In an earlier post I had shared that there are number of methods used to value startups. I had promised that I will detail the methods. Here is the first of those methods listed – ‘The Venture Capital Method’ or VC Method.

The introduction of this method is attributed to Professor William Sahlman, who wrote about it in a 1987 case study. Professor Sahlman is famous for his widely used article ‘How to write a great business plan’ in the Harvard Business Review. I have used it as reading in some of my courses too! That’s enough for background and validity!!

**The VC Method**

The formula used in this method are simple:

**Pre-Money Value = Post-Money Value – Investment**

**Post-Money Valuation = (Terminal or Harvested Value) / (Expected Return on Investment)**

Now you need to know what these terms mean, isn’t it? Here they are:

**Terminal or Harvested Value:** This is the value that the investor expects the startup to have when his/her stake is sold. Now, this could be the next round of investment or after a couple of rounds of investment or when the company goes public or it gets acquired by another company. Whatever be it, the investor must know what will be the value at the point of sale. Usually early stage investors stay only till a couple of rounds of investment. Hence they consider only the value until then.

**How do we calculate Terminal Value?**

Ans: Any usual finance text book will teach you methods to do this. Simple back of the envelope methods include: number of times sales or Industry P/E times Profit, etc. You can get these data from industry analysts or reports or historic datasets or even from angel associations. Recent investment records from new items can also provide pointers. Always use more than one method and then take average to improve your odds.

**Expected Return on Investment (ROI):** This is simply the rate of return that the investor expects to make on his/her investment. While it may be easy to think it terms of percentage, strangely investors of this category (startups) think in terms of ‘number of x’s’ or number of times they expect their investment to multiple. For ex: 10x means 10 times, 20x means 20 times and so on. In Angel investing, it is normal to see investors talk about 10x-30x returns. It varies a lot. But considering the risky nature of these investments, one is bound to expect high multiples.

**Post-Money Valuation:** The value of the startup including the investment made by the investor.

**Pre-Money Valuation:** This is the value of the startup just before the investment is made by the investor.

**Investment:** This is the amount of money invested by the investor into the startup.

**Illustration:**

A startup in software wants to raise 10lakhs. It expects to touch a revenue of 10 Crores in 2 years.

Knowing that software startups are valued close to 2 times sales, the investor expects the harvest value to be about 20 crores. Assuming an average return of 20x, the investor calculates post-money valuation to be = 20/20x = 1crore. Therefore pre-money value is 1Cr – 10Lakhs = 0.9Crore.

Deviation: Lets just understand pre and post money valuation here: If investor considers 1Crore to be post money valuation, then it includes the investment (10lakhs) too. Therefore entrepreneur’s share is 90% and investor’s share is 10%. But if the investor considers the 1Crore as pre-money valuation, then the post-money valuation becomes 1.1Crore. Then the entrepreneur’s share becomes 88.9% and investor’s share becomes 11.1%. Hope you get it!! While the difference seems too small, the trouble is not in the present. Just imagine when you become Infosys at its peak or Flipkart at its peak. Do you think 1.1% ownership can make a difference? I hope I don’t have to clarify this🙂

Continuing with our example:

So, considering that this company in our example is valued at 1Crore post-money valuation, how much percentage should the investor seek to get his 10Lakh investment. It seems that if he takes a 10% stake in the company for his investment and everything goes as per his / her calculation, they will get a 20x return when they exit after 2 years.

This method gets complicated when there are more rounds of investment before harvesting! The current investor will need to factor the new investments too before deciding on how much value the company will have and what stake they will need to keep prior to making an investment. It mathematics. As one of the practitioners suggests, one of the quick methods is to reduce the value by the level of dilution expected in the future rounds. If you intend to dilute 50% before harvest, then decrease value by 50% and so on.

While one can keep on complicating the math, I hope entrepreneurs will get an overview of the method. As with any skill, once you make a beginning (and if it is your cup of tea) you will enjoy the complexities and play the game. I hope this blog will help you move closer to playing the real game.

Try it. Its fun.