On Startups Valuation (Part I): The Venture Capital Method

As more and more startups try to raise capital from the scarce investment pools available, valuations have been a trending topic. Both sides argue for finding a middle ground using assumptions and unrealistic expectations. How to determine a startup valuation

Should I, as a founder, value my company on multiple comparisons with peers but discount it under the current inflationary scenario to arrive at fair value? What if my company is at a pre-revenue stage? Should I use expected sales and forecasted cashflows as guidelines?

Change “founder” for “investor”; as expected, both sides argue about finding that middle ground.

The reality is that academic researchers and practitioners alike have developed various methodologies to arrive at a “negotiable range” or “negotiating starting point” about valuation.

Amidst the current market turbulence, both parties risk being undervalued (founders) or overpaying (investors). Furthermore, as an entrepreneur, your startup valuation must be sensical and reflect the established expectations. Otherwise, you risk having a down-round and being devalued.

In this journal entry, I invite you to explore one of the most straightforward methods for estimating a “valuation distribution,” with a small amount of sensitivity analysis and scenario modeling, you can go well prepared to the table considering the current macroeconomic conditions and capital scarcity. Let's dive in!

Understanding the Venture Capital Method: 

This method estimates a startup's pre-money valuation by considering the projected exit value, expected returns, and the required rate of return for investors. It is widely respected by investors and academics, being included as a practical method by the CFA Institute.

Step-by-Step Process for Conducting Startup Valuation through the VCM:

1. Grasp the Startup's Business Model and Industry: To begin the valuation process, it's crucial to gather comprehensive information about the startup's business model, target market, competition, geography, growth potential, and more. Consider any unique factors that might influence its success. As you will have to determine a comparable valuation, ensuring your classification aligns with a high comparability index will facilitate the determination of its fair value.

1. Identify Comparable Exit Multiples: Research and identify similar companies within the startup's industry that have recently achieved successful exits. Leverage the above data structuring process from step #1 to arrive at a formidable comparison. Analyze their exit valuations and calculate exit multiples, adjusting using the weights calculated in step #1. For the extra sauce, estimate ratios such as exit valuation-to-annual revenue or exit valuation to the active user base.

2. Assess the Startup's Growth Potential: Evaluate its growth trajectory, market size, competitive advantages, intellectual property, management team, and other factors influencing its potential for a successful exit. Each factor can be added as a “sum of parts” to the estimated exit value discounted.

1. Estimate Future Exit Value: Based on an estimated exit timeframe (e.g., 5-7-10 years), apply an appropriate exit multiple to the startup's projected financial metrics at the time of exit (e.g., revenue, earnings). Adjust the future exit value considering the startup's growth potential and market conditions. Consider approaching these metrics using a factor modeling based on genuine comparables such as those selected in step #1. These metrics tend to be very factor sensitive and, as such, may skew your valuation toward ranges that may be realistic. Try using Pitchbook or Crunchbase to tackle those expected exit values comparables.

1. Determine the Required Rate of Return: Evaluate the risk associated with the investment and determine the required rate of return. Consider factors such as the startup's stage, market conditions, competition, management team, and other relevant risks. Remember to adjust for a country risk premium. It’s not prudent to value a startup in Italy using the Silicon Valley ecosystem as a proxy. Damodaran’s table works great for this estimation, particularly when evaluating startups from emerging markets or outside the United States. After all, he is considered the “Godfather of Valuations.” For a more in-depth look, check out his prestigious book on Valuations. #ad

2. Calculate the Pre-Money Valuation: Apply the Venture Capital Method formula to calculate the pre-money valuation:

3. Perform Sensitivity Analysis: If you have gotten to this step, it’s obvious to have conducted a sensitivity analysis, but if not, consider this your second warning. Just like traders at JP Morgan do so in their public market trade books, you have to in your private market doings. Conduct a sensitivity analysis by varying key assumptions like exit multiple, exit timeframe, and required rate of return. This analysis helps assess the impact on pre-money valuation under different scenarios and gives you a range of valuations instead of a single one.

Now let’s dive into a straightforward example, followed by a more robust real-case scenario. If you’d enjoy this entry, please consider sharing it with the community and subscribing for subsequent entries.

Using the Venture Capital Method - Single Round (Example)

Let's consider a hypothetical early-stage startup, XYZ Tech, operating in the software-as-a-service (SaaS) industry.

Assumptions:

Future Exit Value: $100 million (estimated using comparables for XYZ Tech)

Exit Timeframe: 5 years

Required Rate of Return: 30% (adjusted using Rf + ERP + CRP)

Calculations: 

Pre-Money Valuation = $100 million / (1 + 0.30)^5

Pre-Money Valuation = $46,310,092

In this example, XYZ Tech's estimated pre-money valuation using the Venture Capital Method is approximately $46.31 million.

Using the Venture Capital Method - Single Round (Robust Example)

Jirau Biotherapeutics is a biotechnology company that develops gene therapies for orphan diseases associated with carbohydrate metabolism. Jirau’s Board of Directors and founders believe they can sell the company for $100 million in seven years. They need $5 million of investment capital to complete their phase I clinical trials for their therapy. Founders would like to keep at least 1 million shares fully issued.

The venture capital firm, XYZ Capital, decides that given the high risk of this company, a discount rate of 45% is appropriate. As an analyst, you are tasked with calculating the pre-money valuation, post-money valuation, fraction of ownership for this venture, and price per share (PPS), applying the venture capital method with a single financing round discounted to net present value.

Assuming that you, as an analyst with access to the above step-by-step information, compile the data required to assess the company (e.g., completing step #1 of the process), it would go as follows:

1. Post-Money Valuation=Post = $100,000,000 / (1 + 0.45)^7Post = $7,420,343

2. Pre-Money Valuation =Pre = $7,420,343 - $5,000,000Pre = $2,420,343

3. As an investor allocating $5M in a biotech company worth $7.4M, XYZ must own at least 67.38% of Jirau’s:Ownership Fraction = $5,000,000 / $7,420,343Ownership Fraction = 67.38%

4. Considering that the Founders want to keep at least 1 million shares for themselves, you, as an analyst, must consider what your firm gets to keep to obtain the 67.38% of ownership:XYZ Shares: 1,000,000 (0.6738/[1-0.6738)])XYZ Shares: 2,065,604 shares

5. Therefore, given a $5M investment by XYZ Capital into Jirau, the stock price per share equates to:PPS = $5,000,000/ 2,065,604 sharesPPS = $2.42 

Valuation exercises through the Venture Capital Method can get more and more complex as we add multiple financing rounds to the equation (although it should be quite logical). Furthermore, the Venture Capital Method is not the only way to estimate a valuation or range of valuations in this sense. Methods like Comparable Company Analysis (CCA), Discounted Cash Flow Analysis (DCF), Risk Factor Summation (RFS), and Scorecard Valuation (SCV), amongst other more complex ones, are there to fit most situations and modeling exercises for both venture capitalist and startups alike.

Furthermore, for more advanced companies with a vast enough data room, including detailed financials and other quantitative metrics, a 409A valuation may make more sense in the end when calculating fair market value but can prove difficult as it requires a more advanced understanding of equity, debt, and other intricacies on valuations. We will cover these in due time.

Likewise, if you are deeply interested in learning more about Valuations, I can’t recommend Aswath Damodaran’s book enough, “Valuations.” It is considered the “Bible of Valuations.” #ad

Subscribe to my journal as I look to address these other methodologies and help both founders and investors with the required toolbox (or set) of techniques to properly and consciously value their intended investments and current investment portfolio in a fair market approach.