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The Venture Capital Valuation Methodology

There are a number of startup valuation methodologies. Although none of them are perfect (as explained in our article here), they all try to calculate a valuation for a business based on certain factors. By far the most common methodology investors use to value startups is the Venture Capital Valuation Method.

In this article we’ll explain you how the Venture Capital Valuation works and why we use it vs. other methodologies.

But more importantly, we’ll show you how you can use the Venture Capital Valuation Method to assess the valuation of any startup.

What Is the Venture Capital Valuation Method?

The Venture Capital method is a methodology used by many investors to value startups and high-growth businesses in general.

The Venture Capital valuation method calculates the theoretical valuation of a startup using the following parameters:

  • Exit value: the expected valuation of the business in the foreseeable future (usually 5 to 7 years).
  • Investors’ required IRR: the internal rate of return (IRR) that investors would typically require for such a high-risk, high-return investment

The exit value itself is derived from the famous multiple valuation methodology that investors use to assess the valuation of mature companies. Yet, whilst mature businesses often use EBITDA multiples, because startups often are unprofitable, we use revenue instead.

Using the example above, investors would estimate the exit value of $100M by using the startup’s expected 5-year revenues ($10M) and a 10x revenue multiple.

Why Do We Use The Venture Capital Valuation Method?

The venture capital valuation method is quite powerful as it solves an important problem: unlike other methodologies the VC method takes into consideration business, market and investor-specific factors.

Indeed, a startup valuation (and its valuation multiple) is driven by a number of factors which can be grouped in 4 main categories. All of them are business, market or investor-specific, they are:

Product market fit & traction

A startup is more valuable if it can prove investors it already found early adopters for your product (product-market-fit), or even better: it already generate revenues

Team & execution track record

A startup valuation is higher if the founding team has a successful track record

Market

Your startup will be more valuable if your market is large and/or highly fragmented and/or growing at double digits

Investor’s appetite and bargaining power

Above all else, investors value startups so they can make a (substantial) profit in the future. If a startup is deemed too expensive, no investors will invest. Same goes with bargaining power: the more term sheets a founder receives from investors, the higher the valuation

As we’ll see now, the VC valuation method takes into consideration these 4 factors, improving its accuracy vs. other startup valuation methods.

How The Venture Capital Valuation Method Works

The Venture Capital valuation method allows anyone to estimate a startup’s valuation by using 3 main drivers:

Step 1: Forecast Revenues

Expected revenues are usually 5-year revenue projections, meaning the startup expected revenues in 5 years time. Although startup financial projections obviously come with their grain of salt, we wrote extensively on the best practices to build realistic revenue projections for your startup.

By definition, (realistic) revenue projections are a direct function of the business (and by extension product market fit & traction and team & execution track record).

For example, let’s assume we are trying to value a Cybersecurity SaaS startup with the following revenue projections:

For more information on how to create realistic revenue projections for your startup, check out our expert-built financial model templates.

Step 2: Select The Revenue Exit Valuation Multiple

The exit valuation multiple is used to calculate the exit value. For startups, we use revenue multiples (EV/Revenue for “Enterprise Value”) of comparable companies within the same industry.

Naturally, industry valuation multiples are a direct function of the market landscape.

Using the same Cybersecurity example, we now obtain the group of companies and their respective multiples below. The median revenue multiple is 13x.

Important: To keep things simple, and for the purpose of this article, we are using these 13 companies to derive the Revenue valuation multiple we will use as part of the VC valuation method. Naturally, when calculating your startup valuation, you must select the comparables that make more sense to the company’s specifics and not the entire group.

Step 3: Choose The Investors’ Required IRR

Investors’ IRR (“Internal Rate of Return”) is a required return on investment that varies between investors and the stage of investment. The higher the risk, the higher the required IRR. For example, an investor would require a higher IRR for an early stage deal such as a seed round vs. a Series A or Series B round.

Naturally, investors' (required) IRR is investor-specific. 

Naturally, the required IRR vary by investors, the stage they’re investing in (early-stage deals tend to require higher IRR vs. later stage deals) and the industry.

According to a recent study, the average IRR for venture capital firms was 19.8%. Yet, this percentage is an average: it also takes into account failed deals (the ones that go wrong). Indeed, VCs typically hope to realise anywhere between 40-60% IRR on the deals they invest in. Again, this is a high-level average, and depends on a number of factors as explained earlier.

Now, assuming we are looking at a Series A startup, we can reasonably assume investors will require a lower IRR vs. Seed startups. As rule of thumb, a Seed investor would require 50-60% IRR, and a Series A investor 40-50% instead.

Step 4: Calculate The Exit Value

As explained earlier, the exit value simply is the result of:

Exit value = 5-year revenues x Revenue multiple

So in our Cybersecurity example:

Exit value = $4.4M x 13x

Exit value = $57M

Step 5: Calculate Today’s Valuation

In order for us to obtain the valuation, we need to think like an investor. In other words, we need to answer the following question:

How much would an investor pay today to buy 100% of the startup’s equity?

Naturally, to answer this question we need to understand what is the expected rate of return for this investment. In other words, we must factor in a typical investor’s required IRR for such an investment, which we have.

Therefore, the valuation is the exit value discounted by the investors’ required IRR (over 5-years in this case). In our example:

So we obtain $7.5M:

How To Double Check Your Valuation

Whenever we use the Venture Capital valuation method, we also look at what percentage an investor would actually get (and the founder(s) would have to sell) if it were to invest at the obtained valuation. This percentage is often referred to as the “dilution percentage“.

There are 2 reasons for that:

  • We often value startups when there is actually a fundraising round and founders need to agree with investors the right price for their shares
  • Even when there is no fundraising round, calculating the dilution percentage helps us understand whether the valuation makes sense. Let’s see how

Using our cybersecurity startup example, now that we obtained $7.5M as a valuation (the post-money valuation), let’s assume we need to raise a round from investors. Let’s consider 2 scenarios:

  • Assuming we need to raise $1.5M, we would have to sell 20% which is market standard for Seed and Series A startups
  • Now, assuming we had to raise $3M instead, we would have to sell 40% of the company, which is far too much for a typical funding round (as you would eventually lose ownership)

So, as a founder, you need to ask yourself the following question: how much ownership percentage are you willing to give investors for their money?

That’s why valuation always goes in pair with the equity percentage that investors ask for. That’s also why you shouldn’t raise more than what you actually need (see more on that here).

How To Sensitise Valuation

Whenever an investor values a company, it’s common practice to sensitise the resulting valuation by changing the value of key parameters.

For a founder, valuation sensitivities are key to understand the levers driving valuation.

For the VC valuation method, we typically sensitise using the main parameters that are:

  • The multiple
  • The 5-year revenues

Sensitivity #1: Multiple

Here we calculate valuation by sensitising the exit valuation multiple. Using the same example as before, we obtain the following chart:

Note that, for low/mid/high valuation ranges, we use here a variance of the investors’ required IRR (for example 40/50/60%).

Sensitivity #2: 5-year Revenues

Here we calculate the valuation by sensitising the projected 5-year revenues. Using the same example as before, we obtain the following chart:

Note that, for low/mid/high valuation ranges, we use here a variance of the investors’ required IRR (for example 40/50/60%).

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