The ability of the Venture Capital Method to evaluate early-stage, pre-revenue companies, makes it a commonly used approach among venture capitalists worldwide. How does it work?
Here is a high-level overview-
VCs, as well as any other investors, realize their returns when a liquidity event (an exit) occurs, and they expect a certain rate of return for their investments. Thus, the guiding equation is as follows.
Post-money Valuation = Exit Value / Expected Return on Investment (ROI)
Now, to calculate Exit Value (EV), we typically take a multiple of the company's revenues at the time of exit, based on precedent transactions in the sector.
For example, let's consider a company projected to generate $20 million in revenues upon exit, assuming a revenue multiple of 2. The resultant exit value would amount to $40 million.
The Return on Investment (ROI), representing the expected return for investors, is often expressed as a multiple of the initial investment. Given the inherent risk associated with startups, VCs typically target high ROIs, often north of 10x. Now, with an Exit Value of $40 million and an expected ROI of 10, the post-money valuation stands at $4 million.
Finally, the dilution is determined by how much capital needs to be injected. Let's suppose the company is trying to raise $500,000. Then, the stake for the investor comes to 12.5% ($500,000/$4 million).
What do you think about this approach? Let's chat in the comments.
This post was originally shared by Prabhav Narang on Linkedin.