What is the First Chicago Startup Valuation Method?

15 Oct, 2022

The meta image of this post is the result of using the sentence "A tropical forest with a monkey and a flamingo painted with the style of Frida Kahlo" in DALL-E 2

What is it

The First Chicago valuation method differs from other methods I've listed up until now, like Scorecard, Berkus or Venture Capital, in the fact that not only qualitative analysis come into play, but additional financial projection is needed to implement it.

While other methods are fundamentally pre-revenue and rely more on market analysis, comparison with other startups or risk management analysis, the First Chicago method depends on cashflow and earnings to calculate the final valuation, thus a level of growth & revenue is expected in the startup.

How it works

The whole valuation method revolves around this given formula:

First Chicago Formula

The rest of the valuation process is to follow a set of steps to fill-in the blanks and eventually achieve what they call the Enterprise Value (EV), or final valuation.

The main idea of the First Chicago method is to take into account all the possible scenarios a given startup can go through, estimate the valuation per each one of the scenarios, and multiply them by the possibility of that scenario happening.

Once that is done, the total sum of all those valuations weighted by probability represents the average valuation the company is considered to be at.

Step 1: Set the scenarios

One must determine the future scenarios the startup may be facing. Then, considering all the possible shifts of the company taking into account market trends data, establish a bunch of possible cases. Normally 3 scenarios are considered but more can be added depending on the nature of the project.

Best-case
Mid-case
Worst-case

Each scenario means different things to the company, being the Worst-case normally bankruptcy and Best-case a strong exit.

Step 2: calculate the valuation for each one of the scenarios within a given time horizon

This is where the hard formula comes into play. To give a simple explanation, the valuation of a company in a given scenario (best, worst, mid, etc...) is represented by the addition of the Terminal Value discounted to the period in time we want to calculate it, plus the sum of the expected cash flows that we think the startup will have each year until the time horizon discounted by the rate of return.

For the Terminal Value as per the Venture Capital method we must find a market multiple that provides an acceptable rate of return. For the expected cash flows, the required rate of return will be used to discount the value of each year's cash flow.

Terminal Value is the value of an asset or business in a given period of time where the future cash flows can be estimated, normally for startups it's used just for the exit value.
Discount Rate determines the present value of your future cashflows by applying a discount as a measure of the risk of projecting those cashflows into the uncertain future.

Step 3: calculate the probabilities of each scenario happening

To this step, one must mix the financial projections magic with a keen eye to evaluate how likely it is that each of the scenarios in Step 1 is to materialize.

Since statistics about startup exits generally establish that 90% of startups fail, it's not far-fetched to use a 10-15% probability for the best-case scenario, a 20% possibility for the mid-case scenario, and a 70-75% probability of the worst-case scenario. Again, this depends heavily on the nature of the project, its industry, location, etc...

Step 4: Calculate the weighted valuation by executing the formula

Finally, with all the parameters estimated separately, we apply the Enterprise Value formula to get the weighted valuation taking all the scenarios into account.

Example

We are a deeply experienced venture capital analyst looking to discover the next gem in the Computer Vision industry. After plenty of study, discovery, and entrepreneurship meetups & conferences we stumble upon Yateveo (in Spanish "I already see you") promising startup applying Computer Vision and Deep Learning to track in realtime the faces of customers inside a shop to estimate the probability of them to buy a given item based on the expressions they show when looking at those items. By doing so, shops can decide to double increase the stock of certain items before they run out of them and conversely, discard those that are not very popular earlier in time.

This startup has been operational for several years now and they've achieved breakeven after having an initial Seed round and are slowly gaining traction and profitability. They are now looking to do a Series A and are in the process of negotiating with possible investors.

We decide to use the First Chicago method to arrive at a valuation we feel comfortable with so we know what to expect.

We estimate that there are three possible scenarios the startup can end up in. For each scenario, we use the formula with the Terminal Value and expected cashflows in the future basing ourselves on the historic financial data of the company and our own gut feeling about the future of the industry to arrive at a realistic valuation.

Best-case scenario: $50M after being bought by a big advertising conglomerate or a FAANG. Perhaps a media broadcasting company as well, since the product could be adapted. The probability of this happening is 10%.
Mid-case scenario: $30M, growth is steady but not skyrocketing and they are acquired at a smaller price. We estimate this happening with a 20% probability.
Worst-case scenario: $10M, the market is saturated and now everyone is working on AI-related products, they don't get traction and they have to sell their assets to a really small price. The probability of this happening is 70%.

Finally, with each one of the valuations and probabilities estimated separately, we calculate the weighted Enterprise Value:

EV = 50M x 0.1 + 30M x 0.2 + 10M x 0.7 = $18M final valuation

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References

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