Valuation and Equity Allocation: Close But Different
By Lior_Ronen | Founder, Finro Financial Consulting
In an earlier post, I talked about how close yet very different budgeting is from the financial forecast. In a nutshell, budgeting is a short-term planning tool and uses short-term planning elements while the forecast is a long-term planning tool and uses long-term planning elements. You can read more here.
In this post, I want to talk about another couple of tools, that seem almost identical but they are very different from each other: valuation and equity allocation.
The primary problem with financial tools is that many of them use the same terms, phrases, and financial elements even though they are used for different purposes.
It causes many people to mix up between different financial tools and methods, which can end up with the wrong result. So let’s dive in and see what is startup valuation, what is equity allocation, and what are the differences between them.
Startup Valuation
Finro works with startup founders, business owners and tech-focused money managers developing valuations for startup in different stages, niches and business models.
What is Startup Valuation
Founders can fund their startup in three different ways:
(1) Debt: loans from financial institutions or private market investors.
(2) Equity: selling shares of the company to external stakeholders.
(3) Bootstrapping: funding all activities out of pocket.
Venture capitalists will need to know the company's value to understand how many shares or what portion they will obtain for the amount they intend to pour into the company.
Understanding the startup's value will estimate potential investors' return on investment (ROI).
The earlier an investor gets into the company, the higher the return. The math is simple growth rates are higher in the early years and decline as the business grows. However, the investor's high growth also equals high risk.
So, investors would need a tool to estimate if their risk by investing in this startup company will pay off. Startup valuation is that tool, and ROI could help potential investors compare a few alternatives.
Even though I discuss valuation above in the context of startup investing, valuation is certainly not limited only to estimating the value of a startup.
Every transaction in the private market requires valuation as part of the potential investors' due diligence since companies' value is not publicly available.
What is Equity Allocation?
Valuation helps you understand how much a business is worth. But how can you tell what is the value of the holdings of each investor if the startup has different stock classes, investment terms, and liquidity preferences?
In that case, you need to use an equity allocation.
There are a few methods to allocate equity across the different stock classes and consider the various terms and conditions.
The waterfall method is probably the most efficient and most commonly used equity allocation method that shows how a company's specific valuation flows down the company's cap table through the different terms and rights, hence the name 'waterfall.'
So, to understand how much a portion of a specific investment is worth, you need to take two steps: value the company and then allocate the value to the different classes.
For Conclusion
Startup valuation and equity allocation are very similar tools. They use the same language, terms, and even the same data. BUT, they are used for two different actions.
While valuation is used to estimate how much a startup is worth, equity allocation is used to see how the valuation waterfalls through the different share classes.
