By Lior Ronen | Founder, Finro Financial Consulting

Valuing an early-stage company can be highly challenging. 

We need to estimate how much a startup is worth when we have very little information.

We can have little or no historical data on to base our assumptions. Typically the startup has no revenues, which adds another layer of uncertainty about whether it could generate revenues in the future. 

There are many startup valuation methods. Many of them require significant time and effort. Others require an insane number of inputs that we can't back since we don't have enough data. 

Entrepreneurs usually meet with angel investors at the beginning of their fundraising journey.

The experienced ones typically use qualitative valuation methods to estimate the company's value. 

Methods such as the Berkus, Payne Scorecard, or Risk Factor Summation Method value young, pre-revenue companies by grading different aspects of their business. 

While these methods are not very accurate, they give angel investors a ballpark value for a startup company. 

Later in the early-stage investing process, founders will meet with early-stage venture capitalists. These investors are more sophisticated than angel investors. Therefore, they are looking for a more robust valuation for pre-revenue startups, but it is still simple. 

The venture capital method is the correct answer for these specific requirements. 

​What Is The Venture Capital Method?

The venture capital valuation method, or VC method, was introduced by Harvard Business School's professor Bill Sahlman in 1987. 

This valuation method looks at the business valuation from a different angle than the other methods. 

It starts from the end. 

This method's starting point is the post-money valuation of the company's future exit value. In other words, it looks at a potential value in the future that includes future cash injections.

Then, it removes different layers of information until we get to the current pre-money valuation of the startup. The pre-revenues valuation is the business's current value before the initial investment. 

The most significant advantage of this valuation method is that it targets the rate of return that an investor is looking for. 

While not very accurate, the VC method gives an excellent rough startup valuation estimate. More importantly, it takes the venture capitalists' expectations into account. 

How to The VC Valuation Method Words?

The VC valuation method is simple and easy to perform. 

Still, it requires some inputs that we can make either from our experience with similar companies, researching similar deals, or estimating. 

This is the working process:

Step 1: What is the expected exit value for the company? i.e. $450M

Step 2: What is the ROI (return on investment) the investor expects? i.e., 15x

Exit Value / ROI = post-money valuation i.e. $450M / 15 = $30M

Step 3: What is the amount invested? i.e. $3M

Post-money valuation - amount invested = pre-money valuation before dilution. i.e. $30M - $30M = $27M

Step 4: What is the estimated dilution? i.e., 45%

Current pre-money valuation before dilution * (1 - estimated dilution %) = pre-money valuation after dilution. i.e. $27M * (1-0.45) = $14.85M

​What Happens In Later Stages?

The VC method is good enough in some cases to value early-stage startups. 

It's an excellent method when having minimal financial information. 

However, suppose we can build a robust financial forecast, especially revenues. We can leverage these forecasts for a more accurate valuation. 

We can combine them with similar companies' revenue multiple, also known as the comparables method or the multiple method. 

The VC method gives an excellent indication in series A, B, etc. However, to build a solid valuation, we would typically add additional methods based on a robust set of financial models. These methods include EBITDA multiples, price-to-earnings ratio, and the notorious discounted cash flow (DCF).

​Final Comments

The VC valuation method is prevalent across the venture capital community.

However, large venture capital funds might have internal methods to value a startup or back an investment decision. 

Private equity funds and family offices have a different perspective on investing in private companies, and their investment might include other aspects that we didn't cover here.

And it's important to remember that valuation is only one element in the deal process and due diligence also plays a significant role in the investment decision.