Despite the financial crisis raging around us, the world keeps turning, startups keep starting, and the race for investors is ever more cutthroat.
We have arrived at the third part of our four-part series, The Next Round, which breaks down how to attract funding in the reality of a post-pandemic recession. In Part One, we examined the ways investor sentiment has changed post-pandemic. In Part Two, we walked you through how to demonstrate your business plan and financial forecasts in your pitch deck.
In Part Three, we will focus on valuation and equity negotiation. This is an exciting, but fraught, stage in every startup's journey. How can you make sure your valuation is accurate, so that you don't over- or under-sell your business? And how much equity should you really give up? Let's get into it.
Introduction To Startup Equity
When speaking about the equity of a startup, we are usually referring to share of ownership (and therefore entitlement to profits) as well as the right to make decisions for the company. Equity is typically shared between founders, investors, and sometimes even employees.
Although equity can technically be a simple percentage of ownership of the company, most commonly, it is expressed in the form of stocks that people hold. When becoming a stock company, the startup will issue its first batch of stocks and distribute them among shareholders.
The share of ownership, in this case, is calculated this way:
So, if the company has issued 10,000 stocks and you own 1,500 of them, then your share in the company would be 15%.
Types of Stocks
The world of finance and financial assets is super complex, and there are a gazillion types of stocks, options, derivatives, etc. But since I'm not a financial advisor, we'll just focus on the ones you need to know about as someone seeking an investment.
This is the most basic form of equity in a company, and it provides the holder with the right to vote on company decisions, get a share of the company profits, and get a share of the company assets if it is liquidated.
One specificity of the common stock is that its holders are the last in line when it comes to receiving assets in the event of a liquidation. This means that, if the company does not have enough assets to reimburse the investments of all shareholders, those with common stock might end up getting nothing.
This type of stock typically ends up in the hands of founders and employees (in the form of incentive stock options with a vesting schedule, RSUs or restricted stock units, ISOs, etc). Equity compensation packages are usually part of the startup job offer and come as a bonus on top of cash compensation like base salary.
As a side note, employee equity is one of the great ways to retain your talent. You can decide on the number of employee stocks you give, the vesting period (usually four years with a one-year cliff), the deal with non-qualified stock options, tax treatment, and other details during the salary negotiation phase.
Unlike common stocks, preferred stocks gets you protection in terms of getting your assets back when the company stops doing business. The holders of preferred stock will be the first in line regarding access to company assets. They will also take priority when distributing dividends, too.
This type of stock, however, usually carries either no or little voting power. Therefore, shareholders with preferred stock will not be able to participate in the management of the company.
The final concept I'll mention on this topic is what financiers like to call “dilution."
Dilution is the decrease in ownership share when the company issues new stocks. The most common case for issuing new stocks for startups is when the board decides to attract funding and offer these new stocks to investors in exchange for venture capital money.
The math behind dilution is simple. Imagine the company has 10,000 stocks and you own 1,500 of them. This gives you a 15% share in the company (thus, 15% voting power and a share of the dividends).
If the company decides to issue 5,000 new stocks, the total will become 15,000. Now, with your 1,500 shares, you own only 10% of the company.
Now that we're all crystal clear on the core concepts of equity in startups, we can begin with our first important topic—how to figure out the market value of your startup.
How To Calculate Your Valuation
Let me start with the bad news. You don’t really know your true valuation until somebody acquires your startup (valuation = acquisition price) or you go public (valuation = stock price x issued stocks).
However, there is still tremendous pressure to know how much your company is worth, even if it is not a precise number. There are many reasons you want to know your valuation when you are still in the startup phase (for example, to use it to attract potential talent), but the single most important one is calculating the ask for your investors.
No matter the reason, if you want to estimate your worth, there are a couple of methodologies that you can use.
Discounted Cash Flow (DCF)
Here, you are basing your valuation on your financial projections, and specifically your cash flow. The formula for it is the following:
In other words:
- Cash Flow is, well, your yearly cash flow.
- Discount Rate is the % representing the company’s riskiness.
- N is the projected number of years.
Comparable Company Analysis (CCA)
In this case, to understand the value of your startup, financial analysts will look at public or recently-acquired companies that are similar to yours and take their key financial metrics, such as price-to-earnings (P/E) or price-to-sales (P/S) ratios as a basis for valuation.
Let’s assume you are an email marketing service and we use the P/S ratio. In this case, we can look at a couple of other companies like yours (e.g. SendGrid, Mailerlite, etc.) and compare their market valuation with their revenue.
Let’s assume that, for both of them, Market Valuation ÷ Revenue = 5.
This will mean that whatever revenue you have, your valuation will be 5x larger than that. So, the formula will look like this.
Precedent Transaction Analysis (PTA)
With this methodology, your financial analysts or VCs will look at their recent acquisitions and find similar companies. After that, they will look at the Multiplier that they used to invest in that startup and apply that multiplier to you as well.
The formula for calculating your valuation, in this case, is the same as with CCA. The difference is in the methodology of defining your multiplier.
A Few More Words About The Multiplier
The two methods above for getting your multiplier are a bit simplified, as there are a lot of factors that can affect this number, including:
- The nature of your product and your industry: ChatGPT-based startups are hot and will get a larger multiplier.
- The maturity of your startup: Early-stage ones can get around 5X, while established ones will expect something near 20X.
- Your company’s growth rate & retention: High-growth early-stage startups typically get 10X instead of 5.
- The economic situation: The current post-COVID recession has significantly dropped the multiplier rate for almost everyone out there.
Finally, apart from all these factors, your multiplier is up to negotiation with your investors and that is something that you'll want to convince your VCs to increase for you.
So, as you have your valuation ready, you will use it as a base for something venture capitalists like to call “Ask.” Your Ask is the offer that you are making to the investors that includes the money you need and the percentage of equity you are offering in return.
How To Formulate Your Ask
In order to know what your Ask is, you will need to understand the two main sides of it—how much money you need, and how much equity you are willing to part with in exchange. Let’s look at each one in more detail.
Figure Out the Funding Needed
How much money do you want from the investors? In order to understand this, you need to take your financial projections into consideration. This will help you understand your future revenue growth and your existing and future costs to run the business (including startup employee salaries, taxes, infrastructure costs, etc.).
With your revenue and costs projected, you can now understand your runway (the number of months you can cover your costs before you are out of money). And based on the runway, you can figure out the amount that you want to ask for from your investors.
For instance, imagine that your tech company has $300k monthly recurring revenue (MRR) and your monthly costs are $400k. You are burning $100k each month and the $500k in your bank account will let you survive another 5 months (this is your runway).
However, based on your calculations, you will be able to become profitable within 12 months, as there will be a larger MRR of $600k and a relatively smaller monthly burn of $450k.
You can cover 5 out of the 12 months from your own cash. However, you will need to ask for investor money for the remaining 7 months. Thus, the amount you need would be $100k x 7 = $700k.
Figuring Out The Type and Quantity of Equity to Offer Investors
Let’s tackle the quantity first. Usually, what you do is offer a certain percentage of your company that is equal in monetary terms to the amount of funding you are asking for.
Continuing with the previous example, the $700k that you want to ask from investors has to be equal to $700k in the value of the stocks that they are getting from your company.
So, if you have an ARR of $500k, and you end up negotiating a multiplier of 7X (making your valuation $7 million), then your startup offer would be 10% of your company, which is worth $700k—just like the funding you are requesting.
Now, let’s look at the type of stocks you will be issuing and offering to your future investors.
Traditionally, investors get preferred stocks as it is the safer option that guarantees them priority when distributing assets in case of company failure. Many investors will, however, ask for a couple of extras, such as:
- Board member seats in your startup company, which gives the investor(s) voting power in company decisions.
- Dilution protection, which guarantees that their share % will not shrink when you issue new stock.
- Stock type conversion rights, which let them convert their preferred stocks to common stocks at a specific conversion ratio.
The last one is especially common when your startup files for an IPO and converts itself from a private company to a publicly-traded company (where your Share price x Number of shares becomes your Valuation).
You will need to take into consideration the post-COVID recession as well. Investors are more risk-averse now and will only agree to fund you if you give them plenty of safety features in your Ask (including what I mentioned above—stock preference, a say in big decisions, and more).
Tips On How To Negotiate A Better Deal
Now that you have pitched your idea to investors and they have expressed their interest in your product and company, it's time to negotiate your deal. There are two sides to the negotiation that you need to take into consideration.
Make sure it’s a fair exchange of value
Always! This is rule #1 for ensuring that everyone negotiating equity leaves the table with a smile on their face.
What’s your takeaway from this? Well, for instance, if you want your multiplier to go from 5X to 7X, you need to convince your investors that 7X is a fair deal. Maybe it's because your technology is really valuable and, even if you fail, they can still sell it for 7X their initial investment. Or, maybe your growth is so high, you can convince them that they'll get 7X their money back in just 2 years!
You get my point.
Know what you can negotiate with
Most of the time, negotiations quickly become a bartering game (I give you my X in exchange for your Y). So knowing which things you can put in play may help you get the deal you want.
Here are your gamepieces:
- The type of equity (preferred vs common)
- Your valuation
- The amount of equity you're offer (a.k.a. your equity package)
- Priority access to company assets if you go bust
- Dilution protection
- A seat (or several) on the board
- The guidance and expert help of your investors
- Your Multiplier
There are many other “things” that you can barter with. But these are usually the most common ones.
So, imagine that you are asking to increase your multiplier from 5X to 7X, and want investors to guide you, too. To make it a fair deal, you can tell them that in exchange for this Ask, you can offer them a sweet equity package plus dilution protection and a seat on the board.
Times are hard now, but good startups are still getting good investments.
Yes, we're all going through difficult times now—we're all seeing the mass tech layoffs and feeling the cost-of-living crisis. However, it does not mean that investments have stopped overall. If you have a great product and a promising business model, and you offer your investors a fair deal following the guidelines above, then you can still get an investment—no matter what the economic situation.
The next and final installment of The Next Round will focus on the final showdown with your new investor—passing due diligence.
In the meantime, make sure to sign up for our newsletter to stay up to date with the latest trends and best practices in the tech product space.