How is valuation calculated? Imagine you have a plate of ten cookies for sale. If someone offers you $1 for one cookie, your plate is worth $1 x 10 = $10. If the next person offers you $2 for a cookie, how much is your plate of cookies worth? It is worth $2 x 9 (the number of cookies left) = $18. This means the value of your plate of cookies has just increased by 8/10 or 80%.
But if the person who bought your first cookie at $1 wanted to sell their cookie (assuming they have not eaten it), they could ask $2 for the cookie because, of course, that is what cookies go for nowadays. The valuation of their cookie has not gone up by 80%, but actually by 100%!
The Magically Valuable Cookie
Notice two things here:
1. The valuation of the cookie does not correlate with the actual taste or nutrition of the cookie. All that counts is that it looks good to others. This happens with stocks: they go up and down based on perception. A perception which has no link to real life.
2. Note that the person who bought the first cookie has experienced an increase in the valuation of their shares, but none of the rise in valuation flows back to the original creator of the cookies (you). This is a feature in that this increase in valuation is a primary motivator for your investor in the first place.
Valuations need to be justified
In the industrial age, there were sophisticated formulas to explain the relationship between share valuation and the actual value of the physical plant of a business. Factory buildings and machine tools can be resold if the company fails. But in the Information Age, where physical assets are minimal, how are valuations justified? There are formulas based on multiples of revenues, mainly for SaaS business models, but even those are finger-in-the-air guesses.
Another way to justify valuation is to consider the company’s ability to control the market. This may work for more mature firms like Amazon, Facebook or Apple.
How does one justify a valuation for a startup? How much cash should you ask for an equity slice of your venture? It’s interesting to see how this question is addressed on Shark Tank or Dragon’s Den, where startups pitch to investors to raise what is usually their first round of cash. Another tool often used is the SAFE – Simple Agreement for Future Equity, which is a loan that can be repaid at a future date either by reimbursing the principal or by exchanging for shares at a multiple of the price set by the first equity raise.
SAFEs are often seen as an easy source of cash for a struggling startup. You get the money and keep your shares until the hazy future.
However, SAFEs are the most expensive way to raise money. It is debt capital with a ticking bomb.
Remember that investors are not doing you a favour. Sooner or later, they need to get their investment back, plus a hefty premium.