## The Venture Capital Method – Basic Startup Valuation

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.

### Definitions:

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

Example:

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.

October 19, 2018

Shouldn’t the terminal value be discounted to its net present value using the formula tv/(1+r)^n

Where tv= terminal value

R= roi

N = harvest period( could be 3, 5 or 7 years)