation: £500K-£1M — You’ve spent a year building the product with your co-founders, probably not paying yourselves a salary, plus you’ve invested £50K of your own money/time in the project. You’re close to launch, you now want to raise money for that last mile of product development and for marketing.
Stage: Traction, valuation: £1M-£2M — You’ve launched (congrats!) and you’re seeing good signs of early traction, enough to get investors excited. You have revenue plans, but nothing to show yet.
Stage: Revenue, valuation: £1M-£3M — Unlike Silicon Valley, where the vision of being a unicorn is often enough to get investors interested, UK investors (and probably others outside the US) like to see revenue, or at least the promise of imminent revenue. Conservative or sensible? Probably both, but either way if you’re not showing revenue getting funding in the UK beyond Prototype stage is going to be tough. Once you have the some revenue though, along with a plan to scale, you’re on a roll.
Stage: Scale, valuation: £3M+ — To get to this point, you need to have figured out product/market fit, proof of repeatable business, and large market demand provable by data, a clear path to scale and new business acquisition, and have identified customer acquisition cost and customer lifetime value. You’ll know when you get there. But note that with that valuation (and amount raised) you’ll have moved firmly from angel investor to venture capital territory which comes with a great deal more investor and reporting obligations, complex fundraising terms, governance and expectations. Something to note before hopping to the top table too soon.
Cautionary note — Silicon Valley numbers will often be much higher so don’t be tempted to use those for any markets outside the US, or investors will think you’ve been drinking too much Silicon Valley Kool-Aid.
Ultimately, the investor will have the final say but the future is bright for the start-up market, boosted as it is by tech innovation which is simplifying the funding and admin process from the get-go.
The hope is that by removing a lot of the uncertainty currently surrounding admin costs, more businesses will be able to focus on the end goal; making a startup idea a successful reality.
This article was first published by Anthony Rose on TheNextWeb