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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

user Bill Payne Angel Investor ,
Frontier Angel Fund

Bill Payne has been actively involved in angel investing since 1980. He has funded over 50 companies and mentored over 100. He is a founding member of four angel organizations: Aztec Venture Network, Tech Coast Angels, Vegas Valley Angels, and Frontier Angel Fund.

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Comments

5 thoughts on “Valuations 101: The Venture Capital Method”

  1. V Egitaboss says:

    here’s how we calculate the Pre-money Valuation of this transaction.

  2. ProspectStream says:

    Bill, you are an angel. Thank you for posting this clear and concise description.