Valuation vs. Equity Allocation: Which One Should You Use
By Lior Ronen | Founder, Finro Financial Consulting
Startup valuation can be confusing for many founders.
Many mixes up between valuation and equity allocation.
In this post, we’ll cover the differences between them and how to tell when each one is needed.
There is one sentence that I often hear from founders: "can you build us a waterfall valuation for our SaaS startup?". This naive term "waterfall valuation" mixes up different terms, methods, and use cases, so let's break it down and explain what founders should use depending on what they want to achieve.
First, we need to understand the differences between business valuation and equity allocation. While they use similar jargon and data, they are used in different cases to calculate various business aspects for different uses.
If you want to know how much a business is worth, you need to build valuation for the company. However, suppose you want to know how much a single share is worth and how a specific valuation is flowing through the pipes of different stock classes, investment terms, rights, and liquidity preferences. In that case, you need to use equity allocation methods.
Second, once we established that valuation and equity allocation are relevant for shareholders and investors, but they calculate different things and use differently, we can now discuss business valuation.
There are many types of valuation methods, but the entire valuation universe can be broken down into three approaches: the market approach, which uses real market data to evaluate a business, income approach, which uses a company's projected financials to assess it and asset approach, which uses the companies assets and liabilities to define its value.
Additional Read: The Ins and Outs of Startup Valuation
Third, once we established a company's valuation if we want to see the holding value for a specific shareholder or the price of a single share. In a perfect world, we could divide the valuation with the number of outstanding shares, and that would give us the share price that we could then multiply with the number of shares for each shareholder. However, in reality, every funding round is a different share class with a different liquidation preference, liquidity rights, conversion right, etc.
To bake these rights and terms into the analysis and see how the valuation that we built flows through the cap table and how much every share is valued in each class, we need to use an equity allocation method. There are a few methods for equity allocation, but the most common ones are the waterfall model, probability-weighted waterfall model, and option pricing method (OPM).
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.' To build a more robust waterfall model, in many cases, one or more valuations are used in a probability-weighted valuation to cover a broader spectrum of scenarios and how they are translated into a single share price.
In conclusion, valuation and equity allocation methods go hand and hand in many cases. However, they are used for different purposes. If you're looking to evaluate a business, you need to use a valuation method, but if you want to understand the price of a single share in a company with a few share classes, you need to apply an equity allocation method to the valuation you built earlier.
