THE BASICS #4: VALUATION / PRICE OF A SLICE
What is the price of a slice? In other words, what does the price of an equity stake mean? Simply put, the price of an equity stake, or stock in a company, is a reflection of how much the whole company is worth. The estimation of a company's value is called valuation. Another way to think about worth or valuation is how much someone else would pay for it. I like to think of it like a price tag.
Let's flash back to middle school algebra class for a second:
Total Business Worth (Valuation) x Size of Slice as % of Whole = Price of Slice
**This concept applies to the stocks you hear about in the news, but it's a bit more complicated than that. I'll explain the differences more thoroughly in a separate post.**
The valuation of a company, or how much it's worth, depends on a lot of factors: industry, size, sales, age, annual profit, etc. For simplicity's sake, let's say that your cake business' valuation is equal to its annual sales. Right now, without the store, your business generates $250k in sales per year (that's a lot of cake!), so let's say that your company is worth $250k. You need $50k to pay for the store. $50k is one fifth, or 20%, of the total $250k that your company is worth. So you could cut out a slice of your metaphorical equity cake that is one fifth of the whole cake and sell that equity stake to an investor (like the friend you hired) to buy the store. To recap:
- Valuation = Sales = $250k
- Store cost = $50k
- $50k = 1/5 x $250k or 20% x $250k
This type of equity financing happens all the time on a popular TV show. In any given episode, a hopeful entrepreneur marches into the room asking for $X in exchange for X% of their business.
- If you were that entrepreneur, you'd walk in asking for $50k in exchange for a 20% stake in your company.
- Let's say one of the investors loves your business idea and offers to give you the $50k, but wants a 33% equity stake instead. What does that counter offer mean?
- $50k for 33% means that he is putting a price tag of $50k on 33%, or one third, of your business. So imagine that instead of fifths, or five equal slices, your company equity cake is now only divided into thirds, or three equal slices. If the price tag on each slice is still $50k, then the investor is giving your company a valuation of $150k (3 slices x $50k per slice).
So even though it doesn't seem like there's a huge difference between the 20% you offered and his 33% counter offer, it actually translates into a big difference in valuation. Not to mention, he would then be entitled to 13% more of your company's future value.
To test your understanding of the relationship between the price of an equity stake and that company's valuation, take the following quiz!
Can you solve for the price of a slice?
- Business is worth $1,000,000 and you are selling 25%
- Business is worth $750,000 and you are selling 33%
- Business is worth $100,000 and you are selling 15%
- Business is worth $800,000 and you are selling 40%
- Business is worth $550,000 and you are selling 10%
[Answers in order: $250,000 ; $250,000 ; $15,000 ; $320,000 ; $55,000]
Can you solve for the company's valuation?
- You are selling a 20% slice for $40,000
- You are selling a 50% slice for $20,000
- You are selling a 25% slice for $250,000
- You are selling a 5% slice for $25,000
- You are selling a 15% slice for $30,000
[Answers in order: $200,000 ; $40,000 ; $1,000,000 ; $500,000 ; $200,000]