44 Steps to Valuing Your Convertible

There seem to be 2 reasons to do a convertible. First, low legal cost. Fine. Second, your valuation is postponed till the next round. Wait, what? Why would you want to postpone your valuation? Don’t you want to know how many shares you have to give away? Don’t you want to compare issuing equity against doing a convertible?

Valuation: why bother?

Why would you want to know your valuation? So you know how many shares you have to give away when raising money with an investor.

Assume you want to raise 400,000. Assume your valuation is 2,224,991. Then you have to give away 400,000 / 2,224,991 = 18.0% of your shares to the investor.

You can raise this 400,000 either with equity or a convertible.

Assume you raise money by doing a convertible. [Read this if you issue equity]

Isn’t a convertible all about discounts and/or caps? Yes. But you can also calculate the (implied) valuation.

How?

Steps 1–7: Cashflow planning

Step 1: Map out 60 months

To simplify only the first 6 months are shown. Assumptions are in blue. Calculations are in black.

Step 2: Estimate products/month

How many products will you sell each month? To simplify rounded numbers are shown. Calculations use the unrounded numbers.

Step 3: Estimate price/product

What is the price per product?

Step 4: Calculate cash in/month

Products/month in month 1 is 1. Price/product in month 1 is 2,000. So cash in/month in month 1 equals 1.1 * 2,000 = 2,000.

Step 5: Estimate cash out/month

What is the cash out each month?

Step 6: Calculate cashflow

Cash in/month in month 1 is 2,000. Cash out/month in month 1 is -24,219. So cashflow in month 1 equals 2,000 + -24,219 = -22,219.

Step 7: Calculate cash end

Cash end in month 0 is 0. So cash begin in month 1 equals 0. Cashflow in month 1 is -22,219. Equity in month 1 is 0. So cash end in month 1 equals 0 + -22,219 + 0 = -22,219.

Steps 8–10: Milestones

Step 8: Define milestones

When is your startup significantly de-risked? Assume with each 10x in products/month.

A very crude rule of thumb: 10x for software and 5x for hardware. Products/month in month 0 is 0. So the first milestone would equal 0 * 10 = 0 products/month. That doesn’t work. Therefore, if products/month in month 0 is 0, temporarily assume it is 1 when you define milestones. So milestones are:

• 1 * 10 = 10 products/month
• 10 * 10 = 100 products/month
• 100 * 10 = 1,000 products/month
• Etc.

Step 9: Look up month/milestone

Look up each milestone in your cashflow planning.

You have 3 milestones:

• 10 products/month in month 24
• 100 products/month in month 48
• Because 1,000 products/month is outside your 60-month horizon, use the 316 products/month in month 60

Step 10: Look up investment/round

Before investment, you have a negative cash balance.

How much money do you need to achieve each milestone?

_Milestone 1_To get from 0 products/month in month 0 to 10 products/month in month 24, you need to raise a Series Seed of 400,000 in month 0. This keeps your cash balance at 0 or more.

_Milestone 2_To get from 10 products/month in month 24 to 100 products/month in month 48, you need to raise a Series A of 1,000,000 in month 24.

_Milestone 3_To get from 100.0 products/month in month 48 to 316 products/month in month 60, you don’t need to raise any more money in month 48. Your cash balance is already 0 or more.

Steps 11–12: Funding strategy

Step 11: Choose Series Seed instrument

Which instrument will you use for your Series Seed: equity or a convertible?Assume you raise your Series Seed with a convertible. [Read this if you issue equity]

Step 12: Choose Series A instrument

Assume your raise your Series A with equity.

Steps 13–17: Exit

Step 13: Map out rounds

Map out the rounds identified in the previous step. Include the exit.

Step 14: Calculate revenue/year

Cash in/month in month 60 is 632,000 (from cashflow planning). So revenue/year @exit equals 12 * 632,000 = 7,584,000.

Step 15: Look up revenue multiple

How much are investors willing to pay for a company in your region and industry, with a revenue/year of 7,584,000? Assume 4.0x revenue/year (market data).

Step 16: Calculate enterprise value

So enterprise value @exit equals 7,58400 * 4.0 = 30,336,000.

Step 17: Calculate equity value

Cash end in month 60 is 3,684,194 (from cashflow planning). So equity value @exit equals 30,336,000 + 3,684,194 = 34,020,194.

Steps 18–28: Series A equity

Step 18: Look up IRR/year portfolio

How much does the Series A investor want to make on his portfolio? Assume the IRR/year on his portfolio is 20.0% (market data).

Step 19: Calculate years till exit

The Series A investor exits after (60–24) / 12 = 3.0 years.

Step 20: Calculate money multiple portfolio

So the Series A investor wants a money multiple on his portfolio of (1 + 20.0%) ^ 3.0 = 1.7.

Step 21: Look up milestones till exit

How many milestones does the investor have till exit? The Series A investor invests at 10 products/month in month 24 (from cashflow planning). So he has 2 milestones till exit:

1. 100 products/month in month 48
2. 316 products/month in month 60

Step 22: Estimate probability/milestone

What’s the probability to get from one milestone to the next? Either you get there, or you don’t. So 50/50.

Assume a 50.0% probability to get from 10 products/month in month 24 to 100 products/month in month 48. And assume a 50.0% probability to get from 100 products/month in month 48 to 316 products/month in month 60.

Step 23: Calculate probability till exit

So the probability to get from 10 products/month in month 24 to 316 products/month in month 60 is 50.0% * 50.0% = 25.0%.

Step 24: Calculate sub

So the Series A investor has a sub (for lack of a better word) of 1.7 / 25.0% = 6.9.

Step 25: Calculate retention

Because there are no more shares issued after the Series A, the investor retains 100.0% of his initial share percentage.

Step 26: Calculate money multiple startup

So the Series A investor wants a money multiple on your startup of 6.9 / 100.0% = 6.9.

Step 27: Calculate post-money valuation

So your startup has a post-money valuation @Series A of 34,020,194 / 6.9 = 4,921,903.

Step 28: Calculate shares%

Investment @Series A is 1,000,000 (from cashflow planning). So you have to give away 1,000,000 / 4,921,903 = 20.3% of the shares to the Series A investor.

Steps 29–37: Series A convertible

Step 29: Look up interest/year

How much interest/year does the Series Seed investor get till conversion? Assume he gets 6.0% interest/year (market data).

Step 30: Calculate years till Series A

The Series Seed investor converts after (24–0) / 12 = 2.0 years.

Step 31: Look up discount

What is the discount on the Series A valuation when the Series Seed investor converts his debt into shares? Assume his discount is 30.0% (market data).

Step 32: Calculate multiple 1

So the Series Seed investor can choose to get a multiple of 1 / (1–30.0%) = 1.4 times as many shares as the Series A investor.

Step 33: Look up cap

What is the cap for the Series Seed investor on the Series A pre-money valuation? Assume his cap is 2,500,000.

Step 34: Calculate pre-money valuation

Post-money valuation @Series A is 4,921,903. Investment @Series A is 1,000,000. So the pre-money valuation @Series A equals 4,921,903–1,000,000 = 3,921,903.

Step 35: Calculate multiple 2

So the Series Seed investor can also choose to get a multiple of 3,921,903 / 2,500,000 = 1.6 times as many shares as the Series A investor.

Step 36: Calculate conversion amount

Investment @Series Seed is 400,000 (from cashflow planning). So the Series Seed investor converts 400,000 * (1 + 6.0%) ^ 2.0 * 1.6 = 705.064 into shares.

Step 37: Calculate shares%

So you have to give away 705.064 / 4,921,903 = 14.3% of the shares to the Series Seed investor.

Steps 38–40: Series A cap table

Step 38: Look up shares founder

When you raise money, you issue new shares. How many shares does the founder have? Assume he (still) has 1,000 shares @Series A.

Step 39: Calculate shares Series Seed investor

So the Series Seed investor has 1,000 / (1–14.3% — 20.3%) * 14.3% = 219 shares.

Step 40: Calculate shares Series A investor

So the Series A investor has 1,000 / (1–14.3% — 20.3%) * 20.3% = 311 shares.

Steps 41–44: Series Seed convertible

Step 41: Look up shares Founder

The founder has 1,000 shares @Series A. So the founder also has 1,000 shares @Series Seed.

Step 42: Look up shares Series Seed investor

The Series Seed investor has 219 shares @Series A.

Time for a trick. Assume, like the founder, the Series Seed investor would therefore also have 219 shares @Series Seed.

Step 43: Calculate shares%

So the Series Seed investor would have 219 / (1,000 + 219) = 18.0% of the shares @Series Seed.

Step 44: Calculate post-money valuation

Investment @Series Seed is 400,000 (from cashflow planning). So your startup has a post-money valuation @Series Seed of 400,000 / 18.0% = 2,224,991.

So what is your valuation?

2,224,991.

That’s how you value your startup when raising money with a convertible. Now you know how many shares you have to give away. And now you can compare issuing equity against doing a convertible.

Thanks to Chretien Herben.

Joachim Blazer is the author of The #1 Guide to Startup Valuation.