Startup Valuations: The Venture Capital Method

February 5 2011 18 Commented

We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors. 

The Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since.  It is one of the useful methods for establishing the pre-money valuation of pre-revenue startup ventures.   The concept is simply…since:                                                     

Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation

(in the case of one investment round, no subsequent investment and therefore no dilution)

Then:  Post-money Valuation = Terminal Value ÷ Anticipated ROI

So, let’s address each of these:

Terminal Value is the anticipated selling price (or investor harvest value) for the company at some point down the road; let’s assume 5-8 years after investment.  The selling price can be estimated by establishing a reasonable expectation for revenues in the year of the sale and, based on those revenues, estimating earnings in the year of the sale from industry-specific statistics.  For example, a software company with revenues of $20 million in the harvest year might be expected to have after-tax earnings of 15%, or $3 million.  Using available industry specific Price/Earnings ratios, we can then determine the Terminal Value (a 15X P/E ratio for our software company would give us an estimated Terminal Value of $45 million).  It is also known that software companies often sell for two times revenues, in this case, then, a Terminal Value of $40 million.  OK…let’s split the difference.  In this example, our Terminal Value is $42.5 million.

Anticipated ROI:  Angel investing is risky business.  Based on the Wiltbank Study, investors should expect a 27% IRR in six years.  Most angels understand that half of new ventures fail and the best an investor can expect from nine of ten investments is return of capital for a portfolio of ten.  Consequently, the tenth investment must be a home run of 20X or more.   Since investors do not know which of the ten will be the homerun, all investments must demonstrate the possibility of a 10X-30X return.  Let’s assume 20X for purposes of this example.

Assuming our software entrepreneurs needs $500,000 to achieve positive cash flow and will grow organically thereafter, here’s how we calculate the Pre-money Valuation of this transaction:

 From above:  Post-money Valuation = Terminal Value ÷ Anticipated ROI = $42.5 million ÷ 20X

                                Post-money Valuation = $ 2.125 million

                                Pre-money Valuation = Post-money Valuation – Investment = $2.125 – $0.5 million

                                Pre-money Valuation = $1.625 million 

OK…but what if the investors anticipate the need for subsequent investment?  I have seen some complex methods for accommodating anticipated dilution, but here is an easy way to adjust the pre-money valuation of the current round.  Reduce the pre-money valuation (above) by the estimated level of dilution from later investors.  If investors in this round anticipate eventually being diluted by half, the pre-money valuation for the current round would be about $800,000.  If only 30% dilution is anticipated, reduce the pre-money valuation of this round by 30% to about $1.1 million. 

Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for these seed/startup companies.  The Venture Capital Method is often used as one such method.  In a recent post, I described the Scorecard Method, another very useful method.  In future posts, I will describe additional valuation methods.

18 Responses to “Startup Valuations: The Venture Capital Method”

  1. Andy says:

    Bill,

    Thanks for the clear, concise explanation.

    I understand that from a portfolio perspective, VCs need to try for a home run every time, so that they can end up with a 27% IRR on the portfolio, after netting out the losers.

    If that is the model, entrepreneurs should avoid getting in bed with VCs at all costs. Better to bootstrap, bootstrap, bootstrap.

    Here’s why:
    The VCs will pressure every portfolio company to be “the one,” the grand slam. Statistically, only one in 10 will make it. The other nine will fail or underperform, setting up inevitable conflict. (Would you get on an airplane that only had a 1-in-10 chance of landing safely?) Many will fail because the VC pressure drives excessively risky decision-making, especially over-expansion. A self-funded company can grow at a healthy rate, without needing to outrun its capital, systems, or culture.

    A 20x return model may make sense for the VC on one in ten investments. It does not make sense for even 1 in 100 founders.

    Furthermore, if VCs need a 20x winner in order to balance the risk in their portfolios, they shouldn’t also need a 27% IRR to compensate themselves for being such risk-takers. That’s just plain greedy. Of course, the real reason they want to have loanshark level returns is that a high IRR enables them to go out and raise ever larger funds. Their 2% management fee makes for a pretty cushy risk-free income once they get a couple hundred million under management. And their 20% cut of the profits on OPM (other people’s money)can be enormous in a big fund, even if their investors don’t do all that well.

    Unfortunately, the poor performance of most VC funds over the last decade (the vast majority of funds ran below 10% IRR, and many actually lost money)means that they are now more desperate for the home run, and less likely to even consider investing in a solid business that might make them a 2x to 5x cash-on-cash return.

    Fortunately, many exciting business models today do not require huge start-up funding. This makes it easier to rely on savings, friends and family, bootstrapping, and your day job.

  2. admin says:

    Thanks, Andy, for your comments!
    First, a clarification. I am an angel investor. The “Venture Capital” valuation method is only one of several methods we angels use to establish a pre-money valuation for pre-revenue companies. We angels invest our own money. Unlike VCs, we don’t raise funds and, consequently, are not motivated by carried interest, administrative fees or raising additional funds.
    Secondly, I agree with you that (1) if an entrepreneur can bootstrap a company to positive cash flow and organic growth – go for it. Raising money from anyone is painful and time-consuming. And, (2) it definitely is less expensive to start companies than it has been in past. Go entrepreneurs!
    Please understand that we angels only invest in entrepreneurs who choose to scale their companies to 20X or more in 5-8 years. It is not about pushing them for growth…they have chosen a high growth enterprise, or we would not have invested in their companies.
    Finally, we angels invest both time and money in our portfolio companies. Josh Lerner, a pretty famous HBS professor, has studied angel investors and determined that entrepreneurs who receive funding from angel investors actually report that the time angels invest as mentors and directors is more valuable that the capital we invest. So, I think you will find that we angels are not pushing entrepreneurs towards failure as much as we are helping them to succeed.
    Bill Payne

  3. Rodney says:

    Many thanks for the insight. I’m working with a start-up now that is pre-revenue and we were stuck in determining a pre-money valuation. We now have a benchmark when talking to potential angels.

  4. Peter says:

    Bill,
    It takes a good engineer to simplify money matters and remove FUD in what should be a simple process. Thank you for your post. How does the new IRS 1202 exemption (100% capital gains tax free) if held for 5 years or more. Will this change the math given a 10x plus potential investment gain and tax free monies. The 1202 is only available thru Dec 31, 2011.
    Thanks for your informed response.
    Peter

  5. admin says:

    Thanks, Peter
    Frankly, valuation and ROI are estimates, at best. Furthermore, we have no idea what changes in the tax law will take place between now and exit. Congress giveth and Congress taketh away:-) So we usually would not take taxes into consideration in determining the pre-money valuation of pre-revenues companies.
    Regards,
    Bill

  6. Michael says:

    Bill,

    We launched our first product last week which is a direct to consumer web app. We are just starting to see revenue and will stick with our immediate social networking and local marketing efforts until we feel that the product is ready for a wider audience. The problem – and it’s a good one – is that our target market for our second build phase (institutional white labeling) is already calling thanks to a small write up in the local business journal.

    Certainly we want to get this business while they’re knocking on the door, but we don’t have the financial or human resources to build this yet. We anticipate upwards of $500k will be required to build, market, and sell this next phase.

    So here’s the quandary: Do we stick with our original plan and delay the institutional opportunity for one year or should we go out and get the capital since we already have customers asking for it?

    In addition, at what point would we be able to secure $500k? Is there a particular milestone, revenue/profit level, trajectory, etc. where we would definitively justify that kind of investment?

  7. admin says:

    Hi Michael-
    Sounds like you have a tiger by the tail. My suggestions are as follows:
    1. As long as you have traction there, maintain focus on the consumer app. Success is all about focus, focus, focus!
    2. Realize that it will likely take 4+ months and a bunch of your time to raise $500K. See #1 above…focus. You will not be able to raise capital quickly enough to satisfy your early institutional inquiries.
    3. Keep your eyes open for opportunities. Perhaps one of the institutional users will eventually want the app badly enough to pay for your development. What a concept!
    4. But…summary: Don’t get distracted. Raise money when it makes sense to the management team.

    When to raise angel capital? If you have measureable revenues, you are already there. But, don’t raise money unless you absolutely must. Bootstrap as long as possible. If you do have to raise money, with revenues your valuation will be higher and you sell less ownership for equity investment.

    Good luck,
    Bill

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    Tommy
    Small Business

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  17. Carlos says:

    What is the pre-money valuation used for? To be used as a metric for selling the startup outright even before seed financing? For the Angel to ensure that the startup is worth more than the seed investment being asked for? Please elaborate.

    Regards,
    Carlos

  18. admin says:

    Hi Carlos- Thanks for your inquiry. Some time ago, I linked to some good fundamental materials on Valuation. Please search my website for “Kevin Learned”. A blog will be the only citation and that blog has links to four articles explaining valuation to entrepreneur. Good luck! Bill