Figuring out how much to ask for what equity you will give up is an emotionless financial calculation combining the following:
- How much you need – This is based on your financial projections. Whatever your overall cash flow shortfall is till cash flow break-even is how much you need. If you lose a total of $100,000 over 6 months and have $1 of free cash flow at the end of the 7th month, you need $100,000 to get to the end of that 7th month (cash flow break-even).
- Your valuation – What your company is worth, even if pre-revenue. This is usually a multiple of your projected net income (EBITDA).
- The multiple you use is determined by coming up with comparables. PE ratios are nice if you can find publically traded companies like yours and you can justify them. If you cannot you have to find sales of similar companies (very hard as most are private deals). The ratio of sales price to net income for the comps is the multiple you would apply to your projected revenue to come up with your valuation. If a company making 1 million is sold for 10 million, that’s a 10 time multiple.
- What year of your projections you apply the multiple to is more art than science. You obviously can’t apply it to early years with negative net income. Later years when your netting millions is unreasonable because… they are projections and we never really know if you’ll get there. We tend to apply it to the first or second profitable year.
How much you ask for is simply how much you need. Asking for more as a pad or for niceties like an exorbitant founders salary, calls the integrity of the entire study into question and is not recommended.
The equity you offer is simply your valuation divided by how much you need. For example, if you net $500k in the 3rd year and have a 10 time multiple based on comps, you have a $5mm valuation. If you need $100,000 to cover your negative cash flow in your projections, you ask for $100,000 in exchange for 2% equity (100k/5mm).
Of course this is just a base for negotiation with the investor BUT the better you do this, the better chance you have of giving away 2% instead of 51%.