The Logic of the VC Method for Startup Valuation

Yesterday we published an update to our methodology, specifically looking at the required ROI component of the VC Method.

I did not anticipate that the questions this raised would focus on the other part of the calculation, the terminal value, so it wasn't covered in the update.

Here, I'll attempt to clarify everything about how the purpose of the VC Method, and how it works, to better explain the role of the required ROI discount.

1) Why use the VC Method? / Why do Valuation?

In order to understand the value a company, you need a perspective on its future. Valuation is always forward-looking. Past performance is no indication of future success, etc.

To quote Bill Gurley: "Valuation is not a reward for past behavior; it's a hurdle for future behavior."

This is especially true for novel ideas, which the very best startups tend to be. SpaceX, Coinbase, AirBnB, Spotify... At the time of their earliest rounds of financing, these companies had:

• No obvious comparables,

• No obvious intrinsic value,

• Massive upside potential, for those wou could see it.

It's true that making judgements on an uncertain future may feel uncomfortable. Fortunately, we have a whole investment strategy designed specifically to extract value from uncomfortable uncertainty:

It's called venture capital.

If you don't feel prepared to make investment decisions based primarily on future potential, you might be in the wrong industry. PE may be a better fit.

If you do, the VC Method is one of the better approaches to guide your investment decisions, in that it streamlines the valuation process while considering many parameters relevant to VC, including return profile.

It relies on two fundamental inputs, which I will cover below:

• Terminal Value (determined on a case-by-case basis)

• Required ROI (the subject of our recent update)

2) Ascertaining Terminal Value

There are a number of different ways you can calculate terminal value.

One approach is to go top-down, looking at total addressable market, percentage you imagine the company will capture, the revenue derived from that market share... etc. It's a simple but massively uncertain approach, which bakes huge assumptions into the calculation.

Our approach is to look at this from the bottom-up, by connecting terminal value to the strategy of the company. That is, based on the strategy of the company, and the resulting forecasted growth, what will the value of the company be in 3-5 years.

The main problem here is that SaaS made VCs lazy about financial projections, founders stopped doing them well, and so they fell out of use. This shift had obvious negative consequences for VC, evidenced by a generation of zombie SaaS companies.

Today, this topic (how to build coherent projections) is what we spend most of our time educating founders (and investors) about.

The role of projections is simple: take the pitch you are making, the strategy you are presenting, and quantify it. Use logical connections to turn the story into numbers.

Done well, financial projections are no more uncertain than the pitch itself. If a VC feels comfortable investing based on the pitch, they should have a similar level of confidence in the underlying projections.

Of course, startups pivot, markets shift, competition arrives... nothing is certain. But if you want to make better investment decisions, more information is always helpful.

The goal, to paraphrase Michael Mauboussin, is to be approximately right rather than precisely wrong.

3) The Application of Required ROI

Our implementation of the VC Method uses fund return targets, success rates, expected dilution and typical exit horizon to caclulate a discount rate that reflects the required ROI of an investment.

"At what price, based on the fund's target returns, is this investment worth doing?"

For example: If we calculate a Seed/Series A company might be worth $200M in 4 years, based on its projected growth, then the price worth paying today is $33.1M, based on the required ROI of 56.77%.

The goal is not to find certainty in the projections; there's a success rate built into the calculation to account for possible failure. Not is it to find a precise answer; there is always fuzziness in projections. The objective is simply to understand, based on a shared set of expectations and assumptions, roughly what today's value ought to be.

To understand the calculation of the Required ROI discount in more detail, the full paper is available here.

4) The Logic of the VC Method

The VC Method uses a fairly elegant formula. Essentially, it's a streamlined DCF, adapted for startups and venture capital.

The logic is as follows:

1. Is the founder's pitch coherent and credible?

2. If so, where do you expect the company to be, financially, in 3-5 years?

3. What is the implied value at that point? (Terminal Value)

4. Given typical success rates, anticipated dilution, and time to exit, what is the value today? (Required ROI)

Thus, investors get a practical view on the value of an investment where they already have some conviction on the concept and future potential.

Like all valuations, and in contrast to pricing, this has the benefit of shifting the conversation in a much more productive direction: towards the assumptions that drive the outcome.

Finally, a point that bears repeating: Valuation is just one of a few inputs into a pricing decision. The others are fund math, portfolio synergies and market conditions.

You are not bound to the output of any valuation method, it is simply there to guide your decision making.

4) What About "The Market"?

A common refrain from investors is that founders should just "let the market price the round".

By this, they mean go out to raise without a stated price target, and take competing bids. There are so many problems with this, it's hard to fit into one post. To list a few:

• VC is a tiny market, effective price discovery is simply not a thing.

• The whole purpose of valuation is to help both sides align on expectations and assumptions. Skipping that step means investors will make worse decisions.

• If this works anywhere, it's for generic SaaS type businesses. Thus, VC has systematically overlooked deeptech, hardware, etc, for the last 15 years.

• This approach puts pricing power entirely in the hands of investors who are known to use "price anchoring" strategically to suppress entry prices.

• Judging by "average" VC returns, the "average" VC is deeply incompetent, so how well this advice works depends entirely on who a founder ends up talking to.

Great founders do not blindly accept standard terms. They are dilution sensitive, strategic with their fundraising, and have enough agency to negotiate the right outcome with investors.

5) Conclusion

Venture capital is the discipline of finding companies with outlier potential (and thus outlier risk) to extract outlier value. It is fundamentally centered on high-risk, non-consensus judgements about the future.

Given this is the case, the widespread practice of understanding value through the lens of lazy comparables or auction mechanics, is clearly not appropriate.

That's not to say "the market" isn't a concern. Of course, VCs need to consider capital supply, competing opportunities, and downstream funding. But these factors should not be how investors think about "value".

Investors in startups, even at the earliest stages, need to think hard about how they understand value and whether that aperture is wide enough for the most exceptional companies.