What is the Venture Capital Startup Valuation Method?
What is it?
The last one of the pre-money, pre-revenue startup valuation methods I've been covering, the Venture Capital method is the preferred method for VCs all around (that's pretty much from where it got the name).
Deal sourcing entails a long process of discovery and analysis of potential startups to incorporate to a VC portfolio. When it comes to pre-revenue startups there is also a void of financial data to extract projections, thus the analysis must rely on more qualitative methods, and those are by nature slower to evaluate.
The Venture Capital valuation method provides a simple solution to get a ballbark valuation of any startup.
How it works
Money comes back to the investor's pockets whenever there is a liquidity event in the startup. Normally it is an exit (the startup is bought by another company), or it could be an IPO (Initial Public Offer, when the startup goes public and is listed in the stock market).
At the moment of investing, the investor has an expected rate of return on the investment. That expected rate of return is expressed as:
Return Of Investment (ROI) = Exit Value / Post-money Valuation
Thus the Post-money Valuation is calculated as:
Post-money Valuation = Exit Value / ROI
What do each one of these terms mean?
Exit Value (also known as Terminal Value): this is the value the startup is expected to be sold for. The terminal value is normally calculated using market multiples, which merits a post on its own. I might write one in the future to learn more about the topic but in the meantime this post provides a good primer on the different types that are generally used.
Since startups lack public data, normally the best way to get to an approximate number is to use data from the Private Equity/Venture Capital databases of similar companies.
Return Of Investment (ROI): also known as Rate of Investment or Rate of Return, it represents the multiple of the initial investment the investor expects to see in return. Startups are risky investments thus the ROI aims to cover the risk involved. It is common among Venture Capital funds to have portfolios of between 5-10 companies at minimum to spread the risk and expect a return of at least 10x in one to cover for the failing ones.
Post-money valuation: the company valuation after the investment has been made. It equals the Pre-money valuation plus the additional equity received from outside investors.
Example
Having our curiosity piqued by the financial markets and trading industry, we start to scout for companies that cater to provide advancements in algorithmic trading strategies, wealth and portfolio management, and such.
Eventually, we stumble upon AssistedWealth, a new startup developing a robo-investor that uses a particular mix of traditional low-risk index fund & bonds strategies with a bunch of proprietary machine learning & statistical models to allow clients with a higher appetite to risk to allocate a variable part of their portfolios to them and try to beat the index.
The interest retail investors have for investments that fall beyond the traditional real estate & index fund approach has been soaring on recent years, so the startup has multiple venture capital firms interested in putting some money in the project.
The biggest firm has a $100M fund and is thinking of investing a potentially large chunk in the company as they expect it to skyrocket and provide at least 70x return. They decide to use the Venture Capital valuation method to evaluate the company.
The venture capital firm has a proven track record of successful fintech startup exits and based on private historic data and prior purchase of several startups in their portfolio they estimate an exit value of $500M.
With these numbers in place we go back to the original formula:
Return Of Investment (ROI) = Exit Value / Post-money Valuation
Translated into:
70 = $500M / Post-money valuation
And therefore:
Post-money valuation = $500M / 70
Giving us a post-money valuation of $7.14M.
The venture capital fund was thinking of investing between $1-2M based on the final valuation and their gut feeling. Eventually, they split the difference and invest $1.5M, providing a pre-money valuation of AssistedWealth of:
Pre-money valuation = Post-money valuation - equity invested
$7.14M - $1.5M = $5.64M
Have fun!
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References
- https://www.venionaire.com/venture-capital-method/
- https://www.venturevaluation.com/en/methodology/valuation-methods#:~:text=Method%3A%20The%20venture%20capital%20method,the%20risk%20the%20investors%20takes.
- https://www.wallstreetprep.com/knowledge/vc-valuation-6-steps-to-valuing-early-stage-firms-excel-template/
- https://thebusinessprofessor.com/en_US/business-personal-finance-valuation/venture-capital-method