The Venture Capital method is a very useful startup valuation technique during its first years of life. To use it, it is necessary to make certain estimates due to the lack of historical information about the company.
In other words, the Venture Capital method is a way of calculating the value of an innovative firm with high growth potential, but for which, because it was recently founded, not much data is available.
With the appearance of the Internet in 1983 and the technological advance that accompanies it, both factors have allowed the generation of new business models never exploited before. Some of these business models have a potential for exponential growth.
The companies that meet these characteristics are startups. A startup is a small company that has just started its activity and whose business model presents great innovative and technological potential. Along with this, one of its main advantages is scalability and great growth.
Now, with this type of company, investors who want to buy them find it difficult to value them. These difficulties are derived mainly from the fact that they are companies with very few years of life and there is no historical data that allows us to analyze their trajectory. Nor can a discount valuation of cash flows or multiples be carried out.
For this reason, an alternative method is necessary that allows to “price” that company through other variables. The Venture Capital method allows a company to be valued making use, for example, of the investment to be made or the expected return.
Thus, it is important to note that in this method the vision and ability of the investor to estimate the terminal value of the company plays a fundamental role.
Elements of the Venture Capital method
In order to use the Venture Capital method when evaluating a startup, it is necessary to quantify the following magnitudes:
- Amount of the capital increase: It refers to the amount established in the capital increase of the startup to receive financing.
- Expected return on investment (ROI): It is the percentage of the total investment that the investor expects to receive after selling the shares of the company. In the case of startups, due to their growth potential, it is usually measured in multiples. For example, if you invest $ 1,000 and want to receive $ 3,000, the multiple is x3.
- Terminal value: The terminal value of the investment is an estimate of the value that the company will have after a certain period of time. For example, if it is a 10-year investment and after this period the shares will be sold, since the terminal value of that company is the estimate of the value it will have in 10 years.
- Pre-money valuation: It is the valuation that the analyzed company has before carrying out the capital increase.
- Post-money valuation: It is the value that the company has after completing the financing round or capital increase. To calculate this magnitude, it is important to know the pre-money valuation and the amount of the capital increase.
Venture Capital method example
Let’s say we are investors and we have the opportunity to invest in a revolutionary food delivery company. This company is carrying out a capital increase to obtain financing and to be able to start its expansion throughout all the countries of South America.
In order to decide whether to carry out this investment, we will use the Venture Capital method to value the company. In relation to this, we have the following information:
- Amount of the capital increase: $ 300,000.
- Terminal value: $ 30,000,000
- Desired ROI: x15
Now we calculate the post-money valuation and the pre-money value:
The value of this company today, before the end of the capital increase, is $ 1,700,000. Therefore, we have already calculated the value of this company to analyze if it can be an interesting investment.