Although there are many valuation methods used by private venture capital firms (e.g. comparables, NPV method, etc.); the valuation method that is used most frequently by venture firms is called - quite appropriately - the Venture Capital Method. The illustration of this method is illustrated in great detail (among other valuation methods) in a Harvard Business School note # 9-297-050 prepared by John Willinge under the supervision of Professor Josh Lerner. Many points of my discussion are taken from this note.
One of the reasons that this method is preferred over others is that it reflects the characteristics of "venture type" companies (i.e. those that are often characterized by negative cash flows and earnings and high uncertainty). This method accounts for the negative and uncertain cash flow profile by valuing the company at a time in the future when it is projected to have achieved positive cash flows and/or earnings. This "terminal value" is then discounted back to the present using a high discount rate, typically between 40 and 75 percent (i.e. the discount rate is usually the venture capitalists' target rate of return).
~Step 1: Calculate the Terminal Value
The terminal value is usually calculated using a multiple (e.g. a price-earnings ratio may be multiplied by the projected net income in the exit year).
Step 2: Calculate the Discounted Terminal Value
The discounted terminal value is determined by, not surprisingly, discounting the terminal value calculated in Step 1. As discussed above, the discount rate used is typically the venture capital firm's target rate of return and will differ based on many subjective factors, such as strength of the management team, stage of the company, etc.
Discounted Terminal Value = Terminal Value / (1 + Target )years
Step 3: Calculate the Required Final Percent Ownership
This percentage of ownership that is required for a venture firm to earn its desired return (assuming there is no subsequent dilution of its investment) is calculated by the dividing the proposed investment by the Discounted Terminal Value. Note that the above assumption will almost never hold, as most young companies will need more money to continue existing as going concerns and thus the venture firm's position will no doubt be diluted. Step 4 takes care of the future dilution scenarios.
Required Final Percent Ownership = Investment / Discounted Terminal Value
Step 4: Accounting for Future Dilution
As mentioned above, most venture-backed companies receive multiple rounds of financings prior to the IPO. To make the formula above work in conjunction with the further dilution of ownership, venture firms will calculate a retention ratio, which quantifies the expected dilutive effect of future rounds of financing on the venture capitalist's ownership. Consider a company that intends to undertake one more financing round, in which shares representing an additional 25 percent of its equity will be sold, and then to sell shares representing an additional 30 percent of the firm at the time of the IPO. For example, if the venture capitalist owns 10 percent today, after these financings, its stake will be 6.15 percent calculated as follows: 10% / (1+.25) / (1+.30) = 6.15%.
~Required Current Percent Ownership = Required Final Percent Ownership / Retention Ratio
A Word of Warning
Venture capital investing is not as easy as using a simple formula above. I want to reiterate that the method above, although very useful, is based on many subjective items, one being the rate of return that venture firms feel they are required to make on an investment. Additionally, most VCs have internal targets about how much of a company that they want to own at any particular stage, and the targets are varied.
If there is one aspect of the venture business that I have learned, it is that valuation should almost never be the deciding factor between a company and the venture firm. Although there are exceptions, venture firms are not in the business of "stealing" from the founders. On the contrary, most venture firms invest in companies whose capital structure actually creates incentives for the founders. For this reason venture firms almost never take a majority stake in companies.
The last piece of advise is that it is better to have a smaller piece of a much larger pie than to have a bigger piece of a very small pie. Translated into business terms, this means that it is more important to "partner" with the right venture firm whose value can transcend into an IPO, than to partner with the wrong venture firm and never get to the IPO stage.
As always, I was inspired by many of you to write the following piece. It appears that many entrepreneurs are very interested and unclear about how venture capital firms determine its ownership percentage in a given portfolio investment. Although it is more of an art than a science, and it is for the most part a difficult and often subjective process, especially when you consider valuation for private companies in their early stages of their life cycle and with periods of negative cash flows and uncertain revenue streams. Nevertheless, I wanted to describe a process that most entrepreneurs can use to determine whether in fact the percent of companies sought are in the "right ball park." I would also advise you to talk to your trusted advisors (i.e. attorneys, bankers, and accountants) on proposed venture capital offerings. However, I am confident that the discussion below will serve you well.