Venture Capitalist Method

A start-up with a few months of revenue has no meaningful earnings to capitalise and cash flows too uncertain for a full DCF. Yet a venture capitalist still has to decide what percentage of the company Rs 20 crore should buy.

The Venture Capitalist Method works backwards from the exit. The workbook calls it "simple and most commonly used in VC financing of a start-up". Instead of asking what the company is worth today, it asks what the company should be worth when the VC expects to sell, what return the VC needs, and therefore what share of the company today's cheque must buy to get there.

It involves three assessments: the terminal value of the firm at the expected exit; the VC's target ownership stake based on post-money value and the amount invested; and the dilution expected from future fund raising before exit.

Step 1 — terminal value at exit. Usually estimated from projected earnings at the time of exit multiplied by the average prevailing comparable multiple; it can also be assessed by DCF. This terminal value is discounted to present value at the estimated hurdle rate (the VC's expected rate of return).

Step 2 — the stake.

% stake = Investment proposed / Post-money valuation
        = Investment proposed / [Future valuation / (1 + discount rate)^years]

Step 3 — dilution. Later rounds will dilute the VC before exit, so the target stake is adjusted upward by the "dilution factor".

The workbook's illustration: current earnings (revenue) Rs 10 crore, growing 50% a year; required capital Rs 20 crore; holding period 5 years; PAT margin at exit 12%; P/E 35; VC's expected return 40%.

1. Revenue in year 5 ≈ Rs 76 crore (10 × 1.5⁵).
2. PAT at 12% ≈ Rs 9.12 crore.
3. Value at P/E 35 ≈ Rs 319 crore.
4. Present value factor = 1.40⁵ = 5.378; present value = 319 ÷ 5.378 = Rs 59.35 crore, say Rs 60 crore.
5. Stake = 20 ÷ 60 = 33%.
6. With a 20% dilution factor, retention is 80%, so the required stake rises to 41.25%.

The First Chicago Method is a variation: best, worst and survival scenarios are each valued, assigned weights, and the weighted average valuation is discounted to arrive at present value and the stake to be offered.

Present (post-money) value = Future valuation / (1 + r)^n
% stake                    = Investment / Present (post-money) value
Stake adjusted for dilution = % stake / (1 - dilution factor)

r = VC's required rate of return, n = years to exit

Illustrative figures. Kutch Solar Pvt Ltd has current revenue of Rs 8 crore, expected to grow 40% a year for 4 years. A VC fund proposes to invest Rs 12 crore, requires a 35% return, expects a 15% PAT margin at exit and a comparable P/E of 30, and anticipates 25% dilution from later rounds.

Revenue in year 4  = 8 x 1.40^4            = Rs 30.73 crore
PAT at 15%         = 30.73 x 0.15          = Rs 4.61 crore
Exit value         = 4.61 x 30             = Rs 138.30 crore
PV factor          = 1.35^4                = 3.3215
Post-money value   = 138.30 / 3.3215       = Rs 41.64 crore
Stake              = 12 / 41.64            = 28.8%
Dilution-adjusted  = 28.8% / (1 - 0.25)    = 38.4%

The fund asks for about 38.4% today, expecting to be diluted to about 28.8% by exit — the stake at which its Rs 12 crore grows at 35% a year into its share of a Rs 138.30 crore company.

The implied pre-money valuation on the undiluted 28.8% stake is Rs 41.64 crore − Rs 12 crore = Rs 29.64 crore. Change the required return to 30% and the PV factor falls to 2.8561, post-money rises to about Rs 48.42 crore and the stake falls to about 24.8% — which is why founders and VCs argue hardest over the discount rate.

Chapter 11 (Valuation) presents the Venture Capitalist Method and the First Chicago Method in Annexure 11.1 on valuation approaches for start-ups and internet businesses, alongside DCF adaptations for start-ups and non-financial metrics such as GMV and ARPU. Expect a computation question on the stake — especially the dilution adjustment — and a question on how the First Chicago Method varies it (three weighted scenarios).

• The workbook's dilution arithmetic contains a slip. It writes "33/(1-0.2) = 25/0.8 = 41.25%". 33 ÷ 0.8 is 41.25; "25/0.8" is a typo (that would be 31.25). And if the unrounded stake of 33.33% is used, 33.33 ÷ 0.8 gives 41.67%. Expect 41.25% as the workbook's answer, and know why 41.67% is also defensible.
• The discount rate is the VC's required return (hurdle), not WACC. WACC belongs to the DCF method.
• Dividing the investment by post-money value gives the stake — not by pre-money value.
• Adjust for dilution by dividing by retention (1 − dilution factor), not by adding the dilution percentage.
• The terminal value is at exit, discounted back. It is not today's value grossed up.
• First Chicago = three scenarios (best, worst, survival), weighted, then discounted. It is a variation of the VC method, not a DCF.