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We're planning on offering some key early employees equity in our startup, an LLC, in the form of ownership shares. The benefits include: - proportional sharing in distribution of profits - proportional share of money in the case of an acquisition

We aren't looking for an exit however, so in the meantime, we'd like to offer something if/when: - they decide to leave - they would like to "cash out" some of their equity even while still employed

However, given we are a smallish private company that isn't trading on any market, what is a fair way to value the company in order to pay out before an acquisition? We could hire a professional to perform a valuation each year, but that seems like too much money for a young startup. We could go with a formula like book value, but that is pretty paltry especially for a software startup with relatively few "tangible" assets. Are there other formulas out there? Perhaps some function of revenue, number of employees, profits...?

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3 Answers

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As you say, it is very hard to value a company that isn't actually being traded, but there are a few commonly accepted methods. One fairly simple option is to value the company at some multiple of EBITA or profits.

The tricky part is figuring out an appropriate multiple for your business. For example a company selling consulting services will generally have a lower multiple than a SaaS platform company would have. I'd recommend doing some research on said multiples and using that as a guideline for at least starting the valuation process.

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yeah, I think using EBITA over book value sounds right. One thing that comes to mind: earnings fail to account for expenses obviously, so what if one company with 4 employees is making 500k / year vs a company with 20 employees? – Karl R May 6 '11 at 4:30
Normally the E in EBITA isn't revenue, it is net profit. So the payroll expenses are taken into account. – Rain May 6 '11 at 16:00
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We run with a basic premise when you can't get

Sweat Equity multiplier

Basically their time * an agreed amount per day/week = their direct contribution that is comparable to you earning else where.

Apply a multipler to it say 3X or 4X due to the risk and hardship involved in earning less (any maybe not seeing a return)

Then Moving forward their continuing investment would look like

  • You agree that they normally get paid $5000 per month = ~$60,000 per year.
  • You can pay them $2000 per month
  • Their net "factored" contribution is then $3,000 per month
  • They invest 6 months at this rate so you have $3,000 * 6 = $18,000 your out of pocket
  • You agree that you will put a 3X multiplier on this so 3 * $18,000 = $54,000 that you should be paid ahead or above of the other staff in order to consider yourself equal at the end of the day OR this represents their buy in to the shareholding.

As the company starts to make a profit (assuming it does which is their risk), everyone starts to draw earning from the company, they get paid out at a higher rate of pay to the new people until the payment is met.

The other way to look at this that the $54,000 owed to them by the company buys them a greater amount of shares in the company.

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thanks Rob, I think deferred compensation is an interesting option, but not quite what I'm looking for. Frankly, I think it could be too much of a cash liability vs equity in the case where we don't take off, and could also rob the employee of potential upside if we really do take off. – Karl R May 6 '11 at 4:33
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It isn't so much a valuation you need... really what you need to establish is what proportion of the company each member is entitled to, rather than the valuation. As you alluded to, the value of the company will be in constant flux and as you are not trading you are entirely illiquid.

But you're an LLC... In a private limited company this would be relatively simple - there is a pool of stock in the company and it is split across it's founders and key employees and other employees may be offered share options. Over time people accumulate a certain amount of equity and if the company is traded in the future either on the stock exchange or by acquisition, the shareholders will receive their proportion of value either in cash or other equity. Until the company exits there is little opportunity to 'cash out' although you may be able to sell your shares privately.

In both cases the money has to come from somewhere... if an employee that has some 'share' in your LLC leaves and they want to 'cash out' where is the money going to come from? If they leaving and someone is coming in with an investment then this could be the source of funds. Valuation is going to be incredibly hard and to be honest, it will be a major distraction for all the employees of a young startup that is trying to get off the ground.

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thanks, we're definitely going to go with a % equity, but the contingency for when people leave / cash out is what I'm trying to figure out. Valuations of private companies are hard, I just need something straight forward and perhaps more fair than book value. – Karl R May 6 '11 at 4:28
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I really think that spending time and effort worrying about setting up a mechanism to facilitate stakeholders cashing out on an early private venture isn't a standard or normal thing that people set up. One of the biggest reasons people hand out equity or some other stake is to retain their talent and incentivise them to do the best possible job. If you provide a 'cashing out' mechanism, you're clouding the issue and making it harder to retain key talent. I understand this question if it is you thinking of leaving, but if not, don't waste your time... – edralph May 6 '11 at 13:07
that's a good point, probably not worth fretting over too much, I just need to have some sort of clause in the LLC operating agreement that deals with this. Perhaps book value is fine and it just means, you won't make much money by "cashing out", the incentives are really tied to staying with the company and sharing in the profits. – Karl R May 9 '11 at 19:47
Absolutely - you need to have the clause in there so that people know what the deal is when they decide to exit the LLC. If you don't have that in there it can be disastrous as dissolution of the LLC is one possible outcome! As with all things, they are worth what people will pay for them - perhaps the clause should be along the lines of the outgoing member being compensated by the other existing members by whatever they are willing to pay at the time. The interest owned by the outgoing member is going to be split across the other members anyway so they are getting a larger share in return. – edralph May 10 '11 at 9:59

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