Most Founders have NO IDEA about this method by which VCs value their startups!
The VC Method of valuation was developed in 1987 by a Harvard Business School Professor.
In this case, the VC first estimates an exit valuation and then works backward to think how can he make a 20X return on exit by fixing a value to the business today.
Let’s look at it through a simple example.
Target Exit Valuation = 100 Crore
Return wanted on Exit = 20X
Thus, Ideal Post Money Valuation today = 100/20 = 5 Crore
Amount being Invested in the Startup = 1 Crore
Pre-Money Valuation = 5-1 = 4 Crore
Now, assuming the investor’s shares will be diluted by 50%
So Pre-Money Valuation adjusted for future dilution = 4/2 = 2 Crore
The next natural question that comes up is how do they determine the Target Exit Value of the business after 8 years.
This they do by looking at by estimating say in the 8th year from now, the company will have revenues of 80 Crore, on which say the Profit will be 10% at 8 Crore.
In the 8th year, it is expected the PE Multiple for companies in the same sector to be 15. This means, company’s value will be 15 times its profit. Then 15 x 8 = 120 Crores target exit valuation.
I recommend startups use multiple methods before going ahead and pitching to an investor so that their valuation ask is validated through all possible valuation models.
————————————————————————————————————————
Click here to subscribe to my YouTube channel: https://bit.ly/3cpTleK
————————————————————————————————————————-
Like, Share, Subscribe for more!
Follow me on my other social media handles for all updates, events and live sessions-
Instagram: https://www.instagram.com/casarthakah…
LinkedIn: https://in.linkedin.com/in/sarthak-ah…
Website: http://www.casahuja.com/
————————————————————————————————————————-
A Chartered Accountant with about 10 years of experience in areas of Tax Advisory, Startup Consulting, Fundraising, Audits, Deal Advisory, Business Modelling and contract CFO services.
Winner of the ISB Young Leader Award 2017 and the Best All Rounder, PGP Class of ’17, Sarthak has also been published about in the leading financial newspapers such as The Financial Express as possibly the youngest Indian to have completed the courses of CA, CS and CMA along with a graduate degree in Financial & Investment Analysis from University of Delhi, all by the age of 23 years.
No doubt 99% startups are loss making 😅
Please tell the calculations steps
Just to break things in a simpler way:
₹100cr is the terminal value of the company at the end of 8th year (this value is just an estimate on how much an investor can sell his stake for in the future i.e., based on revenue or net earnings projection for the 8th year mutliplied with comparable/transaction multiple). Here, Investor wants 20x ROI, which derives post-money valuation = 100/20 = ₹5cr. (I.e., terminal value at year 8 divided by ROI for the 8 year period). This method is called discounting the terminal value to arrive at present value of the company. The investment made here is ₹1cr. So the pre-money valuation is ₹5cr less ₹1cr equals to ₹4cr (pre-money valuation = post-money valuation less investment) assuming no dilution.
Imagine an investor wants to estimate what a company will be worth in 8 years. Let's say they project the company will be worth ₹100 crore at the end of that period. This is the "terminal value."
Now, suppose the investor wants to make 20 times their initial investment (a 20x return on investment or ROI) over those 8 years. To figure out how much they should pay now for that future value, we work backward:
Post-Money Valuation: To get a 20x return on investment and reach a terminal value of ₹100 crore, the company's value after the investor puts in their money should be ₹5 crore (₹100 crore / 20).
Discounting the Terminal Value: This method of dividing the future terminal value by the desired ROI to arrive at a present value is called "discounting the terminal value."
Pre-Money Valuation: If the investor puts in ₹1 crore, the company's value before that investment (the pre-money valuation) is ₹4 crore (₹5 crore post-money valuation – ₹1 crore investment). This assumes no other changes to the ownership structure.
In short, the investor is using the projected future value and their desired return to determine what the company is worth today.
This explanation describes a method of valuing a company based on its projected terminal value and an investor's desired return on investment (ROI). Let's break it down:
Terminal Value
The terminal value of ₹100cr is estimated for the company at the end of the 8th year. This represents the projected value of the company at that future point, typically calculated using:
Revenue or earnings projection for the 8th year
A comparable or transaction multiple
Discounting to Present Value
The investor wants a 20x ROI over 8 years. To achieve this, they discount the terminal value:
Post-money valuation = Terminal Value / Desired ROI
= ₹100cr / 20
= ₹5cr
This ₹5cr represents the present value of the company, including the new investment.
Investment and Pre-money Valuation
The investor plans to invest ₹1cr. To calculate the pre-money valuation:
Pre-money valuation = Post-money valuation – Investment
= ₹5cr – ₹1cr
= ₹4cr
Key Concepts
Terminal Value: A projection of the company's value at a future point (8 years in this case).
Discounting: Bringing future value to present value based on desired ROI.
Post-money Valuation: Company value after including the new investment.
Pre-money Valuation: Company value before the new investment.
This method simplifies complex valuation processes by using the terminal value and desired ROI to determine current valuation. However, it assumes no dilution and relies heavily on accurate terminal value estimation, which can be challenging for early-stage companies