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
(in the case of one investment round, no subsequent investment and therefore no dilution)
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.
Anticipated ROI: Angel investing is risky business. Based on the Wiltbank Study, investors should expect a 27% IRR in six years. Most angels understand that half of new ventures fail and the best an investor can expect from nine of ten investments is return of capital for a portfolio of ten. Consequently, the tenth investment must be a home run of 20X or more. Since investors do not know which of the ten will be the homerun, all investments must demonstrate the possibility of a 10X-30X return. Let’s assume 20X for purposes of this example.
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.
Written by Bill Payne
You might also be interested in
When entrepreneurs come to me with that “million dollar idea,” I have to tell them that an idea alone is really worth nothing. It’s all about the execution, and investors invest in the people who can execute, or even better, have a history of successful execution. Execution is making things happen, and for startups it usually means making change happen,
I’ve always wondered who started the urban myth that the best way to start a company is to come up with a great idea, and then find some professional investors to give you a pot of money to build a company. In my experience, that’s actually the worst way to start, for reasons I will outline here,
Steve Jobs was one of those entrepreneurs who seemed universally either loved or hated, but not many will argue with his ability to innovate in the technology product arena over the years. He was instrumental in creating Apple, which has pioneered a dazzling array of new products, and even surpassed Microsoft, to become the
If you are a new entrepreneur, or entering a new business area, it’s always worth your time to assemble an Advisory Board of two or three executives who have travelled that road before. You need them before you need funding, and if you select the wrong people, or use them incorrectly, no
Helpers do what you say, while good help does what you need, without you saying anything. People who can help you the most are actually smarter than you, at least in their domain. Top entrepreneurs spend more time putting the right team in place to accomplish their objectives than they spend on any