THUNDER BAY-One of the most frequently asked questions we get when it comes to investment is how to value your company when determining how much to raise and how much equity to offer in return. As has been stated many times over across the web, the actual percentage is far from the most important piece of the puzzle; you should focus more on control from a board and voting point of view and look out for any poisonous or unexpected terms. That said, the amount of equity is a starting point and one of the first questions investors will ask.
A typical raise will include an equity offer of anywhere from 10 – 30%. And the truth is that most entrepreneurs venture into asking for a certain amount of money (say $500k) and just pick an equity they’re comfortable with (say 20%) without ensuring that the math and business model make sense. This will be the first thing an investor will look at in a business plan: does this seem reasonable and is everything accounted for?
Let’s walk through an example of how you can ensure the math works. This example will focus on a growth stage raise; a seed round will use similar math but is a lot more of a “gut check” based on the idea and a bridge round, loan or other financing will use different types of valuations (usually based on existing revenue). A growth stage raise focuses on future potential revenue.
The Basics: What You Should Know
Before diving into this math, and usually before even considering raising a round on financing you should know some key metrics for your business. Specifically, you should know how much it costs you to acquire a new customer and how much revenue you make off of each. These are referred to by many acronyms but for this article, we’ll call them CPC (cost per customer) and LTV (life time value of each customer). If you have a subscription or recurring revenue business, you should also know your churn rate (the percentage of customers that abandon your service each month). The same applies more roughly to one-time purchases: how many customers are likely to return to purchase again? If these numbers are unknowns, then you likely aren’t ready to raise a growth series of funding.
Let’s say that we want to raise $500k and offer 20% equity in our business. This means that after the money is invested, the investor will own 20% of our company, meaning it is worth $2M pre-money and $2.5M post-money. This is the valuation and typically you state that you are “raising $500k at a $2M pre-money valuation” which implies 20% ownership after the round is closed.
Investors typically like to see a return on their investment of at least 10X in 5 to 7 years. A company will also typically get acquired for somewhere in the range of 5X revenue or 10X profit. That means that your business needs to sell for $25M ($2.5M post-money x 10X return), which in turn means you need at least $5M per year in revenue or $2.5M per year in profit.
This is where the information from The Basics starts to come into effect. If you know that it costs you $40 to acquire a customer (your CPC) and that that customer will be worth $100 to you (LTV), then you know that you need to get 50,000 customers ($5M per year in revenue / $100 per customer). To acquire 50,000 customers you know that need to spend $2M ($40 CPC * 50,000).
Now the math should begin to come full circle: if you raised $500k, will that be enough to get you to $5M per year in revenue in 5 years; or, put another way, will it increase your sales enough so that you can afford to spend $2M over the next 5 years to get to that stage? If the answer is yes, then the math above works and should all be included in your business plan.
The math here is obviously simplified for the purpose of demonstration. Other factors will include other financing in which these investors get diluted (meaning you need to grow even more for them to see a 10X return) or factors such as returns, transaction fees, or really any costs. Everything else in your business plan needs to flow from these numbers: at 50,000 customers, how many support staff do you need and what is the cost of that? How many management, operations, technical and sales staff do you need?
More importantly, just because your cost is $40 to acquire a customer today does not mean that it will always be that way. You may only be able to secure up to 10,000 customers via your existing advertising means and something else may cost more, or you may be able to reduce that cost over time. These should all be risks considered in your plan as well or you should be prepared to explain why the math will work. This will also affect your target market size and how big the pool is from which you can draw.
It is important to reassure investors that you have considered your business from all of the financial angles. These numbers are certainly not absolutes and your investors will be unlikely to hold you to them as hard targets, but it should demonstrate a clear path to growth, that you’ve thought through your market, target segment and taht you have a consistent and repeatable way to acquire new customers.
Most importantly the math should “make sense” from both a revenue/profit/business model point of view and from a gut check point of view. How likely are you to have 50,000 customers in 5 years and what sort of growth do you need to get there? In my mind this is the most important part of your business plan and it is likely what an investor will look for first and foremost to make sure they’re not wasting their time with someone who has not thought things through.