Venture Capital Method

Venture Capital Method

Venture Capital Method: How It Works

What it does

A young company has little revenue and no profit, so it cannot be valued from its present earnings. The venture capital method values it backwards from the future instead. The investor pictures the company at its exit (the sale or public listing at which the investor is paid), decides what return the investment must earn by then, and works back to the share of the company it has to own today. That share and the amount invested fix the valuation. The page writes out each step and shows how much the answer depends on the assumptions.

The method

Symbols. I₀ is the investment; V_x the value of all the company's shares at exit; N the years to exit; r_t the target return per year and M_t the same target as a multiple of the money; F_x the value the investor's stake must have at exit; f_x and f₀ the investor's ownership at exit and today; R_d the fraction of today's stake left at exit and d_L = 1 − R_d the dilution; S₀ the fully diluted shares before the round. Percentages are used as decimals: 50 % is 0.5.

Step 1, exit value: entered, or exit-year revenue or earnings times a multiple, V_x = Y_x × m_x.
Step 2, required value of the stake: F_x = I₀ (1 + r_t)^N, or F_x = M_t I₀ for a target multiple. The two are linked by M_t = (1 + r_t)^N.
Step 3, ownership needed at exit: f_x = F_x / V_x.
Step 4, ownership needed today: f₀ = f_x / R_d.
Step 5, valuation: post-money V_post = I₀ / f₀; pre-money V_pre = V_post − I₀.
Step 6, shares: price per share P_s = V_pre / S₀; new shares S_n = S₀ f₀ / (1 − f₀) = I₀ / P_s.

Steps 2 to 5 collapse into one line: V_post = V_x R_d / (1 + r_t)^N. The post-money value is the exit value, reduced for dilution and discounted at the target return.

Post-money and pre-money. Post-money is the value of all shares immediately after the investment, the new money included. Pre-money is the value before it. An investor who puts 2 into a company at 8 pre-money owns 2 / 10 = 20 % of it.

Dilution. When a company issues new shares, every existing holder's percentage falls. In Simple mode one figure d_L covers everything expected before exit. In Advanced mode each later round is entered as the share of the company, measured after that round, sold to its new investors (d_i) and added to the employee option pool (p_i). Earlier holders keep 1 − d_i − p_i of their stake in that round, and R_d is the product over the rounds.

Scenarios (First Chicago method, Advanced). In place of one exit value, several scenarios each get a probability and an exit value, and V_x = Σ probability × exit value. The rest is unchanged. The single-case method puts the chance of failure into a high target return; the scenario method puts it into the probabilities, so it is normally used with a lower target.

Return at other exit values. With the ownership fixed, an exit at V gives proceeds f_x V, a multiple of f_x V / I₀ and an internal rate of return (IRR) of (f_x V / I₀)^1/N − 1 a year.

Liquidation preference (Advanced). For an exit at V, an investment I₀ and an ownership f_x:
common shares: f_x V;
1× non-participating preferred: the larger of min(V, I₀) and f_x V;
1× participating preferred: min(V, I₀) + f_x × max(V − I₀, 0).
The non-participating holder converts to common above the conversion point V = I₀ / f_x.

What it assumes

• One exit, at one date, at which the investor is paid in full; nothing is paid before it.
• The exit value is the value of the equity in the case where the company succeeds (or, with scenarios, the listed cases with their probabilities).
• The target return is the investor's own requirement. It is not derived from market data, and it carries the risk of failure, the years without a buyer for the stake and the investor's costs all in one number.
• Dilution is known in advance, and the investor does not invest again in later rounds.
• Steps 1 to 6 treat the investor's shares as ordinary shares. The preference table considers this investor's 1× preference alone, with no later preferences, caps or dividends.
• No option pool is created in this round; the fully diluted share count entered already includes every option.

When it misleads

• The answer is a product of guesses. Ten points of target return, or a different exit multiple, moves the valuation by a large part of itself (Table of pre-money against target and exit value). It shows what a set of assumptions implies; it does not measure the company.
• A success-case exit value discounted at a very high rate is a rough stand-in for averaging over outcomes. Two investors with the same view of the company can reach different values only because they split risk differently between the exit value and the rate.
• Later rounds may be larger, more numerous or priced lower than expected, and the dilution with them. A down round can also trigger anti-dilution terms that this page leaves out.
• Preferred shares are worth more than the common shares the method prices. In a poor exit the preference changes who gets what, as the last table shows.
• In practice a round's price is negotiated. The method gives one party's arithmetic, not the outcome.

Worked example

The default case: an investment of 2,000,000, an exit value of 100,000,000 in 5 years, a target return of 50 % a year, 30 % dilution from later rounds and 1,000,000 fully diluted shares before the round.

F_x = 2,000,000 × 1.5⁵ = 2,000,000 × 7.59375 = 15,187,500
f_x = 15,187,500 / 100,000,000 = 0.151875 (15.19 %)
R_d = 1 − 0.30 = 0.70;   f₀ = 0.151875 / 0.70 = 0.216964 (21.70 %)
V_post = 2,000,000 / 0.216964 = 9,218,107;   V_pre = 9,218,107 − 2,000,000 = 7,218,107
P_s = 7,218,107 / 1,000,000 = 7.2181;   S_n = 1,000,000 × 0.216964 / 0.783036 = 277,081 new shares
Check in one line: 100,000,000 × 0.70 / 7.59375 = 9,218,107.

If the company is sold for half the expected value, 50,000,000, the investor receives 0.151875 × 50,000,000 = 7,593,750, which is 3.80 times the investment and (3.796875)^1/5 − 1 = 30.58 % a year.

This page is a calculator for education and analysis, not investment advice.