One of the principles I outline in my Rules of Engagement is that I am happy to provide my services to clients in exchange for equity.
I believe this arrangement has a number of benefits for both sides of the engagement:
It makes working with me a lot more affordable (in the short term) as clients who are in the early stages of their lifecycle often don’t have the means to hire full-time (that being why they resort to extern help in the first place).
Even more importantly, it aligns the incentives between me and the client, as we’re now both interested in the same thing – the company being a long-term success.
The way this work is that I take a share of my monthly retainer (up to 50%, the client decides the exact %) in equity (i.e. stock options, shares, etc.)
Which means that we need to know what the value of a share is in order to understand how many shares exactly are owed as part of the agreement.
This is easy with publicly traded companies – they have an exact share price.
However, as you can guess, most of my clients are not huge publicly-traded companies – which makes pricing their shares a little bit trickier.
With companies that have raised capital from an investor, this exercise is not so hard. Take the total implied (post-money) valuation of the latest financing round, divide it by the total number of outstanding shares and you have a price per share.
However, many startups choose not to raise capital and they still need help with growth.
Most of my career has been spent in such bootstrapped companies and I understand how they think and approach growth very well.
So, I’m happy to work with such teams – which makes it necessary to have a way to value their equity when they want to use this compensation option.
So, how do we do it when there hasn’t been an institutional investor to do the work for us?
The old-school way!
Enter asset pricing
One commonly (ab)used metaphor around startups is that working on one is like building a plane in flight.
And now what we’re trying to do is put a price on how much that plane is going to be worth when (if) it lands...
Which is just an overly-dramatic way to say that we’re engaging in a good old case of asset pricing.
There are many ways to price an asset, but one of the most basic ones is by projecting the future cashflow it will generate.
You’ll often see this in real estate as yield. Essentially, it’s the ratio between the income an asset can generate in a year and it’s total price, expressed as a %.
If a house costs $1,000,000 and generates $50,000 in annual revenue (i.e. rent), that means the yield is 5%. Or 20 years worth of rent.
That means you can now compare other similar properties and evaluate them based on the income they’re generating.
Thus, a property generating $20,000/annum, should be valued at around $400,000 (20x20,000).
Of course, properties vary in many things – no two locations are exactly the same, state of disrepair, etc. So the yield is not the only factor when pricing a property.
Companies (and their shares) vary a lot less, especially when they’re in the same neighborhood industry, therefore, their valuation should be a lot more uniform when we apply the same lens.
Pricing SaaS companies
We don’t need to reinvent the wheel, because the good people at Meritech have already done the heavy lifting for us.
Every month or so, they publish a report (latest available one) which outlines the performance of publicly traded SaaS companies.
(You can subscribe to their newsletter to get the report in your inbox.)
I want to warn you right away that it does not make for the lightest read. Among other things, the analysts at Meritech try to isolate and understand things like how the market values growth at these companies, etc.
So, for our purpose we’ll focus on one specific section/chart within it: Enterprise Value / Implied ARR:
Even this is quite confusing, I know.
Simply put, this graph tells us that on average SaaS companies are currently valued at 6.9x their ARR.
This is the same concept as the yield ratio in real estate – how far into the future does the market rate these companies.
Which means we can take this average multiple and apply it to the ARR of any company to price its total value.
Cleaning up the model
Unlike Meritech’s definition of ARR as total revenue for last 3 months multiplied by 4 (which is the same as taking the average MRR of your last 3 months and multiplying it by 12 months), I use the widely recognized definition of ARR as (latest) MRRx12.
If you’re already enjoying strong growth, this gives you a higher overall evaluation (because it takes a higher number as the basis).
Another thing to keep in mind is that using this average multiple is already a generous basis for the evaluation – the companies included in the Meritech report are publicly traded meaning i) they’re some of the top performing SaaS companies (to make it to the stock exchange in the first place) and ii) because their stock is highly liquid, they tend to enjoy a higher evaluation.
Aligning incentives
Hopefully this gives you an idea on how to approach evaluating a company.
Of course, no approach is 100% accurate and fair (whatever that means). I can almost hear founders complaining that applying this prism to a very early-stage company will most likely result in an extremely low valuation.
It is important to remember, however, that working in this way is to a large extent an exercise in aligning incentives.
Joining a company at the first stages in its lifecycle is essentially a bet – it carries a lot of risk and you have to wait a lot longer to see whether it works out. Thus, you would expect to benefit from a high rate of growth enjoyed over a longer period of time.
As always, I’m looking to learn from others. Have you been through a similar pricing exercise? Leave a comment to share your thoughts.