Valuations 101: The Venture Capital Method
We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors.
The Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since. It is one of the useful methods for establishing the pre-money valuation of pre-revenue startup ventures. The concept is simply…since:
Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
Then: Post-money Valuation = Terminal Value ÷ Anticipated ROI
So, let’s address each of these:
Terminal Value is the anticipated selling price (or investor harvest value) for the company at some point down the road; let’s assume 5–8 years after investment. The selling price can be estimated by establishing a reasonable expectation for revenues in the year of the sale and, based on those revenues, estimating earnings in the year of the sale from industry-specific statistics. For example, a software company with revenues of $20 million in the harvest year might be expected to have after-tax earnings of 15%, or $3 million. Using available industry-specific Price/Earnings ratios, we can then determine the Terminal Value (a 15X P/E ratio for our software company would give us an estimated Terminal Value of $45 million). It is also known that software companies often sell for two times revenues, in this case, then, a Terminal Value of $40 million. OK…let’s split the difference. In this example, our Terminal Value is $42.5 million.
Assuming our software entrepreneurs needs $500,000 to achieve positive cash flow and will grow organically thereafter, here’s how we calculate the Pre-money Valuation of this transaction:
From above: Post-money Valuation = Terminal Value ÷ Anticipated ROI = $42.5 million ÷ 20X
Post-money Valuation = $ 2.125 million
Pre-money Valuation = Post-money Valuation – Investment = $2.125 – $0.5 million
Pre-money Valuation = $1.625 million
OK, but what if the investors anticipate the need for subsequent investment? I have seen some complex methods for accommodating anticipated dilution, but here is an easy way to adjust the pre-money valuation of the current round. Reduce the pre-money valuation (above) by the estimated level of dilution from later investors. If investors in this round anticipate eventually being diluted by half, the pre-money valuation for the current round would be about $800,000. If only 30% dilution is anticipated, reduce the pre-money valuation of this round by 30% to about $1.1 million.
Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for these seed/startup companies. The Venture Capital Method is often used as one such method. In a recent post, I described the Scorecard Method, another very useful method. In future posts, I will describe additional valuation methods.
How does your venture stack up? Get free investor-grade startup feedback in just 15 minutes >>
Written by Bill Payne
You might also be interested in
Canada has not tapped its female angel investor potential – yet.
The female angel investor conversation has been discussed inside and out. From TechCrunch, BetaKit to the Financial Post, there have been more than a few arguments made about the lack of female representation in Canada’s early-stage investment community and the benefits of tapping into this financial resource.
One of the most common questions we get is: What are the biggest challenges and rewards of angel investing? High net worth individuals become angel investors for a number of reasons, but the opportunity to work with entrepreneurs and provide guidance to founders is typically high on the list. In this video, angel investor Chenoa Farnsworth explains why, interestingly, both the biggest
Entrepreneurs seem genuinely surprised to find that investors in Peoria or Little Rock are not willing to invest in startup companies at Silicon Valley prices. After all, they just read in TechCrunch that investors funded a company similar to theirs at an $8 million pre-money valuation!
The valuation of startup companies shouldn’t be impacted by location, should they? Guess again!
The first question you need to ask is “What country are you in?” and the second is “Are you an Accredited Investor by that country’s standards?”
If we’re talking about the US and you are NOT at the Accredited level ($1 million in investable assets, or $200,000 annual income), then for the moment you are actually not allowed to invest in privately held startups
First, it’s important to understand that the four platforms you list fall into two very distinct groups.
Kickstarter and IndieGoGo are project-based crowdfunding platforms through which anyone can contribute money, either as a donation or with the promise that they will receive a tangible ‘reward’ of some kind if the project is successful.
Gust and AngelList are equity-based platforms, used by Accredited Investors to facilitate the investment of money for an ownership interest in