The valuation of a company and its price per share are closely related. When a company starts out, its stock is essentially worth nothing, which is why its price per share is $0.00001.
I’ve spent the past four years reviewing the value of startups and performing private stock valuations for companies ranging from in-the-garage and idea-stage companies to OfferUp and Kickstarter. Sometimes, when early-stage startup founders want to exchange their shares for services or supplies, they’ve approached me to assess the value of their stock.
Here's the main thing startup founders need to know about this topic: using common stock of your very early stage company to pay for goods and services is not a good idea, and you shouldn’t do it (regardless of the value of your stock).
What is value? What’s a valuation?
To understand what a valuation is and how analysts or investors decide on one, you must first understand what value is.
In its simplest terms, the value of a “thing” (or security) is the price (in cash or cash equivalent) that two people (a buyer and a seller) agree upon during a transaction. However (and unfortunately for many early-stage founders), no one is exchanging cash or cash equivalent for the stock of the company (which is the reason they come to folks like me to get a “valuation”). In the absence of trading data, there are generally two ways to derive value:
- Compare the thing that you want to value to similar things with quoted prices in active markets or identical things in inactive markets, or things which can be priced by taking into account non-price inputs.
- Priced through “unobservable inputs,” like asset values, financial forecasts or comparison to similar things in a similar market.
Basically all startups fall in that last group, meaning their equity can only be priced very approximately. In reality, a pre-investment, unpriced, pre-revenue, early stage startup should be considered as having a value near $0.
From a high level, there are generally two ways of estimating a value for the company:
- What is the value of the company's assets?
- What could this company be worth in the future?
Few pre-seed startups have any real assets. What investors will eventually base the startup’s value on is its team: startups have people with ideas and ambitions and know-how, which is why the investor believes it will be successful, but these people are (of course) not owned by the startup and can walk away. They don’t count as assets, so until there is money exchanged for the stock of the company there is no solid data point to value for the shares of the company (and estimating the value of a team or a founder is not impossible, but it’s subjective at best).
The other way to value a startup, which also contributes to the first investors’ valuation, is to derive the price based on the company’s potential future value, adjusted for time and risk. For a startup, this is particularly difficult, because it’s almost impossible to estimate:
- The future value of the company
- When the company will be worth that much
- The probability of it ever being worth that much
Altogether, this basically means that there is no foolproof way to arrive at a number greater than 0 for the value of a share of a startup before its first priced round. But all this is irrelevant to you, the founder, who may want to just pay for something with shares of your company.
How to compensate key early-stage startup contributors with equity
There are situations in which a founder needs advisors or contractors to come onboard and provide key services to help the venture take off, and in some cases, it makes strategic sense to compensate these people with equity (usually with vesting). Instead of tying this compensation to a dollar value for the work performed, the founder should think of it as part of the future of the company’s ownership structure. Seed rounds are relatively regularized in terms of the amount of equity a founder can expect to give employees, advisors, and investors. That means it’s possible to anticipate the cap table (and the dilution) at each round. Here’s the rough breakdown for startups today:
To see how the chart above typically plays out, let’s look at some data from Craft that ranks founders’ equity stakes in 71 IPOs:
As you can see, the vast majority of founding teams end up with less than 30% of the startup’s ownership at IPO, and many startups founders end up with less than 10% of the startups ownership. In light of this data, you can see why equity compensation for early contractors should be carefully considered.
What this means for a pre-seed startup is that, given the equity distribution at each stage, they will likely want to give away no more than 3-5% total before you hit your first round to minimize the dilution to your founding team. This includes all the equity you want to use to compensate contractors and advisors. If you find that a person’s contribution is worth more to your company than 3-5%, it’s likely that you have found a co-founder, rather than a consultant, and you should treat them as such.
In other words, compensate people on the basis of their role and the future potential path of your company, not by multiplying the price-per-share based on your current estimated value. Which brings us back to the original question:
What’s my stock worth?
Use one of two different frameworks when thinking about what you can do with your company’s stock:
- If giving it away to contractors and service providers, or exchanging it for good and services, be very stingy, and plan to give no more than 3-5% in aggregate. If you have to give a bigger lot to a single individual for their services, you may be looking at a co-founder or a first employee, rather a service provider. If they are truly a co-founder, convince them to come onboard with your mission and vision, and use existing frameworks to split equity (such as our own Co-founder Equity Split). If they are an early employee, use industry benchmarks to arrive at their equity compensation (and make sure they have vesting).
- If you are giving out equity and need to understand the tax implications of such a transfer (either in form of options or shares), you’re going to need a 409A valuation. Shoot me a note and one of my team members can tell you more about it.
The bottom line for founders: don’t think about valuing your shares. Think about creating value.
Learn how to pick the right startup legal entity:
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.