Sliding Scale Valuation Formula

When an entrepreneur pitches his or her company to a potential investor there always comes a moment where the following conversation takes place:

investor: “So how much money do you need”
entrepreneur: “About a million”
investor: “Sounds reasonable, and much do I get for that?”
entrepreneur: “10%”
investor: “10%??? So you value your company at 10 million right now? I don’t think so. I was more thinking along the lines of a 2.5 million valuation.”

I have had to defend myself a few times in this situation but also used the same argument when talking with other entrepreneurs. But I don’t like it one bit. I think we need another way to look at this and I have come up with a simple formula which I would like to call the Sliding Scale Valuation Formula.

The basic thinking goes like this: If I pay 1 euro for 10% then 100% must be worth 10 euros. Simple and clean and shown in the illustration. But what entrepreneurs and investors often overlook is that in reality each share has a different value.

One simple way to prove this is if you would own 10% and would be able to buy 1% more. If the company would be worth 1 million that one percent would cost you 10.000. Right?

Now let’s assume you have 50%. Would that extra 1% still cost just 10.000, or would you be willing to pay more for it? Having 50% or 51% in a company makes all the difference so my guess is that you would easily pay more than 10 times the amount.

So all percentages are not created and valued equal.

Another example, in the form of a very old joke: a man pulls into a gas station and asks the owner: ‘How much for one drop of gasoline? The owner replies ‘don’t worry, that’s free’ to which the man replies ‘Ok, give me a full tank of gasoline drops then’.

We all understand that there is a huge difference between one drop of a full tanks of gas. So why does this not apply to a start-up? Why does the selling of 10% for 10 imply that the other 90% must be worth 90? It doesn’t. In fact, the other 90% is completely worthless to anyone but the owners. If they would sell the full 90% there wouldn’t be a company left.

So in fact there is a sliding scale in the valuation of a start-up which I illustrated here too. Each company is different and the numbers are influenced by the percentage you sell, the number of shareholders and the age and status of your company and so each sliding scale will be different. In some cases the scale might even tip the other way which would mean that the percentage you are selling is worth less then the percentage you keep. And the more value is inserted into the company and the more shareholders you have the more likely it will be that the scale evens out and a percentage actually equals a percentage.

But for start-ups I think we need a Sliding Scale Valuation Formula.

So what formula do we use? If you find a good investor, with a great network and fantastic ideas his investment easily doubles the chance that your start-up turns into a successful company. So it doesn’t really matter if he has 5%, 10% or 35%, his investment is responsible for 50% of your success. So let’s use that as a starting point and construct the following formula:

What the investor invests is doubled to calculate the value of the start-up

Simple, elegant and effective. It helps you defend the percentage you are offering and puts a bunch of feathers up the butt of the investor because you get to explain that he is responsible for 50% of your success.

So the next time a VC or investor asks you about your valuation I suggest you tell them an old joke, about a drop of gasoline…