One of the things I recommend to entrepreneurs formalizing their operating agreement, which spells out the rules of the business, is to define a simple formula for company valuation in addition to a buy/sell agreement that gives the startup the right, but not obligation, to buy back stock from team member no longer associated with the business. Best practices like a four year vesting schedule, one year cliff, and defining of roles and responsibilities among founders are more important, but having a defined buy/sell agreement is right up there to get in place immediately.
Here’s a simple methodology I like to use for company valuation in a buy/sell agreement:
- Take the comparable public market multiples of the business (e.g. 3x revenue for enterprise software companies, 5x revenue for SaaS companies, etc)
- Divide the public market multiple in half to account for lack of liquidity and make that a fixed number in the formula in the operating agreement
- Multiply trailing twelve months revenue times the discounted public market multiple by one plus the trailing twelve months top-line growth rate
- So, with a public market multiple of 2.5, revenue of $1 million, and growth rate of 70%, the company would be valued as follows: (2.5 x .5) * 1,000,000 * (1 + .7) = $2,125,000
- The formula put in the operating agreement would be as follows: 2.5 times the trailing twelve months revenue times the result of one plus the trailing twelve months revenue growth rate
This formula is easy to calculate and takes into account the dynamics of the market, recent revenue performance, and a premium for growth.
What else? What are your thoughts on having a defined formula for company valuation in a startup buy/sell agreement?