The Lemonade Stand: How to Value Your Private Shares
Jun 21st, 2014
I always find it easiest to boil businesses down to lemonade stands.
Lemonade stands are simple business structures. They have very few inputs (ice, sugar, lemons) and really only one output (lemonade). Profit calculations are therefore easy (Profits = Sales - Ingredients - Labor).
Sensing an opportunity, you've been keeping track of the number of people walking past your front lawn every day, staring at your precious lemon tree. You're onto something.
Being the budding entrepreneur you are, you talk to your wealthy Uncle John. You tell him that you want to launch your new venture, Larry's Lemonade. You need some money to purchase ice and sugar. Would Uncle John be interested in investing in Larry's Lemonade?
Uncle John happily agrees to invest, but he asks that you agree to a few of his terms:
- John will invest $50 in cash, and in return he will own 40% of Larry's Lemonade, including his investment, i.e. the post-money valuation is $125 ($50 / 40%).
- John will be issued Preferred Shares in Larry's Lemonade. His Shares will have a Liquidation Preference (hey, they're called Preferred Shares for a reason) entitled to 2 times his initial investment, in the event that Larry's Lemonade is ever sold, before your Common Shares receive any proceeds.
- After John has received 2 times his investment, his shares will convert to Common Shares and rank the same (pari passu) as your Common Shares.
Three months later, business is booming. You've earned a reputation as a sterling provider of chilled beverages on your street. A rival refreshment company, Polly's Popsicles, offers to buy your business for $200 in cash. After talking with Uncle John, you both decide this is a great valuation for Larry's Lemonade. You take the deal.
Congratulations, entrepreneur! Your first company sale! Let's see what happens to your 60% equity stake:
First, we have to pay out the Preferred Shares. John, as per his terms, is entitled to up to 2 times his initial $50 investment:
Cash Proceeds: $200
Less: Preferred Shares = 2 * $50 = $100
Balance remaining for Common Shares: $100
John's 40% stake = $100 * 40% = $40
Your 60% stake = $100 * 60% = $60
Sixty bucks. That's it?
But wait: didn't you own 60% of Larry's Lemonade? And didn't it get sold for $200? Shouldn't you be getting $120 (60% * $200)? Where did the remaining $60 ($120 - $60) go?
This Larry's Lemonade story is not uncommon. Apart from avoiding awkward conversations with investor family members, the lesson learned here is that as a private company shareholder (owner or employee), you likely own equity that is lower on the totem pole than that of your investors. It is important to understand this discrepancy. Communicate as best you can with the folks in the know, your employer. Ask questions like:
- How many more financing rounds does the company anticipate (this will impact share-count, and therefore dilution)?
- What is the company's exit strategy and timeline?
- What kind of liquidation preferences do current investors have?
- What was our company's last valuation? How does that impact me?
In talking with private shareholders, EquityZen has realized there is a real lack of communication between company and employee when it comes to share valuation. We encourage you to check out these posts that cover the topic in greater (and more eloquent) detail:
And just remember, the money's not always in the