Valuation Methods: Spotlight on the Venture Capital (VC) Method
Worthworm uses a blend of questions from some of the most popular valuation methods, including the Venture Capital (VC) Method. This methodology calculates a valuation using the venture’s anticipated value and ROI. Learn more about it in our Valuation Methods Spotlight on the VC Method.
Choosing valuation methods is one of the many confusing challenges of startup funding negotiations. There are several popular methods, each with its own approach to determining how much a venture is worth. Previously, we’ve discussed the Berkus Method and the Scorecard Method. Now, let’s take a look at the Venture Capital (or VC) Method.
This method was created by Harvard Professor Bill Sahlman in 1987 and is one of the most popular methodologies for valuing pre-money ventures. Here is the basic calculation:
Terminal (or harvest) value ÷ post-money valuation = return on investment (ROI)
Post-money valuation = terminal value ÷ anticipated ROI
The terminal or harvest value is how much you reasonably expect to sell your company for in the future. Anticipated ROI is the multiple that you expect the company will produce in return.
So for example, let’s say you’re building a SaaS company and expect to be making $15 million when you sell the company in 5 years. If your after-tax earnings are 15%, this leaves you with $2.25 million. Then, we need to multiply this value by a Price/Earnings ratio (or P/E ratio), which should be selected based on benchmarks for similar public companies (keeping in mind that a public company’s P/E ratio will likely be higher than that of a private company). For the purposes of this exercise, let’s choose a P/E ratio of 15x.
$2.25 million * 15 = a terminal value of $33.75 million
Then we divide this number by our anticipated ROI to get the post-money valuation. Most conservative investors plan to get a 10x-30x rate of return, while aggressive investors may hope for up to 70x return. Let’s use 20x for this example to be conservative. We divide the terminal value by this anticipated ROI to get the post-money valuation.
$33.75 million / 20 = $1,687,500 post-money valuation
Finally, we need to subtract the investment amount from this post-money valuation to calculate the pre-money valuation. Let’s use an investment of $250,000.
$1,687,500 – $250,000 = $1,437,500 pre-money valuation
As you can see, the Venture Capital Method may produce a more optimistic pre-money valuation than other methods because it’s based on future projections, whereas the Scorecard and Berkus Methods focus more on the current state of affairs. However, just to be safe, it’s wise to use multiple methods to calculate your PMV and ensure the number you use with investors is as sound and realistic as possible.
That’s one of the things we considered when building Worthworm. Our tool uses a blend of questions from the VC Valuation Method, Berkus Method, and the Scorecard Method. Then, the answers to those questions are put through a sophisticated analytic engine that produces a well-rounded PMV that entrepreneurs and investors can feel confident about from the get-go.
Curious which questions we incorporated from the VC Method and how much your venture could be worth? Or looking for a world-class teaching tool? Or are you trying to do due diligence on potential deals? Then try a subscription to Worthworm, and let us help you.