My clients are often in the position of having to offer equity in their company to potential investors. However, how does one know what percentage to give?
Well, one way is just by gut. You got a person willing to invest $20,000 into your company but you don’t know want to give up too control so you offer 25%. Conversely, on Shark Tank we see entrepreneurs be given very little money while giving up a large portion of ownership in their company.
There are other more quantitative methods such as asset-based, comparable, option-based, etc. However for a start-up without much in assets or earnings per share data, these methods are difficult because there aren’t enough figures to go by. Also, if the business is truly unique, then comparisons of “similar” companies don’t exist.
One of the more common measurement for valuing public and private companies used by investment bankers is the Discounted Cash Flows Method. This is useful because with every business plan and financial projection I create for my clients, I create a cash flow statement. With this I take the total projected cash flows from each year and adjust their future value into their present value. This is to adjust for interest (i.e. $100 today doesn’t the same as $100 in ten years). Then I take the discount rate (risk-free U.S. treasury rate is most common) to calculate the present day equity value of the company in X years using this formula:
The amount of investment capital received is the percentage of equity given. There is obviously room for negotiation because forecasted cash flows is debatable and the amount of involvement (i.e. sweat equity) the investor wants to put in is also a factor. Nonetheless, it is a gauge one can use to make sure they’re not giving up too much.