It can be challenging to derive the price or value of a startup, when the company has not generated revenue yet. The Venture Capital Method arrives at a value by estimating what the company will achieve several years with an investment made today.
Our goal: identify the current value of a startup, before an investment is made (pre-money valuation)
This valuation method was first described by Professor Bill Sahlman at Harvard Business School in the late 80s and has been slightly modified since.
Before I walk you through the process, I want to offer you a free Google Sheets calculator to derive the pre-money valuation using the Venture Capital Method. The link to the calculator can be found on the bottom of this post.
First, let’s cover the basic keywords used in this valuation method.
- Harvest year: the time (year) that the investor plans to exit the startup. Example: the investor plans to invest today and withdraw his shares in 5 years. Year 5 would the investor’s harvest year.
- Pre-Money Valuation: the value of the startup before any investment has been made
- Post-Money Valuation: the value of the startup after an investment has been made.
- The formula for post money valuation is as follows:
Post-Money Valuation = Pre-money valuation + investment amount
- P/E: price / earnings. For a public company, this would be the stock price / earnings. A P/E ratio of 5 would indicate that an investor is pricing the value of a stock 5X $1 in earnings. You can find industry average P/E ratios on the here.
The Venture Capital Method: Process of valuation
The valuation is a 2-step process.
- First, we want to derive the terminal value of the business in the harvest year.
- Second, we work backwards using our (desired) ROI and investment amount to derive the pre-money valuation.
Calculating terminal value
We need the following inputs:
- Projected revenue in harvest year
- Projected (or industry average) profit margin in harvest year
- Industry P/E ratio
Terminal Value = projected revenue * projected margin * P/E
Terminal Value = earnings * P/E
Suppose a software company projects to generate $20M in revenue in 5 years (harvest year). It projects to have a profit margin of 10%. The industry P/E ratio is 25. Therefore, the terminal value = $20M * 10% * 25 = $50M
Calculating the pre-money valuation
We need the following inputs:
- Required return on investment (ROI)
- Investment amount
Pre-Money Valuation = Terminal value / ROI – Investment amount
Suppose the investor requires a return of investment of 20X. He plans to invest $1.5M.
Pre-Money Valuation = $50M / 20 – $1.5M = $1M
Finally, we have arrived at the current value of the startup before any investment has been made. The current value is $1M.
Using an investment of $1.5M, some assumptions on the growth projections and industry PE ratio, the company will be worth $50M.
Pros & Cons of the Venture Capital Valuation Method
- Pro: conceptually, it is easy to understand and implement
- Con: Besides the industry average P/E ratio, many of the required inputs are based on assumptions and “desires”. If you feed the model with wrong assumptions, you will derive at a wrong value.
Free Pre-Money Valuation Calculator
In conclusion, the Venture Capital Method of valuation is an easy approach to derive the value of a startup that is not generating any revenue, yet. To see the calculations live in action, find a link to our free calculator below.
Find the free pre-money valuation calculator using the venture capital method here.