The valuation method assumes that the investors will liquidate their investments at the end of the fifth year and the company will be evaluated using price/earnings and other ratios of similar firms in the industry. This projected evaluation is then discounted by a high discount rate, typically 30–50%, given the illiquidity and high risk of the investment.
This calculation yields the current valuation of the start-up business. If interim financing rounds are foreseen, then the investment is diluted. The venture capital method involves many assumptions and the results can vary widely depending on the specific computations of the person doing the analysis.
Although this method is commonly used in the venture capital industry, it has been criticized for being too simplistic—there are related methodologies such as the weighted average cost of capital (WACC) that are considered far more accurate. However, the venture capital method has the advantage of being readily understood both by venture capitalists and the entrepreneurs that they fund.
|Venture Capital Method|