Ep. #535 - How to Value Equity

Matt DeCoursey 0:00
And we’re back. Back for another episode of Startup Hustle. Matt DeCoursey here with Matt Watson. Hi, Matt!

Matt Watson 0:06
What’s going on?

Matt DeCoursey 0:08
Oh, just ready for part six of our series about how to start a tech company. And we’re finally going to talk about stuff that isn’t cautionary, but yet it still kind of is. So Matt, you know, I have this great idea. And it’s worth like a zillion dollars, and I want you to buy part of it. And I just think you should, because you should. So it’s really valuable. Are you cool with that?

Matt Watson 0:37
Yeah, sure. Whatever. That’s fine. Do you take third party handwritten payroll checks?

Matt DeCoursey 0:42
Yeah, yeah, we take it all, crypto doll hairs dollars, really any of it? But you know, what we’re going to talk about today is is a really pressing question that so many startup founders have. And it’s, I mean, the answers to how to value your equity. I mean, it’s all over the place. It is really something that I really, really, it’s just really all over the place that Matt before we get too far into that. And speaking in terms of investments, today’s episode of Startup Hustle is brought to you by OurCrowd. And if you wish you were in on some of the early and best performing IPOs, 2019 and 2020. OurCrowd investors were now you can join them. And what’s next with our crowd accredited investors have access to invest directly, easily and importantly, early, OurCrowd investors have benefited from OurCrowd company’s IPO and like beyond me and been bought by other companies like Intel, Nike, Microsoft and Oracle, if you go to ourcrowd.com/hustle, you can learn all about it. Go to the link in the show notes. Now, we’re talking about investing. We’re talking about valuing equity for a company. I mean, Matt, where do we start?

Matt Watson 2:03
Well, you know, so the first time I started a company, me and the other gentleman owned the company, 5050. And, you know, this time around was stock fi I was the only founder. So I own 100% of it. And then it was different, because like when I hired my first employees, you know, you got to figure out, are they part of the team or not part of the team? Like, every startup is different. So I’m excited to get into this.

Matt DeCoursey 2:31
Yeah, and you know, this is this is a question that so many people have, and we’ve run into this year, we’ve got either clients from Full Scale coming in asking questions about it, people that have wanted us to invest in their businesses, and there really are, there really are a whole lot of different ways to determine the value of your equity. I think one of the things that startup founders and entrepreneurs, well, they often overvalue the equity, and they often undervalue the equity. But I think in the end, no one really knows what the equity is worth until later. So are you right? Or are you wrong? That’s pretty subjective.

Matt Watson 3:09
Well, you potentially blow up the company and never get off the ground, because you’re fighting about who owns how much of nothing?

Matt DeCoursey 3:16
Yeah, and, you know, there’s a lot of we run into a lot of companies or people that have an idea, and it’s still vapor at this point, you know, it’s a vapor and paper, you know, ideas and business plans, they don’t necessarily have any revenue. And there’s a whole lot of different, you know, methods that people go through to look at what a company could be worth some of them more scientific than others. I one thing I do know is once a company has actually started and has revenue, and all of that, it’s a little easier, but pre revenue is a real challenge. So one of the things and Alright, so I always learn so much, Matt, when I, you know, when I do episodes of Startup Hustle with you. And I have learned today about the Burkus method, or have you ever heard of the Burkus method? Nope. Okay, so this is this is a method of startup valuation and equity valuation that is often used for pre-revenue companies, and they’re gonna look at at five major factors and they are do you have a sound idea? Have you built a prototype yet? Do you have a quality management team? Does Do you or that team have any strategic relationships? And have you had a product rollout or any sales? So the yes or no nature of each of those goes into factoring what your equity could be worth?

Matt Watson 4:49
Well, and it’s totally different. If you and I are like, hey, maybe we should start a company. I’ve got an idea versus this big company came to me they begged me to build something for them, they offered us $5 million a year for the product, we just need to build it. So do you want to do this thing like that those are totally different scenarios, right? And I know a company here in Kansas City that’s in the ladder, like they have one customer that has their entire business, but their business has really grown from that one customer that’s seen it, all of it. And sometimes you got big companies that are begging, like, we need to solve a problem, we can’t do it, we don’t have time. Can somebody else just come solve this thing for us? And we’ll pay you a bunch of money. And you’re, you’re the lucky guy, if you can, you can fall into one of those situations. But the absolutely, when you’re starting a company, the more of these things on your list, you’ve got put together the way easier it is to raise capital and the way easier or the way better your valuation is.

Matt DeCoursey 5:47
Yeah, I think also, when it comes to the value of your equity, the stage that your business at is it is a major factor. Like I said, Yeah, you look at Full Scale, or stack of Fi or really any company that’s already on has their feet on the ground, and they’re running, they have a proven model, they have a number of clients, and you mentioned a company that has one client, that isn’t necessarily that doesn’t necessarily check the box for sound idea, like, cause the problem is and with that company, when it comes to their valuation is they have a strategic relationship. What happens if that goes away? And that would be that would be a really difficult that it would be very difficult? Well, I’d have a hard time placing a value on that company, would you?

Matt Watson 6:37
Yep. I mean, it depends on if you’ve got a contract and money in hand. And then the one thing in this list that probably to me is the can be the most valuable is who the management team is. And I think the more I’m around startups the, the more I appreciate that part of it. I mean, can you imagine a startup and then the exact same startup, but Elon Musk owns part of it?

Matt DeCoursey 7:00
Sure. And with that, you would have obviously some quality management, you would have a quality management team, but the strategic relationships, and you know, some of that has a huge effect on your ability to draw more money out now. Yeah, let’s just play hypothetical here, Matt. So you and I, you know, whether those of you listening think that the mats have done, have done, okay, a lot of people do. And so that would be a contribute, that would be a contributing element to a quality management team that a quality management team is also balanced. One of the things that’s been really helpful as we’ve built Full Scale is I’m non technical and your technical and we have specialties and and honestly, passion and interest in different things that lead to a well rounded all of it.

Matt Watson 7:48
Yep. All right, yeah. It’s, it’s no different. It’s no different than thinking about, hey, we’re gonna start a football team who’s gonna play on the team? I don’t know, we’ll find some guys versus like, Hey, we got Patrick Mahomes. On the team.

Matt DeCoursey 8:01
Yeah, totally. That’s where we’re start. That’s where we’re going to start. That’s where we’re going to be led. And by the way, when it comes to a sound idea, I mean, that’s back to that product market fit that we’ve spent a lot of time talking about, you know, the sound ideas, gotta have an addressable market that it was the, the TAM, or the total addressable market will affect the future everything of a business because if your total addressable market like, well, when we use the company with one client, if their total addressable market is only that one client, that can be problematic. But if you have a commitment, so I totally not a tech startup, but as you’re aware, a few years ago, I made an investment in a moving company, that in this moving company, they had only one client, but they also had significant contracts and future guaranteed business, if X, Y and Z would have occurred now, and I did make that investment, it’s worked out very well it’s for both myself and the guy, the and the founder of that company. Now the problem was is, and that was something I addressed this if that contract or that relationship went away, there then it would have dramatically changed the business but there was a guaranteed contract with the guaranteed length and we set it up in a way that I knew at a minimum, I wouldn’t lose money. So there are ways to set that valuation now. Alright, so the next next on our list, you have comparable transactions. And in a world where a lot of people do a lot of stuff, there are usually similarities to companies. Alright, let’s use Giga book for an example. There’s a whole lot of booking stuff out there. Right. So you look at transactions that have occurred, whether they be exits, investments or other stuff that could affect it, like you kind of run into that with sacrifi and you know, Go to stack fi.com. If you want to see what what Matt does with most of his day, and you know, there are there are comparable application performance management things, there’s an industry that goes around it. I mean, when it comes to comparable transactions, what’s your input on that?

Matt Watson 10:15
Yeah, definitely looking at comparable multiples, things like that. I think it all depends on the industry, let’s, you know, take Full Scale, for example, if it’s a service-based business, like Okay, for this kind of business, it’s usually one and a half times annual revenue or whatever, whatever the you know, valuation is. And then it’s just kind of industry standard, like if you owned an accounting firm, or you know, some type of company, they usually have kind of very, you know, industry-specific valuation methods that you may just kind of fit into.

Matt DeCoursey 10:43
Well, let’s talk about that for a second. Because you talked, you mentioned the word multiple, so multiple is, is almost well in tech companies is almost always referring to your revenue. And in different types of, of tech and software companies will trade a technically, I think Full Scale is still a tech company, even though we do tech services. But that’s a completely different valuation than your other business stack of phi, which draw well does draw hire multiple, the and there’s a lot of reasons for that, software is a lot more scalable. As our friend Neil Sharma mentioned, when an episode 150 software shows up to work every day, it can be a lot more predictable. And it’s also oftentimes sticky. Meaning once a company or a client, or a user basically embeds that in the use of their business, they oftentimes stay with it for a very long time. And that has a lot. So when it comes to value in your equity, you’re whether you’re a tech company, or a different kind of company, you’re gonna have a diff, there’s a lot of variants. And we’ve even seen like, like at one point, there are certain software well, okay, you look at something like Facebook might be a really high multiple, because who, well who do they compete with at this point? That means, their competitors are just other social network platforms are different stuff like that? I mean, what Where have you seen, multiples just look outrageous before.

Matt Watson 12:16
And it’s usually companies that have very high margins, and they’re growing very, very fast, very, very fast. Through you, you see that even in the public markets, today, you’ve got, you know, we have a competitor that was trading at like 30, or 40 times multiple, which is like off the chart, but they were growing at a insane pace. I think another good example, this was a comparable transactions, if you’re an early stage company, let’s take Uber for an example. Let’s say Uber raises $50 million in their Series A, well, if you’re a Lyft, it makes it a lot easier to go around to investors and say, hey, look, our competitors just raise, you know, $50 million, or whatever, we can do this to, you know, jump on board get behind us, we’ll compete with them. And it helps you have some kind of comparables, you know, within the same industry or you know, marketplace going on.

Matt DeCoursey 13:04
And you have a good point about the growth. And that’s where those multiples often do look like a hockey stick with their growth. Because as a company is gained traction is moving forward and growing in a predictable way. You say, hey, look, you know, this is where our revenue is already headed to be in 12 months. So me selling you this now isn’t really fair to us. Because six months from now, that’ll be 40%, more or 12 months. And that’s always the fast growing company, when that comes, you know, when that comes into it. So one of the things I think with all these methods that we’re talking about that I think is important to remember is really if you’re in the earliest stages of starting a tech company, much like we’re talking about in this whole series, which by the way you can listen to every Wednesday here on Startup Hustle. So a lot of this kind of comes down to what you feel comfortable and good about, right?

Matt Watson 14:00
Absolutely.

Matt DeCoursey 14:01
So, but you’re never really right or wrong. You can’t there’s you’re never going to ink a deal. And immediately you’re like, Okay, that was right, that was wrong. I mean, these are all this is all TBD kind of stuff. You never really know. Until the end, whether it was great or not a

Matt Watson 14:19
lot of shades of gray in the middle somewhere. Yeah.

Matt DeCoursey 14:23
And then I mean, really, it is kind of more on your own, per set of personal expectations, what you feel good with and often who you’re partnering with. So, you know, and let’s throw that in there, Matt, because I’d rather take a lower valuation from an amazing investor slash partner or contributor than it take a higher valuation from just a checkbook.

Matt Watson 14:46
Yeah, it’s like when you watch the show Shark Tank and you see people give all their money all their stock away, but they get you know, these celebrity investors involved that they hope will make a big difference and who knows if they really do we don’t we don’t see the whole story but you’d like to think it will, and you’re willing to give up more of the pie to have them involved.

Matt DeCoursey 15:05
You know, where you will see the whole story mount.

Matt Watson 15:09
On Startup, Hustle TV,

Matt DeCoursey 15:11
you got to check out our new web series, we’re telling you the real story. And that’s the good and the bad, which, by the way, if you go and watch Episode 2.0, you will get to see my reaction to turning down a million dollar investment offer and hear about why go check that out on YouTube. And you know, the one thing when it comes to equity and investment, whatever, this can be very excruciating. So be prepared, prepared to drive yourself crazy. Alright, next on the list, the scorecard valuation method. Now, Matt, this is theirs. This is very similar to Berkus and some of the things that are on here, and I’m going to cruise through this pretty quickly because this is a list of attributes. So they’ll give zero to 30% of the valuation to the strength of the team zero to 25%, to the size of the opportunity, fit zero to 15% to the product or service, zero to 10% for the competitive environment, marketing, sales channels and partnerships up to another 10%, the need for additional investment five and then a 5%. wildcard for other

Matt Watson 16:19
sounds about right.

Matt DeCoursey 16:21
I mean, it’s pretty similar. But you know, one of the things is looking at the second biggest one on who or what 55% of this potential scorecard is the strength of the team and the size of the opportunity. I mean, think about that, that is without a doubt that the biggest bet is on the jockey, they’re not the horse, the 15% is 15% the product or service

Matt Watson 16:48
really shows how important the team is. It’s all about the team.

Matt DeCoursey 16:51
I mean, it’s it’s amazing how, how much of an echo we hear with that, because we have asked and I have asked anybody that invests money, who do you Who do you go with the jockey or the horse? And it’s literally a unanimous response, or is it unanimous? Yes, a unanimous response, I must say, anonymous, it’s an anonymous response that nobody answered the question. No, but it’s unanimous, everyone, it’s got to start with great people, because a great idea run by a terrible team is not going to happen. So okay, well, what do you agree with this, like, when you look at this list, like because competitive environment of zero to 10%, I mean, that has a third of the potential weight is the strength of the team. That means that with the scorecard valuation method that potentially you could have, you could enter a highly competitive and saturated market, but if you have the right people, and the right size of opportunity, or total addressable market, then then it’s where equity cuts your EQ. Do you agree with that?

Matt Watson 17:59
I think I think if you have the right team and business model, right, you can be disruptive and in a market that you don’t think is ripe for disruption. So I mean, absolutely.

Matt DeCoursey 18:09
Always back to the team. So okay, now we’re gonna get into some some fancy stuff here. How about the cost to duplicate approach, which, you know, what this? I mean, this actually isn’t that fancy. This is almost like the buyer build

Matt Watson 18:22
out. Yeah. And so it’s a similar, it’s somebody who works in tech, this one’s always interesting, because, you know, sometimes rebuilding software is way easier than buying somebody else’s company, and then integrating it into your own and figuring out how to do all that stuff. Sometimes it’s just easier, like, I’m just gonna rewrite this stuff and bolted on to our other things we already have. Sometimes the cost to duplicate it is way easier, even. But usually, when you think about investors, you know, an investor may look at your like, say, gigabit, for example, and be like, you know, the company’s young, whatever, why don’t I just hire three developers and just rewrite this stuff? Like, I could just do that myself? Why would I? Why would I invest in you. And if you’ve got a super simple product that doesn’t have a well defined market and a lot of traction, you know, somebody could copy you and, and compete with you, it can always happen.

Matt DeCoursey 19:18
Well, I’ll give you an example. So you know, an Instagram you can only you can only put one link anywhere in anything that’s a real link and that’s in your profile, right? So a lot of people including us, you often use something called link tree, which is a super simplistic thing like honestly, you could you know, giga book has a link tree option a link tree widget and and and that’s an example of that cost duplicate approach where you could duplicate or build that product very quickly and very easily, and now it becomes a race to marketing. So with the cost of duplicate approach, you know, it’s like in this is this is really more so for things that exists so you’ll you’ll things you’ll be considering with this are like development costs, the cost of creating prototypes, patents, perhaps more and then honestly timeline. So you know you like you use Giga book as a comparison as well as like you might want to buy that if you alright, so Giga book would be a good acquisition for say a company like paychecks, who had 750,000 clients that they could roll it out to very quickly and paychecks if you want to talk about that call me up. So, but the thing is, is like they might want to, and this is where companies acquire, because they could probably go build it themselves. But why go through the hassle? Why go through the timeline, why go through all of the chaos and when you can just pick it up now?

Matt Watson 20:50
Well, and that and this is a good example with Giga book where they might look at that and say, Man, it would cost us $5 million in three years to build this. But I bet DeCoursey would take a check for a million bucks. So you know that that cost to duplicate is interesting. And a lot of times, this probably comes into very early stage companies that like they’ve, like they’ve been in the basement writing code for a long time, but they don’t really have any customers. And you go to them like, hey, you know, you’ve been working on this for a long time, I’m gonna give you X amount of money to take the code and do something with it.

Matt DeCoursey 21:22
Sure, yeah. And that’s, I mean, that’s the same thing. And that’s, I mean, that’s where a lot of acquisitions occurred, a lot of mergers and things like that, because it’s like Aqua hire, you’re ready to go, you’re just ready to go. And, and really, in the end, big companies that that look at valuations and stuff like that, I mean, that’s a big thing. Like they don’t want to sit there for it’s hard to sell to their shareholders or board, why we’re going to spend two years doing something when we could just fast forward to now because if they get revenue now that well, the acquisition costs pay itself off a lot faster. Now, that particular model doesn’t necessarily have a lot to do. That’s an I don’t think that’s as applicable to like the earliest stages, because if you’re still like a pre revenue, pre product kind of company, then that wouldn’t even apply to you. Okay, so, Alright, the next one. Now, this one’s a little more interesting, the risk factor summation method. Alright, so this is, this is, it consists of some common risk factors, such as management, the stage of your business legislation or political risk. And that’s a good example there, because you have like, remember jewel, like the vape? Company? Yes, yeah. And then they shot up in valuation, and then shot back down because they had legislation problems. You have manufacturing risks, sales and marketing, funding, different competitive competition, technology, litigation, international reputation, and the potential lucrative exit. So in this model, they give things like, it’ll be either a plus factor, a plus plus factor, or a minus factor, or a minus minus factor. So this is almost kind of like the pros and cons list in many ways. Yeah. So

Matt Watson 23:14
let me I got a couple of great examples of this. So a really good example would be like, the marijuana industry, right? You’re like, Oh, you got a great business, we would normally value you at $10 million. But because you’re in the marijuana industry, like, you’re gonna take a big haircut, right? Like, your valuation is gonna go down several, because we’re worried about all the risk, right? Like that. Those are the types of scenarios you’re gonna run into. Or like, say, Robin Hood right now, who is you know, the the Trading App and stuff that people use? Like they’re getting sued over all the Gamestop stuff? Does that affect their valuation? The risk of that maybe not, like, you never know, right? But those are the types of things we’re talking about that go into your valuation that you could take a haircut for.

Matt DeCoursey 24:01
Now, speaking of valuations, and you know, making investment I once again want to give ever give a shout out to our crowd. So you know, today, you can join our crowds investment platform, it’s free to sign up and check it out. I did, I went in and looked at it. It’s really an amazing platform. It’s got a lot of cool stuff. Now, you do need to be an accredited investor to make certain types of investments or receive them. And that’s one of the things that our crowd helps their investors do. Our crowd is investing in medical technology and breakthroughs, ag tech, food production solutions, and multibillion dollar robotic industries. And more if you want to take advantage of the professional VC research they use to identify promising companies and funds across a range of sectors, stages and global locations. Well, you can learn more, go down to the show notes and click the link for our crowd.com forward slash hustle. It’s free to sign up for the account. Now, one of the things that we should talk about, as I mentioned, and while we were thanking our crowd, a crowd investors, if you’re raising money, and you’re even having the discussion about certain types of equity, well, that what is an accredited investor?

Matt Watson 25:10
Well, they define it a couple different ways. It’s somebody who makes more than a certain amount of money a year, like your income has to be a certain amount, or you have to have more than a certain amount of dollars in the bank. And I think it’s like $200,000 a year in income or a million dollars in assets, I think. But,

Matt DeCoursey 25:26
yeah, your assets can’t end and it can’t be your home. Right, either. So and So and part of the reason that that exists and is, well, they there’s a lot they that they meaning the government and the IRS, assume that people that are of a certain type, level of net worth, have a level of sophistication when it comes to investment and making certain decisions with their money, and they’re trying to protect people. And you know, that’s, that’s there for certain reasons. But if you’re even discussing, like the value of your equity and getting investment, and it’s not coming from an institutional investor, you do need to do some research and see, if you’re trans at the transaction, you’re talking about potentially making or the, the equity you’re about to sell if you’re even allowed to do that. Because you can’t accept investment from people that aren’t accredited in some regards, in some amount. So what like Matt said, that’s a, that can be a moving target. And that can change. And you in this last lesson, we talked about things like legislative and political risks. Well, we just changed presidents, and parties, which often creates turbulence. Like, for example, you mentioned cannabis and marijuana, which by the Biden administration is seen as being really favorable and possibly decriminalizing it, and whatever. So that was a favorable factor. I mean, there’s a whole lot of different stuff. Another thing to the the probably increased, became a bigger factory manufacturing risk. Last year, I mean, how much how many supply chain disruptions and manufacturing problems did we have? And you have all these things that are made in China and overseas and mean that can be that can be problematic if things shut down?

Matt Watson 27:13
Yeah, I’m trying to buy flooring right now. And they’re like, Well, it’s a little delayed.

Matt DeCoursey 27:19
Yeah, the Perkins brothers that are cast members on Startup, Hustle, TV, and make sure you come over and check that out, I’m having a lot of fun with it. The you know, they’re the turnaround on getting Windows is months, like it used to be like four or five weeks, and they’d order in the heart, it’s hard to deliver a home to someone without any windows. Yeah, especially when it’s in the mountains. So you know, that’s, that’s been a problem for them. And other things, too, that. And this isn’t necessarily related starts with the price of lumber went up 40%. And last year, and there was just a lot of demand, a lot of people are at home, and they were doing home improvements. And you know, some of that can. So Matt, what’s a technology route? That you could the I mean, when I get asked like what what kind of risk factors would occur with a, quote, technology risk,

Matt Watson 28:09
I’m using specific technology that is at risk of not being supported anymore, or not working or security, or I talked to me the other day, and their whole business was based around some integration to something but it was a hostile integration. Let’s say like, my whole business is around scraping data from Facebook or something. Well, Facebook at any time could turn that off, because I don’t have like a license to do that with them. And then my whole business is gone. Right, like So sometimes there’s like technology you’re using that is you don’t necessarily own it, or control it or whatever. And you get into problems like that. We had some of that back in my VinSolutions days, because we would integrate with basically accounting systems, but some of the integrations were hostile. Like, they weren’t like certified interfaces. So the accounting systems could have shut us off at any time. And sometimes they did. And so you get risk and things like that.

Matt DeCoursey 29:08
I’ve never heard the term until now, I’ve never heard the term hostile integration, but it makes so much sense. And that’s I mean, you look at so many businesses our reliance on one form of data or input or something, you know, another thing too with that is so you know, I had a history in the ticket business and, and so did you, you have some history there. And for the longest time, and I had been away from that for years, but I was talking to someone that I know is a few months ago. So StubHub used to let their API data and their sales and other other information related to that you could tap in and access it and then all of a sudden, you couldn’t, and they and they started charging money for it. And that became like that. They just really, really, really flipped the business model. On its head because what was free Now wasn’t and you know, and so now they had to change your pricing structure, which caused a lot of their clients to quit because they had to raise their prices. It was just I mean, and that’s, that makes sense technic technological risks. I think another thing too is certain platforms and we see this a lot of Full Scale is well, I mean not a ton, but you know, occasionally people call us up and they’re looking for they’re using some technology that was all the rage 15 years ago, and now nobody uses it. And yeah, that’s so that’s another he can’t find people to work.

Matt Watson 30:34
Yes. And that’s a different kind of risk. Like I’m working with a company now that does a lot of programming in Perl. And they’re like, we literally can’t find people that even know Perl. So that’s a huge risk to the company. Like we can’t support your own product, we can’t improve it, we, you know, it’s a liability.

Matt DeCoursey 30:50
And also that can dramatically raise the price. And we see that happen a lot too, because well, it’s either with old, it’s either with old kind of technology that isn’t too common. Because if you need, like you said a Perl developer, you do well, if other people need it, too, now you’re competing for a shrinking pool. Yeah. And another another thing we run into a lot, and then we see this, this is very common, is all of a sudden, okay, so like React, which is a front end technology is suddenly has become so popular. There aren’t enough people to work on it. And there are I mean, man, we got a waiting list at Full Scale for people that one qualified react developers, and there’s a very small pool of them everywhere, because it hasn’t even been out that long. So you run into that. And that what that causes is, it’s not always about the supply and demand factors. It’s also about can you even build what you want to build? Yep, without people to do it. So sometimes that also, then you have to start training people and getting less qualified people to do it. Wait for them to ramp up. I mean, there’s a whole lot, a whole lot you got to deal with there. Okay, next on the list, how about the discounted cash flow method, we were talking about this a little bit. And that’s when you take your forecasted future cash flows, and basically apply a little bit of a discounted rate. I mean, it’s given, it’s giving a little credence to the future, while still giving some discount for the fact that the future has yet to occur. Because as an investor, it’s everyone that I’ve talked to you that it wants me or us to invest in anything now. I mean, they’ve got smooth sailing all the way to the moon, right?

Matt Watson 32:31
Yeah. And I actually liked this. I think about this, usually, they call it like a clawback or other performance oriented goals, right? Like, okay, I’ll invest a million dollars and Full Scale, but you’ve got to do X amount of revenue next year. If you don’t, then I own you know, more of the company, or I unless the company if you outperform, so as an investor, I like those kinds of scenarios, right? Because I want to protect myself, if, if you say you’re gonna, you’re going to the moon next year, but you really don’t make it, then you know, what, I’m going to call that back and one more of the company. That’s another way.

Matt DeCoursey 33:05
And that term, clawback really is is a real term. And that’s, you know, oftentimes, it says, Look, this is a way to kind of protect yourself and the investor to protect themselves. It gives you a reward and something like, Okay, if this occurs, yeah, I get it, that’s fine. Cuz, really, in the end, if you if you do the math, and you figure it out, I mean, 15%, of a company that’s doing X revenue is worth the same as 25%, that’s doing y revenue. It just got to find that balance. And I like this too, from from an investor standpoint, because, hey, if you’re, hey, founder and team, if you’re gonna get out there and crush it, and make this really make this big. Yeah, I’d love to give you an incentive to do that.

Matt Watson 33:53
Yeah, I like it, too.

Matt DeCoursey 33:56
Okay, the venture capital method, who this maybe this should have been first, but I mean, this is kind of the go to method for venture capital firms. And I mean, it’s an option to consider if you need the pre revenue valuation, which by the way, is the trickiest always the trek. Yes. So it kind of, you know, so basically, you’re talking about this is, well, there’s a couple formulas one is your anticipated return on investment, and that equals the terminal value divided by the post money valuation. So what does that even mean?

Matt Watson 34:32
I can tell you what it means. Please, I’ve talked to

Matt DeCoursey 34:36
it’s why we keep you around that.

Matt Watson 34:38
I I’ve talked to enough VCs that I know one thing. The only thing they know how to do is use Excel. And there’s some formula somewhere where they do this where they’re like, Okay, we’re gonna buy this company for x. We gotta make you know, 30% rate of return every year. So we gotta be able to sell this company for why in five years or whatever, and how much more money we have to invest in it. And are we gonna hit our, you know, ROI that we told our shareholders that we would hit and blah, blah, blah, blah, blah, blah, blah. They don’t know anything else, they just know that it goes in that formula and what number comes out in the end? That’s my experience with VCs anyways. So back to this spreadsheet.

Matt DeCoursey 35:18
Yeah, so venture capital firms are really like their formula revolves around being bright one out of 10 times, but being really right, that one out of 10 times, and because of that they’re going to look at that’s why they’re looking at things like your total addressable market, and just all of it like, what’s the size of the opportunity? Because when they’re right, like I said, they need to be really right, like big, right? And not just like baby, right, like Mega array, like getting 100 times back their money, because they’re going to cover all the other stuff that fails, or just get stuck in the middle. And never really does anything. So. Okay. Number eight, Matt, the book value method?

Matt Watson 36:08
Yeah, so it’s all based on assets? What’s the company worth based on? Its actual.

Matt DeCoursey 36:14
So this is challenging for a tech company.

Matt Watson 36:21
Yeah, it doesn’t really apply to startups. But you know, if you’re a marijuana shop, and you got a million dollars with a weed, then you know, it’s probably worth a million bucks.

Matt DeCoursey 36:29
Well, can also, I mean, this, this can have something to do with startups, though, because, you know, we’re talking about tech startups, tech startups can they don’t, it’s not just software, right. So there could actually be hardware, and other assets. And assets come in many shapes and forms. But this is the this is what, when, when being looked at with this method, this is one of the most frustrating things that startup founders will go through. And Matt, we’ve been through it before. And we were you know, you talk about, you’ll see a company, you’ll talk to a founder that had $100 million exit. And they’ll tell you that because a bank uses the book value method that they couldn’t even get a loan or any kind of anything. Because they didn’t have tangible assets, like a truck, like a warehouse full of bolts and screws.

Matt Watson 37:19
You know, I think Full Scale has like 200 laptops, so I’ll give you like, 10 grand for the company.

Matt DeCoursey 37:25
Yeah, well, we’ve run into that too. Like, we go to talk to the bank. And they’re like, Well, what are you what kind of assets you have? And you’re like, Yeah, well, we own, you know, $400,000 with a laptop. So like, okay, good. That’s good. I’m like, now they’re on the other side of the world. And they’ll be Oh, yeah, but their assets. I’m like, really? Like, are you gonna go collect them if you ever needed to, but it’s, it’s goofy. And you know, some of this too, though. Like, there are other things that I think that in tech companies that aren’t fully tangible, my say tangible mean, like something you hold in your hand, something you open the door to something you drive around town, will patents and IP Yeah, yep. Can can be seen, but they’re not generating revenue or money, you’re gonna, you’re gonna have a whole nother pain in the ass to try to put what that value is. So Matt, we just went through eight different methods. And I mean, that’s eight. And by the way, there’s probably 18 more. Have we answered the question of how to value your equity? Because I still think the best answer is mine. When I say in the earliest stages, it’s about who you’re getting the money from? And what feels good.

Matt Watson 38:34
Well, it’s all it’s all comes down to who will write a check and what they’ll write the check for.

Matt DeCoursey 38:39
Oh, we need that, too. So wait, it’s not just what we think the equity is that look, I run in, I’ve run into too many people. And so they come there, hey, we’re raising at a $3 million valuation, you’re like, cool. Do you have any revenue? No. Do you have an MVP? No, what do you have? We’ve got this 60 pieces of paper that are telling you this is our blueprint for getting to the moon and that that’d be and that’s

Matt Watson 39:08
I think it all comes back to the where we started with the Burkus method, which was those five things right? Like you got to have the right idea. And then you talk about prototype, which is like, do you have an MVP? Do you have traction? Like, where are you at with that part of it? The team? It’s all about the team? Do you have strategic relationships or partnerships that are really valuable? Because you know, hey, if Elon Musk is agreed to resell your product that might make it worth more, right and then you got rollout sales, you know, marketing, you know, it’s the basics, right? And if you’ve got a good story for every one of those, you’re going to have a higher valuation.

Matt DeCoursey 39:42
So so a lot of this comes in as well into play as well. And one thing that we possibly in this episode could have addressed a little earlier is the possible assignment of equity to co founders Yeah, or other investors, which, by the way, and in parts Seven in this series, we’re gonna talk about finding, finding startup co founders. But this is a huge mistake I see people make, and they’re like, Okay, So Matt, we’re going to start a tech company and I know you write code, and then you got another job. And I can’t afford to pay you yet. But I’m going to give you 40% of my company. Why?

Matt Watson 40:20
Yeah, it’s that part of it’s always really hard figuring out how to divide the pie up and who brings what to the company and how much effort they put into, did they put money into it, like all all of those things combined, or make it really difficult to figure out how to split up the pie, per se,

Matt DeCoursey 40:37
we’ll speak well speaking of pie, and I wanted to mention that there’s a past guest, Mike Moyer has a really cool app, you go to slicing pie.com. And it literally assigns value to the sweat equity that people put in and, and, and really kind of controls and takes care of the vesting part of it and really does put a valuation on the the contribution that is made from founders. And the thing is, is like I mentioned, this hypothetical situation where my buddy Matt, who I know writes code, but he has another job, I’m gonna give him a huge percentage of the company, the thing you have to ask yourself is, okay, if I were to replace that same effort with someone else, that I was just paying to do it, how much would that cost? Yeah, because if it’s just like simplistic stuff, like, for example, if you could hire a full time developer from Full Scale, for $4,000 a month, well, now that person is going to work eight times, if you’re only going to do an hour a day, and they’re going to do a they have eight times more contribution. For so what is what is the replacement value of what you’re getting or gaining? And you can look at so many of the things that we’ve already talked about, for value in that. So now, Matt, if you have some specific attributes, input experience, or possibly connections or street cred? Well, those might be pretty valuable.

Matt Watson 42:07
Yeah, absolutely. And I think the example you just gave goes the other way, too, because let’s say you’re not a technical person in you desperately need to get some technology created, and you don’t have the money to hire somebody. That’s where you’ve got to give up some equity in the company, to get somebody to do the work. And, you know, sometimes it’s what you got to do is find a technical co founder or, or somebody you can give part of the company. And that’s not necessarily a lot, it could be 5% of the company or whatever. But say, hey, I need you to do this, this project, because if you don’t get it done, the company’s never going to succeed. So there, you know, you always have to balance that, too. If you don’t have money, you’ve got to give up equity.

Matt DeCoursey 42:48
Yeah, and once again, you don’t know if you’re right or wrong, enough, so down the road. So if you’re gonna make yourself crazy, you got to kind of just get yourself to a point where you feel comfortable with what’s occurring and make a decision, yes, or no, and you gotta live with that for a while. Now, I do want to remind you that when you take on partners and investors, in many cases, it’s easier to get rid of your spouse or your life partner than it is to get rid of them, the co-founder or the investor, because once they have bought in, that’s it. And you know, there’s other episodes we’ll get into in this whole series, which talks about how to deal with that. Now, we’ve got a list of some of the some of the wrong ways to value equity. And before we get into that, I just wanted to throw out another thanks to our crowd, go to our crowd.com forward slash hustle, there’s a link in the show notes. If you’re interested in investing in startups, and you’re an accredited investor, they have a really cool platform to take a look at. You can learn more about their investment platform and how other accredited investors and VCs are looking at stuff just by signing up. It’s free accounts. Pretty cool. I I like what they’re doing there. I think it’s pretty cool. So, you know, when we get back to the subject of how to value your equity, I mean, well, the some of the wrong ways using flawed valuation models. I mean, that’s probably pretty easy to do, right?

Matt Watson 44:09
Hey, Uber raised, you know, money and a billion dollar valuation. So says my company, it’s worth it. So we should too. Yeah, it’s worth it.

Matt DeCoursey 44:19
So well, number two, oh, man, Matt. Are my financial are my future sales and revenue projections accurate?

Matt Watson 44:27
No.

Matt DeCoursey 44:30
Hell no. Sure. They are. Oh, they are all they all are dude. No. So use it. So so if you’re if you’re, if your equity valuations are based on your future sales projections, Well, Matt, what’s the one thing we’ve learned about about business plans are all wrong? Correct. So, you know, like, it’s easy to draw the hockey stick and be like, Look, you know, four years from now

Matt Watson 44:57
1% of the market and we’ll be building There’s, oh, no, that occurs

Matt DeCoursey 45:01
after six months with my plan. Okay. We’re not waiting four years, we own the planet and four years. What’s that? what’s that worth? Is there a model in here for that global domination? Alright, so you have other things in here like, well, they’re like, there really is no rule of thumb on, you know, this has over reliance on it. I mean, these every deal is different, blindly, blindly using comparable transactions, like, I mean, you really have to, like, there’s no company that’s like yours.

Matt Watson 45:32
No, no, there’s not. You can

Matt DeCoursey 45:35
be in the same industry, you can make a similar product, but that doesn’t mean the companies are the same. Right? Yep, absolutely. Okay. I mean, that so. I mean, okay. All right. On this, I love this one failing to investigate mathematical errors. Alright, so, so. So let me give you a comparison that so people will show, I’m gonna give a free shout out to live plan.com. And I love live plan, because it makes making financial projections really easy. And here’s the thing is, is when you’re using Excel and other stuff, and you’re typing it in Z, an extra zero turns $100,000 into a million dollars with one keystroke, if all the other cells are reliant on the whole thing, it’s all screwed. It’s all it’s all. It’s and there is a lot, there is a lot of places. Now look, when at the last college that I dropped out of Matt, they had classes that were that were nothing other than creating these kinds of financial projections, because things like live plan didn’t exist, which makes it really easy. That’s why I love the platform. Because it’s like, if I didn’t know best, they’re not paying for sponsorship here. I just didn’t know how much time, effort, energy and emotion, it saved me. And you know, that simple zero really does. And it’ll throw off an entire table. And, you know, really easy to

Matt Watson 47:09
do, you’re saying we’re not going to the moon because you added a zero.

Matt DeCoursey 47:13
I added two zeros. So it’s 10 million, not even just one. But think about that dude, one, zero, and you have other cells and things that are relying on that. It just messes it all up. And, you know, I think it’s fair to assume that that, you know, your your highly optimistic plan is probably wrong. And you know, everyone’s hoping you get there. But if you don’t have a concrete why, and how it’s gonna be a problem. So, you know, I mean, now, what are some other wrong ways? I think other wrong ways are just literally just just throwing a number out.

Matt Watson 47:54
Yeah, I mean, I feel like my company’s worth $10 million. I mean, usually, when I see things on TechCrunch raised money, it’s like, you know, a $10 million valuation. So sounds good.

Matt DeCoursey 48:07
I mean, Matt, for you a $10 million valuation. I mean, why are you shooting so low body like, Yeah, have you? Are you only working at like 6% of your normal? The Watson effect?

Matt Watson 48:20
I think that’s diminishing over time.

Matt DeCoursey 48:25
Maybe that’s another another, another episode to get into. So I think when it and for me, the number one wrong way is literally that shot from the hip. And I think that that’s the things that get you in the most trouble is, you know, like, when I say shooting from the hip, I’m talking more about sharing equity with other people, partners, co-founders, stuff like that. Because I imagine how many times have you seen people give away the farm? And then regret it later? Yeah, absolutely. So how do you avoid that?

Matt Watson 48:57
You know, I, from my VinSolutions days, nobody cared too much about equity, or any of that, until everybody figured out the company was really worth something. And then all of a sudden, everybody’s willing to fight to the death. And you know, I had I had co-founders who tried to stake, like, take some of my stock away from me and stuff. And yeah, it’s, nobody cares until everybody figures out it’s worth something and then all of a sudden, it’s a battle.

Matt DeCoursey 49:25
I think the way to avoid it is, is to abide by the concept that good fences make good neighbors and I got you when you make agreements. This is probably the best advice that I have for just startups in general is don’t just always don’t always plan for the sunny day scenario. And I see too many too many operating agreements and just contracts, in general, are all written around like the sunny day. So what happens if things don’t go well? What happens if someone dies or gets divorced or does a whole lot of other stuff and how are you going handle that the best way? And while those aren’t always inspiring or uplifting conversations, it’s usually the best way to handle it upfront.

Matt Watson 50:08
Yep. You know, one of the other things I think we’ve talked about mistakes people make when we talk about valuing the company, is we talked about the planning, but it’s just assumptions, its assumptions around, you know, we’re gonna get our product done, we’re gonna get it to market, this marketing plan is gonna work, we’re gonna sign up this number of customers, we’re gonna get this partnership, we’re gonna, we’re gonna do all these things, right? And then they don’t happen. And, you know, we’ve even done that with Full Scale, right? We sit down, everyone’s, when we make a forecast, and we’re like, we’re gonna do this, we’re gonna do this, we’re gonna do this. And things never, those assumptions never come to exactly the way that you plan them. And with an early stage company, the odds of them those assumptions happening is even much, much less, you know, because like, you didn’t have a product yet, like, you think it’s going to be done in six months, you think your marketing is going to work? Like, there’s so many assumptions. And so when you forecast out, you’re like, we’re gonna own you know, 1% of the market and three years and do a billion dollars revenue, like, three years now, you’re probably still gonna be trying to get the damn product finished. Like you’re just assumptions are all wrong.

Matt DeCoursey 51:14
Yeah, we run into that a lot. I think that I think the number one, the number one assumption that always fails is, is over reliance on on a lot of revenue early. Yep. I mean, that’s, that’s, I mean, gosh, now how many times have we looked at plans this you and I had, and we’ve made quite a few investments through Full Scale, but we’ll look at the bull look at someone’s playing on this, okay. There’s nothing that had nothing, they have nothing right now, like literally nothing. And this calls for in six months having 1000 users. And, you know, like you said that in six months, you’re probably still trying to, like, get something online. And one thing when, and you will kind of just roll this straight into the founders freestyle mat. But, you know, no one knows how long it’s going to take to build technology. It’s and that’s and that’s it doesn’t make me sound like an expert to say that. But I think that might be the most expert opinion I can give you is that it’s a guess it is a guess when it comes to the timeline, because there are a zillion things that can throw you offline. Everything from people quitting, to pandemics to who knows and you just really like you’re hoping that you that you land, the product and your launch in a way that is somewhat close. But overall, it’s it really is a huge gas. And when it comes to value in your equity it I mean, and like I said, and one of the least scientific methods mentioned in here, but maybe one of the most reliable methods is how do you feel about it? How do you feel about it as a company like Matt, when you became my partner Giga book, which then turned into Full Scale, I was asking for a much higher price, and came way down with that, because we realized that we had a good fit, we were friends, we had already been working together, we saw a lot of opportunities that came up. And that made it a lot, it made it feel really good for me to engage in that journey. And all of that was someone who had already been there, you’d already exited and accompany stack a phi was already well in motion. And that had more value to me than someone’s check. That wasn’t going to work with me and help with and help and, you know, help along. So Matt, and very, I’m Startup Hustle fashion, I’m gonna let you take the second freestyle and close the episode out.

Matt Watson 53:42
I think valuation, of course, is always really hard for a super early stage company. But I think that as a potential investor, and as a founder myself, the thing you always have to think about is how big is the opportunity? Right? And how fast can you build a product? How fast can you scale the company? Do you have the team to do it? You know, if you’ve got a lot of traction, you’re like, hey, we, you know, we’ve got customers lined up, we, you know, all that sort of stuff is totally different than you’re like, we think we’re gonna build this thing. We don’t really know if we have product market fit, we don’t know who’s gonna buy it. Yeah, we, you know, the more you have a better idea of who your customer is how you can get to them, having traction with the product. And the more expensive your product is, the more people you can sell it to all those things together, you know, you’re just gonna get a much bigger valuation, right? If if I’m looking at, you know, Uber, and I’m like, hey, yeah, everybody needs to rent. You know, everybody needs to use a car and every city in the world like, Yeah, that’s probably going to be worth a lot of money. Like the valuation could be really big, right? And so the, the total addressable market and those cases, how easy it is to get there. Back to your point earlier about software comes to work every day. I would not want to be in the Uber business of dealing with all those Uber drivers and all that stuff. I’d rather be in the software side and and complexity, right so valuation stuff. There’s no right or wrong way.

Matt DeCoursey 55:06
Well, I’m gonna get back to work man, I’m gonna go try to find that extra zero and my projection so we can come to a reasonable valuation on the company that I haven’t built that is going to be worth a trillion dollars soon.

Matt Watson 55:18
I’m gonna go work on software development planning. I can get anything you want done in two weeks and nothing at the same time.

Matt DeCoursey 55:25
I love it. I love it. I’m in I’ll see you next time.