Many startup founders don’t fully understand why it is important to have a company valuation, especially at an early stage. We demonstrate how a company valuation affects the amount of control you, as a founder, are going to have and how much money you end up making in case of an exit with a help of a fictional example.
In this example, our company goes through three rounds of financing. Its valuations and investment amount at each round are below.
As you see above, there are three stages in which this company raises money. The first stage is Friends & Family, the next is the seed stage, and the last is Series A.
At the first stage, the company raises $100K to develop its minimum viable product on the $500K valuation. The founder gives up ($100,000 / $500,000), or 20%, of the company. Notice that if the company valuation had been $1M, the founder would have had to give up only 10% of the company.
At the next stage, in a half a year or a year later, the company needs $1M to develop its product fully and to launch it. At this point, it is worth $10M. Therefore the founder gives up ($1M/$10M), or 10% of the company in addition to the 20% he gave up in the Friends and Family round.
Lastly, in order to scale the company, he needs to raise $10M. At this point, the company is worth $40M. In this last round, he will give up ($10M/$40M), or 25% more of his company for a total of 55% over the three rounds. This means that after the last round the founder no longer holds the controlling 51% stake.
How did we come up with the equity stake at each round? We used two inputs:
- How much money you need to raise at each stage
- How much money your company is worth at each stage
The result above cautions you to be careful and raise only as much money at each stage as you need and to have a fair company valuation so that you give up the least amount of equity each time. While there are known valuation ranges, your valuation should reflect your company’s fundamentals, your business plan, and your strategy.
If you do the valuation improperly or if you trust investors to do it for you, you may end up with an unfavorable deal where you give up more equity than you should and you lose control of the company you created before it’s warranted.