How to set share prices

Ross Woods, 2013, rev. 2014

 

To keep this simple, let’s presume that there is:

 

Timeline

The timeline is this:

  1. Incorporate with founders’ shares being held by the founders
    If it has any equity, the value of the corporation is reduced according to the amount of risk. For example, if it has only a patent and a business plan with a well-researched forecast, its prospective value can be discounted by up to 90% due to the high risk level. On the other hand, it could be given full value if it is a functioning business with a good cash flow, its own assets, and convincing prospects. The share price is then the book value plus the anticipated profit.
    New corporations can have different kinds of equity, for example:
    1. "sweat equity", the time that the founders put into preparing and firming up a business plan
    2. cash contributed by the founders
    3. a patent
    4. a working prototype
    5. an established cashflow
    6. a functioning business as a sole trader
  2. Pre-release shares
    These are discounted shares sold to establish equity and reduce the risk of the new company folding. This equity increases future prospective investors' confidence that the new company will survive. As these shares are relatively high risk, investors need commensurate reward later on. However, the reduced risk can raise the share price and generate approriate rewards.
  3. Initial Share Offering
    Set the number of shares offered for sale. These can be at a higher price than the pre-release offering, because the company has assets and does not need to discount its stocks so heavily for risk.
  4. Subsequent Share Offerings
    Variable amount of shares offered for sale.
  5. Exit plan start (Four years from Pre-release share date)
    The company has the liquidity for early investors to cash in their shares at a better than industry ROI that suits the risk they have taken. In the case of a public company, the exit plan start is the date of the Initial Public Offering.

At some point between stages one and three, preferably as soon as possible, the corporation should start earning income and establishing a healthy cash flow. The amount of cash flow will also affect the subsequent share price.

 

How much seed capital will you need to reach a particular initial share offering goal?
(Based on Nesheim, 2000, p. 181-83.)

Your end goal is to have enough funds to enable pre-release shareholders to cash in their shares without wiping out the share price.

  1. Start with:
    1. a target date for the end of the initial business plan. For example, the target date could be a four-year date to start the early investors' exit plan, or the IPO as a public company.
    2. a target company valuation at that time, for example, $100 mil. at IPO for a public company.
    3. a dollar value of shares at that that time.
  2. Work backward from the end of the business plan based on ROI. Work out how much revenue you will need to reach the goal.
  3. This will tell you how much seed capital you need to reach your goal. It will also give you revenue and ROI targets.

Note that you are caught in a squeeze, because you need to make higher than industry profits:

  1. Your capital is relatively expensive, because your risk levels are high and you need to offer fairly high ROI to your investors.
  2. You will need strong enough finances to buy back the early investor shares.
  3. Founders, who are probably majority shareholders, get their first round of shares for nearly free, but thoses shares also need to have value.

 

Share pricing factors

  1. Consider the price of similar stocks in other similar companies following similar trajectories.
  2. Consider various business ratios:
    1. Earnings Per Share (EPS)
    2. Price to Earnings (P/E) ratio for the last year or four quarters
    3. Growth rate
    4. Industry average ROI
    5. Price Earnings to Growth (PEG) Ratio
    6. Anticipated cash flow (not necessarily profits)
    7. Return on invested capital
    8. Expected ROI per year for the next four years
    9. Will this be attractive for new share issues?
    10. Will it continually need fresh capital?
    11. What proportion of vested shares and share options have been issued?
  3. Financial structure:
    1. What proportion of the invested capital does the company plan to use?
    2. How much will be put into low-risk investments?
    3. How much debt does the company carry? (Debt is cheaper than capital, because interest is tax deductible.)
    4. Etc.
  4. See also http://en.wikipedia.org/wiki/Stock_valuation for more business ratios.

 

Nesheim advises:

 

Simple and complex forms

The calculation would be simplified by eliminating founders’ shares and pre-release shares, which are issued below the price of the initial share offering. In other words, the money put in through full-value shares has to work much harder just for these other shares to catch up. Then again:

It would also be easy to make the formula more complex by:

 

Reference

Nesheim, John L. 2000. High Tech Start: The Complete Handbook for Creating Successful New High Tech Companies (New York: The Free Press). See esp. pp. 181ff. See also pp. 112ff, 255ff.