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Venture Capital Method
The venture capital method (VC Method), as the name implies, is most commonly used in the venture capital industry and for valuing startup ventures. As discussed in separate lectures, investors seek to capitalize on their investment via an exit at some future date in the startup’s lifecycle. Investors will seek a return equal to some multiple of their initial investment or will seek to achieve a specific internal rate of return based upon the level of risk they perceive in the venture. The VC method incorporates this understanding and uses the relevant time frame in discounting a future value attributable to the firm.
The future value of the firm can be determined by any of the previously described methods, including the discounted cash flow or using market multiples. Using market multiples is the most common method of arriving at a terminal value, because a projection of future cash flow at that point would be excessively speculative. The parties will generally use a price to earnings ratio to calculate the terminal value. Once a terminal value is calculated, the post-money value is calculated by discounting (dividing by a discount factor) that represents an investor’s expected or required rate of return. The investor seeks a return based on some multiple of their initial investment. For example, the investor may seek a return of 10x, 20x, 30x, etc., their original investment at the time of exit. The required multiple is based upon the risk perceived by the investor. The higher the risk, the higher the return required. Also, angel investors generally have a portfolio of approximately 10 companies. If statistically 6 will lose money and 3 will break even, the angel investor needs the successful venture to carry the entire portfolio. As such, the investor will seek a minimum of 10x return in most (if not all) of its invest. On average, the entire VC portfolio returns about 27% on average.
Below is an illustration of the calculations.
- Return on Investment (ROI) = Terminal Value ÷ Post-money Valuation
- Post-money Valuation = Terminal Value ÷ Anticipated ROI
If the investor expects 10x as her return on investment and her terminal value is $10,000, then the post-money valuation will be the terminal value divided by 10 or $1,000.
- Pre-money Valuation = Post-money Valuation – Investment amount.
If the investor invests $250 for 25% of the ownership interest, the pre-money valuation is $750.
Taking Dilution into Consideration
The above formula demonstrates the venture capital method in its purest form. If, however, the startup is likely to need additional capital prior to an exit event where the investor can liquidate her investment, she will be diluted by the follow-on issuance if she does not participate. The investor will account for and attempt to mitigate this risk in a number of ways. The investor may seek anti-dilution protection, but exceptions to these provisions are often crammed down by the follow-on investors. There are also complicated formulas used to calculate probability of future funding rounds. A simple manner to address the threat of future dilution is to make a strategic guess as to the future capital needs of the firm and calculate what level of dilution that would be. You will calculate dilution for a scenario where the firm meets its optimistic projections, grows but misses it projections, and a scenario where it stays flat in its growth. Average the expected dilution between these scenarios and reduce the post-money valuation by this percentage.
Issues with the Venture Capital Method
The VC Method (discussed in a separate lecture), while the dominant method used in early stage investment, has numerous shortfalls. First the VC method requires reliance on projected growth and future revenues. As discussed below with regard to income-based valuation methods, projecting company revenue at a future date is extremely difficult and speculative. Further, the VC method relies upon valuation multiples in deriving a terminal valuation. All of the issues identified in market-based valuations make this method less certain. Lastly, the discount rate of return or multiples required by investors is a subjective determination based upon the perceived risk of a given investor. There is no fixed method for assessing risk associated with the subject business. Therefore, the VC method can produce wildly varying results between investors.