VC Method of Valuation in layman’s terms

Everywhere we turn nowadays, we hear about startups and the phenomenal valuations obtained once they reach out for investors. As a founder one needs to know how startup valuation works. Sitting at the negotiation table is never comfortable if you do not have a good grasp of the terms used.

Startup valuation is far from being an exact science and can vary from one business sector to another. The valuation methods you are most likely to come across are DCF (Discounted Cash Flow), Comparable Transactions Method, and the VC Method. The VC Method of startup variations is one of the most common, and we will look at it in detail. What differentiate it from other methods is that it works backward. Retracing the steps can reveal the expectations of the venture capitalist (VC) when it chooses your startup over others.

The scope of the VC is to obtain the biggest exit multiplier over the shortest period. Say for example your startup has GMV of $5 Million after 3 years as per your business plan. VC may think that they can sell your startup at 10X GMV i.e. 10 * $5M = $50 M and exit.

Parameter Year-0 Year-1 Year-2 Year-3
Revenue          $5 M
Exit Multiplier          10X
Exit Valuation           $50 M

Though not always the case, ambitious VCs typically target a 100% return on investment each year. So, this means that the valuation at the end of Year-2 should be $50M / (1 + 100%) = $25 M. Similarly, the valuation at the end of Year-1 should be $25M / (1 + 100%) = $12.5 M and the valuation at the end of Year-0 (which is now) should be $12.5M / (1 + 100%) = $ 6.25 M

Parameter Year-0 Year-1 Year-2 Year-3
Revenue          $5 M
Exit Multiplier          10X
Exit Value           $50 M
Expected Return 100% 100% 100%
Post Money Valuation $6.25M $12.5M $25M

That shows how the current post money valuation is arrived at. The post-money valuation of a startup sums the pre-money valuation and the amount of new equity. To reach these projections, suppose you need an investment of $1M from VC, it means that VC will get 1 / 6.25 which is 16% of the company and the founder retains the remaining 84% of company.

Parameter Year-0
Post Money Valuation (A) $6.25M
Money invested by VC (B) $1M
% Shares given to VC B / A = 1/6.25 = 16%
% Share held by Founder 1 – 16% = 84%

Looking at the VC Method is a great way of figuring out what percentage of the company will go to the funder. In addition, it shows just how big your business can grow once it reaches the juice. It is definitely worth mastering the terminology and mechanism of the VC Method.

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