"How much should we charge for stock sold to investors?" is a question I got yesterday and a very common query I am asked.
The answer is simple, while the calculation is more complex.
STARTUP STOCK PRICING
There is no huge stock market to go to for comparing the price of stock for a startup companies similar to yours. Only a very few private deals involve selling of private shares. Thus founders need to go elsewhere, use a different method to set the price for shares to sell to investors.
Investors in private companies begin by setting the return on investment target for their next deal. They think about past deals, the deals they are currently exposed to, and what their investors (giant private pools of cash, mainly pension funds and private endowments and foundations) expect to get. That ROI is always compared with the alternative investments (public stocks, bonds, commodities, real estate, art). One example is for a seed round to need to earn at least 100 times each dollar invested to compensate them for the ultra high risk they will take investing in your new enterprise.
TIME TO LIQUIDITY
With the target set, angels and venture capitalists then ask how long they will have to wait for the cash to return to them from selling the private shares, either through sale to another company or via an initial public offering (these are "liquidity events"). For instance, a five year wait for an IPO or sale event is common. However the recent decade of disappointing economic conditions have added several more years to the classical five year horizon. So today's investors are prepared to wait as much as ten years for a liquidity event. If you have a life sciences event requiring trials on humans of a device or drug, add around five years to that time expectation. For our example, let's use a total of five years.
Then the potential investor will estimate the size of the startup's IPO value ("market capitalization") and calculate the price per share at IPO. I'll use $1 billion for our example. That will be 5 times sales (an historically frequent multiple of value), so this startup will haver to generate $200 million of sales the year of the IPO. That also means you'll need a forecast of your financial statements to negotiate the pricing of your shares.
Next comes determination of what percent of the startup the investor needs. In our example, the cash invested by the investor (perhaps $1 million in a seed round) needs to be worth X100 or $100 million at IPO. With a company valued at $1,000 million at IPO, the seed round in our example must own 10 percent at IPO. The seed round investors will project how many more rounds of financing will come for your startup, calculate the related dilution of their initial ownership, and use that to finally price their stock offer to you. For our example, let's say the investors expect three more rounds of financing resulting in cutting their initial ownership in half. Then they know their initial ownership will have to be 20 percent of your startup.
And finally, the seed round you are asking for is to raise $1 million, thus your startup will be worth $1 million divided by 20 percent, or $5 million "post money". Before the $1 million investment ("pre money") your new enterprise is worth $4 million.
So then you have 80 percent of the company owned by the founders, plus a reserve for stock options for employees and others, plus shares to be sold to the next two rounds of investors in our example. That means you have to have a plan for the number of shares needed for stock options and for the next rounds of financing. Let's say you have 5 million shares to use for the pre-money calculation. The price per share for the seed round would then be $4 million divided by 5 million, or $0.80 per share.
Is that a fair price? The answer depends, mainly on what other investors are willing to pay to buy your shares. So ask a lot of people familiar with startup financings what the going cost of capital is and reach your conclusion about accepting the offer of the investors in our example.
Yes, that's a lot of work. But it's the most important work you can do with numbers as a founder. If you get the pricing of a deal wrong, done poorly, and regret it, changes are nearly impossible to get approval to do from you investors (who will have legal virtually-monopoly rights to making such changes).
Further help can come from my past blogs related to this important topic:
HELP WITH THE NUMBERS
Take a look at QuickUp, a simple Excel model you can purchase for $25 to forecast your financial statements and calculate the price per share of each round of your financing.
BOTTOM LINE: Serial entrepreneurs spend the time needed to prepare the numbers and reasoning for each round of financing of their startups. They know the importance of doing that. It is not rocket science. You can do it, so get started right now. After you are done, you'll add it to building your unfair advantage as a leader of a potentially great new enterprise.
I wish you The Best on your Adventure!