The VC Method of Startup Valuation

"How should one value a startup? It’s obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price."

This post from Ryan Junee describes is one of the most widely used (often called the ‘VC method’) using a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing, stating:

"The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit...

Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M...

The Venture Capitalist’s Required ROI
Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later).

This means in year 5 the VC’s investment must be worth (1 + 0.50)5 x $2M = $15.2M. [That’s just (1 + IRR)years x Investment] So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.

Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M.

The Discount Rate
Above we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be)...Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:

Seed stage: 80%+
Startup: 50-70%
First-Stage: 40-60%
Second-Stage: 30-50%
Bridge/Mezzanine: 20-35%
Public Expectations: 15-25%...