How to Value Equity
Many business owners struggle with how to value equity. Equity shares have to be split properly so the business thrives. Today, we’ll look into the methods designed to determine how you can value and fairly split the equity.
One of the traits of a good entrepreneur is having the ability to make proactive decisions for their company. A lot of the things that could make or break a startup root from early decision making. Who you choose as your supplier, how you will do your operations, the market you will target—these are all crucial points for your business’ success. How you value equity, for one, will dramatically impact your startup.
An equity split is a common reason for a company’s pitfall. Allocating ownership clearly and fairly is a must when you’re just starting. It serves as a significant foundation for the stability of your business.
Let’s get a better understanding of how equity split works and discuss how to avoid its common complications.
Understanding Equity Shares
First, let’s define what equity is in the business context.
Equity refers to the amount of money a company’s shareholder receives when assets have been liquidated. The investor’s value of ownership determines the equity. These funds are distributed during liquidation (when the company’s debt is paid off) or acquisition (minus the startup’s liabilities). In short, it’s everyone’s slice of pie. And the business owner decides who gets the biggest and smallest slices. But this is often where things get tricky.
Ideally, you have to divide equity shares in a way that’s “fair” to everyone. But “fair” is fairly subjective. Who gets the bigger share? Is it the one who put in more hours? The one who offered resources? Or the one who gave the bigger chunk of the capital?
When it comes to business, you have to redefine what fair is for everyone involved. Fortunately, there are plenty of methods you can use to value equity. You can pick out which one fits your business’ dynamics more.
Startup Guide: How to Value Equity
These are the most popular valuation methods you can use for your equity split.
1. The Berkus Method
The Berkus Method was developed by a serial angel investor, Dave Berkus. His principle of valuation is to assign a number and financial valuation to each major element of risk. His method is best used in the pre-revenue stage of a company.
You can calculate the value of equity by using both qualitative and quantitative factors based on these five elements:
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
You can refine this model based on the average market valuations. But keep in mind that this method is best for the pre-revenue phase. It no longer applies when you have revenue, as you can use concrete data to project the value over time.
2. Comparable Transactions Method
It’s never a bad idea to look around. And this is exactly the whole principle of Comparable Transactions. The more you can gather data from competitors, the more material you can compare and analyze in valuing your company’s assets. This method is best used in estimating a company’s value when there are plans of merger and acquisition (M&A).
Comparable Transaction uses a specific valuation metric called EV-to-EBITDA multiple. This form of valuation is generally used alongside other data, including the startup’s discounted cashflow, price-to-earnings ratio, price-to-sale ratio, and price-to-cash flow ratio.
3. Scorecard Valuation Method
The Scorecard Method works by scoring your startup on a list of qualities and comparing how you fare against competitors. This method is designed for the pre-revenue stage of business.
You have to find the average pre-revenue valuation of comparable companies and then assess how you score according to these criteria:
- Strength of the team: 0-30%
- Size of the opportunity: 0-25%
- Product or service: 0-15%
- Competitive environment: 0-10%
- Marketing, sales channels, and partnerships: 0-10%
- Need for additional investment: 0-5%
- Other: 0-5%
4. Cost-to-Duplicate Approach
How much would it cost to recreate your startup? The Cost-to-Duplicate approach studies all your physical assets to figure out how much it would cost to duplicate them elsewhere. For this method, all you have to do is calculate the fair market value of your entire tangible assets. This also includes development cost, product prototype expenses, patent cost, etc.
As with most of the methods already mentioned, the cost-to-duplicate approach doesn’t apply if the startup already generates revenue.
5. Risk Factor Summation Method
For a more quantitative approach, the Risk Factor Summation is useful when you want a broader scope of valuation. It brings in further risk management and governance consideration into the system of valuation.
It starts with an initial valuation using other methods. From there, it’s a matter of decreasing or increasing the monetary value. The derived base value is then adjusted according to 12 standard risk factors.
These are the standard risk categories:
- Stage of the business
- Legislation/political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Keep in mind that the above-mentioned methods are just a few of the valuation approaches you can try on your startup. Some companies use a specific form of valuation according to their industry, while others combine multiple methods of valuing equity. You can study these valuation methods further or enlist the help of an investment analyst.
Tips on Valuing Equity
In summary, you have to value your company at a decent number to be fair to early investors without impairing later rounds. It’s not easy to study your numbers but your operations must succeed in the long run. You have to balance being fair to investors and looking out for the well-being of your company.
Now, if finance and investment aren’t your forte, it’s best to just leave it to the professionals. They can handle all the intricate processes of analyzing your business data and give you advice on which methods to use to value equity. This will give you a better understanding of your company’s outlook and create more accurate decisions.
You have the option to pass on all the nitty-gritty work of running a business. You can employ third-party services like Full Scale to help manage things.
Full Scale specializes in helping entrepreneurs manage their business. We offer a wide variety of startup services such as mentorship and talent resources. Our founders, Matt DeCoursey and Matt Watson are angel investors themselves who have a passion for helping aspiring business owners succeed. They are more than willing to share their expertise and advice regarding finances and investments.
So, what are you waiting for? Get your FREE Consultation today!