# Venture Capital Method Concept Card: [Your company, case or course] > A concept card for the valuation tool venture investors actually use at the term sheet stage: the venture capital > method. It turns an exit scenario and a target return into a post-money valuation, adjusts for the dilution the > investor will suffer in later rounds (the retention ratio), and then checks the answer with a probability-weighted > scenario view (the First Chicago method) and a fund-level test (can this company return the fund?). It is for MBA > students in the venture capital, entrepreneurial finance and private equity electives, founders preparing to > negotiate a round, and anyone interviewing for a venture investing role. It builds on > mba/mba-venture-finance-cap-table-card (pre-money, post-money, the option pool shuffle and dilution through Seed, > Series A and Series B), which you should read first: this card reuses its Corvane Robotics cap table and does not > re-teach the mechanics. Source basis: the venture capital method as taught following Sahlman and Scherlis (1987), > Sahlman (1990) on the structure of venture capital organisations, Cochrane (2005) and Gompers, Gornall, Kaplan and > Strebulaev (2020) on venture returns and how venture capitalists decide, written in original words. Replace every > [bracketed] value and every row marked *Example*. This is a learning aid, not investment advice. ## Document control | Field | Value | |---|---| | Company, case or course | [Company name / course, session 5] | | Learner or analyst | [Your name] | | Round being priced | [Seed / Series A / Series B, amount] | | Exit evidence used | [Comparable transactions, public multiples, date of data] | | Spreadsheet used | [Excel / Google Sheets / LibreOffice Calc] | | Reviewed by | [Study partner, tutor or investment team member] | | Version | [0.1] | | Last updated | YYYY-MM-DD | ## Contents - [When to use it](#when-to-use-it) - [The idea in plain language](#the-idea-in-plain-language) - [Formulas and notation](#formulas-and-notation) - [Assumptions and limits](#assumptions-and-limits) - [How investors and founders use it](#how-investors-and-founders-use-it) - [Worked example A (fully solved): Fund I prices the Corvane Series A](#worked-example-a-fully-solved-fund-i-prices-the-corvane-series-a) - [Worked example B (half solved): a seed investment in Start-up S](#worked-example-b-half-solved-a-seed-investment-in-start-up-s) - [Exercise C (unsolved): a Series A with a counter-offer](#exercise-c-unsolved-a-series-a-with-a-counter-offer) - [Process diagram](#process-diagram) - [Connections to other cards](#connections-to-other-cards) - [Common mistakes and misconceptions](#common-mistakes-and-misconceptions) - [Self-test questions](#self-test-questions) - [My notes and next steps](#my-notes-and-next-steps) - [Sources and further reading](#sources-and-further-reading) - [Answer key](#answer-key) - [Revision history](#revision-history) ## When to use it | Question | Where this card answers it | |---|---| | What is the highest post-money valuation at which this investment can still meet our target return? | Formulas, Worked example A | | How much ownership must we buy today to own enough at exit, after later rounds dilute us? | Retention ratio, Worked example A step 3 | | What return does a proposed term sheet imply if the success case happens? | Worked example A step 5 | | What success probability is hidden inside a 40% or 60% target return? | Worked example A step 6 | | Can this one company return the whole fund? | Worked example A step 7 | | Why does the founder's valuation differ from the investor's by a factor of two? | Common mistakes, Exercise C | | Use this card when | Use another tool when | |---|---| | The company has little or no profit and a wide range of outcomes | Cash flows are forecastable and the firm is mature (mba/mba-dcf-valuation-card) | | You price a minority venture round with later financing expected | You price a control buyout with debt (mba/mba-paper-lbo, mba/mba-lbo-model-card) | | You need a quick, defensible price range for a term sheet | You split a given price among classes of shares (mba/mba-venture-finance-cap-table-card, mba/mba-term-sheet-card) | | You test a fund's ability to reach its target multiple | You size reserves and the number of companies in a fund (mba/mba-vc-portfolio-construction-card) | ## The idea in plain language A venture investor buying a minority stake in a young company cannot sensibly forecast ten years of cash flows. What the investor can do is ask: if this company succeeds, what will it be worth when we sell, and how much of it must we own at that point to earn the return our fund needs? Work backwards from that exit to today and you have the price. The method has four steps. 1. **Terminal value.** Estimate the company's equity value at a plausible exit date, usually four to seven years out, in the success case. Analysts typically apply a multiple from comparable public companies or acquisitions to a forecast metric (revenue for young software and hardware firms, earnings for profitable ones). 2. **Required future value.** Grow the investment at the target rate of return for the holding period: $I(1+r)^T$. Dividing by the terminal value gives the ownership the investor needs **at exit**. 3. **Retention ratio.** Later rounds will issue new shares and enlarge the option pool. The investor's stake today will shrink to a fraction of itself, the retention ratio. Divide the exit ownership by the retention ratio to get the ownership needed **today**. 4. **Price.** The post-money valuation is the investment divided by today's required ownership; pre-money is post-money minus the investment. **Why the target rates are so high (often 30% to 70% a year).** The target rate is not a cost of capital in the CAPM sense (mba/mba-capm-wacc-card). It mixes three things: compensation for risk that investors cannot diversify away, compensation for the investor's advice, network and monitoring, and, most importantly, an adjustment for the fact that the terminal value is a **success-case** value rather than an expected value. Many venture-backed companies fail or return little. A target of 40% applied to the success case is roughly equivalent to a lower discount rate applied to a probability-weighted outcome. Worked example A step 6 makes this explicit. Cochrane (2005) shows why measured venture returns are hard to interpret: we observe values mostly when firms raise money or exit, which biases simple averages upwards unless the selection is corrected. **Why the method is still used.** It is transparent: every input can be argued in a partner meeting or across the table from a founder. It ties price to what the fund must achieve. And Gompers, Gornall, Kaplan and Strebulaev (2020) report, from a large survey of venture capitalists, that many investors rely on target multiples and target internal rates of return rather than discounted cash flow, and that a large share use no formal DCF at all at the early stage. ## Formulas and notation **Basic venture capital method** (single investment, single exit): $$ FV_{req} = I\,(1+r)^{T} \qquad \omega_{exit} = \frac{FV_{req}}{TV} \qquad \omega_{0} = \frac{\omega_{exit}}{R} \qquad V_{post} = \frac{I}{\omega_{0}} = \frac{TV \cdot R}{(1+r)^{T}} \qquad V_{pre} = V_{post} - I $$ **Retention ratio** with $K$ later rounds, each selling a fraction $d_k$ of the post-money company (including any pool top-up counted as dilution in that round): $$ R = \prod_{k=1}^{K} (1 - d_k) $$ **Terminal value** with a multiple: $$ TV = m \times X_{T} \quad (\text{e.g. } m = \text{EV/revenue},\ X_T = \text{revenue in year } T) \quad \text{less net debt at exit for an equity value} $$ **Implied return** of a proposed price in the success case: $$ M = \frac{\omega_0 \, R \, TV}{I} \qquad IRR = M^{1/T} - 1 $$ **First Chicago (scenario) view** with scenarios $s$, probabilities $p_s$, payoffs $Y_s$ to the investor and a discount rate $r_c$ for the risk the investor actually bears: $$ V_{inv} = \frac{\sum_{s} p_s\,Y_s}{(1+r_c)^{T}} \qquad \text{NPV} = V_{inv} - I $$ **What the target rate hides.** If only the success case pays and it occurs with probability $p$, the target rate $r$ that gives the same price as discounting the expected payoff at $r_c$ satisfies: $$ (1+r)^{T} = \frac{(1+r_c)^{T}}{p} \qquad \Longleftrightarrow \qquad p = \left(\frac{1+r_c}{1+r}\right)^{T} $$ **Fund-returner test** (exit value at which this one investment returns the fund size $F$): $$ TV_{F} = \frac{F}{\omega_0 \, R} $$ | Symbol | Meaning | Unit | |---|---|---| | $I$ | Investment in this round | Currency | | $r$ | Target rate of return (success case) | Rate per year | | $T$ | Years from investment to exit | Years | | $TV$ | Terminal (exit) equity value in the success case | Currency | | $m$, $X_T$ | Exit multiple and the metric it is applied to | Multiple, currency | | $FV_{req}$ | Value the investor must receive at exit | Currency | | $\omega_{exit}$, $\omega_0$ | Ownership needed at exit and today | Ratio | | $R$, $d_k$ | Retention ratio and dilution in later round $k$ | Ratio | | $V_{pre}$, $V_{post}$ | Pre-money and post-money valuation | Currency | | $M$ | Multiple of invested capital (gross) | Multiple | | $p_s$, $Y_s$ | Scenario probability and payoff to the investor | Ratio, currency | | $r_c$ | Discount rate in the scenario view | Rate per year | | $F$ | Fund size (committed capital) | Currency | ## Assumptions and limits 1. **The terminal value is a success case.** It is not an expected value. Applying a modest target rate to a success-case value overprices the company; applying a high target rate to an expected value underprices it. State which you use. 2. **Exit multiples are borrowed from today.** A multiple taken from current comparables assumes the market in five years prices growth the same way. Use a range and a date for every multiple (finance/comparable-companies-analysis). 3. **Retention is a forecast.** It depends on how much capital the company will need, at what prices and with what pool top-ups. A capital-hungry business (hardware, robots as a service, biotech) retains less. Tie the retention ratio to the company's financing plan, not to a rule of thumb. 4. **One exit date.** Real exits are spread over time. The method compresses that into one $T$; test $T \pm 1$. 5. **Preferences are ignored in the basic method.** The basic method treats the investor as owning a share of common equity. Preferred terms (mba/mba-term-sheet-card) protect the investor in the sideways scenario and raise the value of its claim relative to common; the scenario view can include them. 6. **Headline post-money is not fair value per share.** Venture post-money valuations multiply the latest preferred price by all shares, including common with no preference. Gornall and Strebulaev (2020) show that this overstates the fair value of the company, often substantially, for later-stage firms with strong preferred terms. 7. **Fees and carried interest.** Target rates are usually gross, at the company level. Investors in the fund (LPs) receive net returns after fees and carry, which are lower (mba/mba-pe-fund-economics-card). 8. **Not advice.** The method gives a price range for discussion. It does not replace diligence on the market, the team and the technology. ## How investors and founders use it | Role | How they use the method | What they challenge first | |---|---|---| | Venture partner | Sets a maximum price and the ownership target for the term sheet; checks the fund-returner test | The exit value and the dilution path | | Investment committee | Compares the implied multiple with the fund's target and portfolio needs | Whether the success case is credible and how often it happens | | Founder | Understands why the investor's price is lower than the founder's DCF; negotiates inputs, not outputs | The exit multiple and the retention ratio (a credible financing plan raises it) | | Later-stage investor | Uses a lower target rate because the risk of failure is lower | The growth path from today's metrics to the exit metric | | Corporate venture unit | Adds strategic value to the success case, and checks it is not paying twice | Whether strategic value is captured by the parent or by the start-up | | Board member | Checks that the round's price leaves room for the next round to be an up round | The milestones the round must fund | In practice, investors run the method several times with different exits and target rates, and present the result as a price range rather than a point. The negotiated price then depends on competition among investors, the founder's alternatives and terms beyond price (mba/mba-term-sheet-card, mba/mba-negotiation-planner). ## Worked example A (fully solved): Fund I prices the Corvane Series A **Situation (fictional).** Fund I, an early-stage venture fund with USD 150m of committed capital, is considering leading the Series A of Corvane Robotics, the warehouse-robotics company followed in mba/mba-venture-finance-cap-table-card. Corvane wants USD 12m. The proposed term sheet (the one that closed in the core card) is USD 12m at USD 36m pre-money, USD 48m post-money, so Fund I would own 25.00% after the round. The partner on the deal must show the investment committee whether that price is consistent with Fund I's target of 40% a year in the success case. All numbers are fictional. **Step 1: terminal value.** The success case is an exit five years after the Series A, at revenue of USD 90m, valued at 4.5 times revenue (the deal team's range from comparable warehouse-automation transactions is 3.5 to 5.5 times, dated in the memo). Corvane is assumed to have no net debt at exit. | *Example* item | Result | Excel formula | |---|---|---| | Terminal value $TV$ | USD 405.0m | `=90000000*4.5` | | Required multiple $(1+r)^T$ | 5.3782 | `=(1+40%)^5` | | Required future value $FV_{req}$ | USD 64.54m | `=12000000*(1+40%)^5` | | Ownership needed at exit $\omega_{exit}$ | 15.94% | `=12000000*(1+40%)^5/405000000` | **Step 2: dilution path.** Fund I expects two more rounds before exit: a Series B and a Series C. For the Series B it uses the round modelled in the core card (USD 30m at USD 120m pre-money with the pool topped up to 10%), in which the Series A holders fell from 25.00% to 18.74%. For the Series C it assumes the company sells 15% of itself. **Step 3: retention ratio.** | *Example* item | Result | Excel formula | |---|---|---| | Retention through the Series B | 0.7495 | `=(5565863/29702624)/(5565863/22263451)` | | Retention through the Series C | 0.8500 | `=1-15%` | | Retention ratio $R$ | 0.6371 | `=0.7495*0.85` (unrounded in the sheet) | | Ownership needed today $\omega_0$ | 25.01% | `=0.1594/0.6371` (unrounded in the sheet) | **Step 4: price.** | *Example* item | Result | Excel formula | |---|---|---| | Maximum post-money $V_{post}$ | USD 47.98m | `=405000000*0.6371/(1+40%)^5` | | Maximum pre-money $V_{pre}$ | USD 35.98m | `=47976818-12000000` | | Same, ignoring later dilution ($R = 1$) | Post USD 75.30m, pre USD 63.30m | `=405000000/(1+40%)^5` | The proposed USD 36m pre-money is, to rounding, exactly the maximum Fund I can pay at its 40% target in this success case. The row without dilution shows the most common error: forgetting the retention ratio would have suggested Fund I could pay a USD 63.3m pre-money, 76% more. **Step 5: implied return at the proposed price.** At 25.00% today and a retention ratio of 0.6371, Fund I owns 15.93% at exit and receives USD 64.51m in the success case: a multiple of 5.376 (`=0.25*0.6371*405000000/12000000`) and an IRR of 39.99% (`=RRI(5,12000000,64507710)` or `=(64507710/12000000)^(1/5)-1`). **Step 6: what the 40% target hides (First Chicago view).** The deal team writes three scenarios for year 5 and discounts expected proceeds at 20%, a rate it considers fair for the risk once failure is counted in the probabilities. In the sideways case the 1x preference (USD 12m) is checked but does not bind, because the as-converted share is larger. | *Example* scenario | Probability | Exit equity value | Fund I proceeds (15.93%, with 1x preference check) | Excel formula | |---|---|---|---|---| | Success | 35% | USD 405.0m | USD 64.51m | `=MAX(MIN(12000000,405000000),0.1593*405000000)` | | Sideways | 35% | USD 90.0m | USD 14.34m | `=MAX(MIN(12000000,90000000),0.1593*90000000)` | | Failure | 30% | USD 0 | USD 0 | `=0` | | Expected proceeds | | | USD 27.59m | `=SUMPRODUCT(B2:B4,D2:D4)` | | Present value at 20% | | | USD 11.09m | `=27594965/(1+20%)^5` | | NPV to Fund I | | | USD -0.91m | `=11089797-12000000` | With a 35% chance of success the price is slightly rich: NPV is about USD 0.9m negative. The equivalence formula explains why. A 40% target on the success case alone is the same as a 20% discount rate on expected proceeds only if the success probability is $(1.20/1.40)^5 = 46.27\%$ (`=(1.2/1.4)^5`). With a success probability of 35%, the target consistent with a 20% discount rate is 48.04% (`=((1.2^5)/0.35)^(1/5)-1`). The sideways scenario recovers part of the gap, which is why the NPV is only slightly negative. The partner's memo should say which probability the fund believes and therefore which target is right. **Step 7: fund-returner test.** A common heuristic in early-stage funds is that each new lead investment should have a credible path to returning the whole fund on its own, because a small number of companies produce most of the returns. With 15.93% at exit, Corvane returns USD 150m only if it exits at USD 941.7m (`=150000000/(0.25*0.6371)`), more than twice the success case. The committee must decide whether a larger outcome (a broader product line, an international roll-out) is plausible enough, or whether this is a solid but not fund-returning investment that the portfolio plan can accommodate (mba/mba-vc-portfolio-construction-card). **Sensitivity chart.** Maximum post-money valuation as a function of the target rate, for exits in year 5 and year 6, with $TV$ = USD 405m and $R$ = 0.6371. ```vega-lite { "$schema": "https://vega.github.io/schema/vega-lite/v5.json", "description": "Maximum post-money valuation for the Corvane Series A by target return and exit year (fictional, USD m)", "width": 420, "height": 240, "data": {"values": [ {"target": 20, "exit": "Exit in year 5", "post": 103.7}, {"target": 25, "exit": "Exit in year 5", "post": 84.55}, {"target": 30, "exit": "Exit in year 5", "post": 69.5}, {"target": 35, "exit": "Exit in year 5", "post": 57.54}, {"target": 40, "exit": "Exit in year 5", "post": 47.98}, {"target": 45, "exit": "Exit in year 5", "post": 40.26}, {"target": 50, "exit": "Exit in year 5", "post": 33.98}, {"target": 55, "exit": "Exit in year 5", "post": 28.84}, {"target": 60, "exit": "Exit in year 5", "post": 24.61}, {"target": 65, "exit": "Exit in year 5", "post": 21.1}, {"target": 70, "exit": "Exit in year 5", "post": 18.17}, {"target": 20, "exit": "Exit in year 6", "post": 86.41}, {"target": 25, "exit": "Exit in year 6", "post": 67.64}, {"target": 30, "exit": "Exit in year 6", "post": 53.46}, {"target": 35, "exit": "Exit in year 6", "post": 42.63}, {"target": 40, "exit": "Exit in year 6", "post": 34.27}, {"target": 45, "exit": "Exit in year 6", "post": 27.76}, {"target": 50, "exit": "Exit in year 6", "post": 22.65}, {"target": 55, "exit": "Exit in year 6", "post": 18.61}, {"target": 60, "exit": "Exit in year 6", "post": 15.38}, {"target": 65, "exit": "Exit in year 6", "post": 12.79}, {"target": 70, "exit": "Exit in year 6", "post": 10.69} ]}, "mark": {"type": "line", "point": true}, "encoding": { "x": {"field": "target", "type": "quantitative", "title": "Target return (% a year)"}, "y": {"field": "post", "type": "quantitative", "title": "Maximum post-money (USD m)"}, "color": {"field": "exit", "type": "nominal", "title": "Exit timing"} } } ``` **Reading.** One year of delay at a 40% target cuts the price Fund I can pay from USD 47.98m to USD 34.27m post-money, a 29% fall. The price is far more sensitive to the target rate and the timing than to small changes in the exit multiple, which is why investors and founders argue about milestones and timelines as much as about multiples. ## Worked example B (half solved): a seed investment in Start-up S **Situation (fictional).** A seed investor is asked to put USD 2m into Start-up S, a software company with early revenue. The investor's success case is an exit in seven years at net income of USD 12m and a price-to-earnings multiple of 20. The investor uses a 60% target return for seed deals. The company is expected to raise two more rounds, selling 30% and then 25% of the company. The founders ask for a USD 8m pre-money valuation. | *Example* item | Result | Excel formula | |---|---|---| | (1) Terminal value | USD 240.0m | `=12000000*20` | | (2) Required multiple $(1.60)^7$ | [ ] | [ ] | | (3) Required future value | USD 53.69m | `=2000000*(1+60%)^7` | | (4) Ownership needed at exit | [ ] | [ ] | | (5) Retention ratio | 0.525 | `=(1-30%)*(1-25%)` | | (6) Ownership needed today | [ ] | [ ] | | (7) Maximum post-money and pre-money | [ ] | [ ] | | (8) At the founders' USD 8m pre-money: ownership, success-case multiple and IRR | 20.00%, [ ], [ ] | [ ] | (9) Explain in two sentences why the investor's maximum pre-money is so far below the founders' ask, and name two inputs the founders could credibly argue about. (10) Which of the two gaps is larger in the formula: the 60% target or the 0.525 retention? Show it by recomputing the post-money with $r$ = 40% and, separately, with $R$ = 0.75. ## Exercise C (unsolved): a Series A with a counter-offer A Series A investor considers USD 5m in a company whose success case is USD 30m of revenue in year 5, valued at six times revenue. The investor's target is 50%. Two later rounds are expected, each diluting existing holders by 20%. 1. Compute the terminal value, the required future value and the ownership needed at exit. 2. Compute the retention ratio, the ownership needed today, and the maximum post-money and pre-money valuations. 3. The founders counter at USD 25m pre-money. Compute the investor's ownership, success-case multiple and IRR. 4. The investor's scenario view: 30% success (USD 180m), 30% sideways (USD 40m, with a 1x non-participating preference), 40% failure (zero). Using the ownership at the founders' price and the retention ratio, compute expected proceeds, present value at 25% and NPV. 5. What target rate is equivalent to a 25% discount rate if the success probability is 30% and only success pays? 6. Write a three-line note to the investment committee: price, what it implies and the one diligence question that would change your view most. ## Process diagram ```mermaid flowchart TD A["Success-case exit: metric x multiple = TV"] --> B["Required value at exit: I x (1 + r)^T"] B --> C["Ownership needed at exit = required value / TV"] D["Financing plan: later rounds and pool top-ups"] --> E["Retention ratio R"] C --> F["Ownership needed today = exit ownership / R"] E --> F F --> G["Maximum post-money = I / ownership today"] G --> H{"Proposed price at or below maximum?"} H -->|Yes| I["Scenario check: probabilities, preferences, NPV at r_c"] H -->|No| J["Negotiate price or terms, or pass"] I --> K{"Fund-returner and portfolio fit?"} K -->|Yes| L["Recommend to investment committee"] K -->|No| M["Size down, syndicate or pass"] ``` The two inputs on the left are independent pieces of diligence: the exit case comes from market and comparable work, the retention ratio from the company's financing plan. The two decision points are where Worked example A stopped: the price passed the first test at 40%, the scenario check showed it was slightly rich at a 35% success probability, and the fund-returner test sent the question to portfolio construction. ## Connections to other cards | Card or template | Connection | |---|---| | mba/mba-venture-finance-cap-table-card | The core card: share counts, the pool shuffle and the Series B dilution used for the retention ratio here | | mba/mba-term-sheet-card | Price is only one term; preferences, anti-dilution and control change the value of the investor's claim | | mba/mba-venture-capital-guide | The elective course this card belongs to, with a mini-case on the same Series A decision | | mba/mba-vc-portfolio-construction-card | The fund-returner test and reserves for follow-on rounds at portfolio level | | mba/mba-pe-fund-economics-card | Gross company-level targets versus net returns to LPs after fees and carry | | mba/mba-dcf-valuation-card | DCF is the alternative when cash flows can be forecast; compare both for a later-stage company | | mba/mba-capm-wacc-card | Why the venture target rate is not a CAPM cost of capital | | mba/mba-options-real-options-card | Staged financing is a sequence of options to continue or abandon | | finance/comparable-companies-analysis | Where the exit multiple comes from | | finance/investment-committee-memo | How to present the price range, scenarios and risks | ## Common mistakes and misconceptions 1. **Forgetting dilution.** Using the exit ownership as today's ownership overstates the affordable price; in Worked example A by 76% on the pre-money. 2. **Mixing success case and expected case.** A 40% target belongs with a success-case value. A probability-weighted value should be discounted at a much lower rate. 3. **Treating the target rate as the investor's expected return.** Funds that apply 40% to success cases do not expect to earn 40% on average; the target compensates for the failures in the portfolio. 4. **Using today's multiple on a future metric without a date or a range.** Multiples move with markets; state the source and date and show a range. 5. **Equity value versus enterprise value.** A revenue or EBITDA multiple usually gives enterprise value. Subtract net debt at exit to get the equity value the shareholders split. 6. **Reading post-money as fair value.** The headline post-money prices every share at the preferred price. Common shares and earlier preferred are worth less per share (Gornall and Strebulaev 2020). 7. **Ignoring the timing.** One extra year at a high target rate cuts the price sharply; milestone slippage is a valuation event. 8. **Arguing about the output.** Founders who argue "our company is worth more" rarely move the investor. Founders who bring evidence for a larger exit, a faster path or less future dilution change the inputs, and the price follows. ## Self-test questions 1. Write the venture capital method in one formula for the post-money valuation and name each input. 2. Why is the target rate in venture capital far above a CAPM cost of equity for the same industry? 3. An investor puts USD 3m into a company with a success-case exit of USD 100m in four years and a 50% target. Ignoring dilution, compute the ownership needed today and the post-money and pre-money valuations. 4. Repeat question 3 with a retention ratio of 0.6. 5. Convert into annual IRRs: a 10x multiple over six years and a 3x multiple over five years. 6. A fund discounts expected proceeds at 15% and believes the success probability is 25% over six years, with no value outside success. What success-case target rate is equivalent? 7. A USD 200m fund will own 12% of a company at exit. What exit value returns the fund? 8. Name three things that lower a company's retention ratio. 9. Why do Gornall and Strebulaev (2020) argue that headline post-money valuations overstate company value? 10. A founder says the investor's price ignores the company's DCF value of USD 120m. Give two reasons the investor's number may still be the relevant one for the round. ## My notes and next steps | Item | My entry | |---|---| | The input I find hardest to estimate | [ ] | | Evidence that would improve it | [ ] | | One deal or case I will reprice with this card | [ ] | | Questions for the instructor or an investor | [ ] | | Next card | mba/mba-term-sheet-card | ## Sources and further reading - Sahlman, W. A., and Scherlis, D. R. (1987). A method for valuing high-risk, long-term investments: the "venture capital method". Harvard Business School, product no. 288-006 (read it through your school's course materials). - Sahlman, W. A. (1990). The structure and governance of venture-capital organizations. *Journal of Financial Economics*, 27(2), 473-521. - Cochrane, J. H. (2005). The risk and return of venture capital. *Journal of Financial Economics*, 75(1), 3-52. - Gompers, P. A., Gornall, W., Kaplan, S. N., and Strebulaev, I. A. (2020). How do venture capitalists make decisions? *Journal of Financial Economics*, 135(1), 169-190. - Gornall, W., and Strebulaev, I. A. (2020). Squaring venture capital valuations with reality. *Journal of Financial Economics*, 135(1), 120-143. - Hall, R. E., and Woodward, S. E. (2010). The burden of the nondiversifiable risk of entrepreneurship. *American Economic Review*, 100(3), 1163-1194. - Kaplan, S. N., and Schoar, A. (2005). Private equity performance: returns, persistence, and capital flows. *The Journal of Finance*, 60(4), 1791-1823. - Textbooks (by name only): Metrick, A., and Yasuda, A., *Venture Capital and the Finance of Innovation*; Gompers, P., and Lerner, J., *The Venture Capital Cycle*; Damodaran, A., *The Dark Side of Valuation*. - Open resource: OpenStax, *Entrepreneurship* (CC BY-NC-SA 4.0), chapters on funding and financing. ## Answer key **Worked example B.** (2) 26.8435 (`=(1+60%)^7`). (4) 22.37% (`=53687091/240000000`). (6) 42.61% (`=0.2237/0.525`, unrounded in the sheet). (7) Post-money USD 4.69m (`=2000000/0.4261` or `=240000000*0.525/(1+60%)^7`), pre-money USD 2.69m. (8) At USD 8m pre-money the investor owns 20.00% (`=2/10`), receives 20.00% x 0.525 x USD 240m = USD 25.2m in the success case, a multiple of 12.600 and an IRR of 43.61% (`=12.6^(1/7)-1`). (9) The investor's price compounds a 60% target over seven years (a 26.8x multiple) and expects to keep only 52.5% of its stake; the founders can argue for a shorter path to exit, a larger exit or less future dilution (a capital-efficient plan). (10) With $r$ = 40%: post-money `=240000000*0.525/1.4^7` = USD 11.95m. With $R$ = 0.75: post-money `=240000000*0.75/1.6^7` = USD 6.71m. The target rate is the larger gap. **Exercise C.** (1) TV USD 180m; required value USD 37.97m (`=5000000*1.5^5`); ownership at exit 21.09%. (2) Retention 0.64; ownership today 32.96%; maximum post-money USD 15.17m, pre-money USD 10.17m. (3) At USD 25m pre-money: 16.67%, multiple 3.840 (`=5/30*0.64*180000000/5000000`), IRR 30.88%. (4) Ownership at exit 10.67%; success proceeds USD 19.2m; sideways USD 5.0m (the 1x preference binds, because 10.67% of USD 40m is USD 4.27m); expected USD 7.26m; present value USD 2.38m (`=7260000/1.25^5`); NPV USD -2.62m. (5) 59.03% (`=((1.25^5)/0.3)^(1/5)-1`). (6) A good note says the founders' price implies a 3.8x success-case multiple against a 7.6x requirement, that the scenario NPV is negative, and that the key diligence question is whether revenue can reach USD 30m in five years with only two more rounds. **Self-test.** 1. $V_{post} = TV \cdot R / (1+r)^T$: success-case exit value, retention ratio, target return, years to exit. 2. It applies to a success-case value, so it embeds the probability of failure; it also pays for illiquidity, the investor's active work and risks that are hard to diversify (Hall and Woodward 2010 discuss the founder's side). 3. Required value USD 15.19m (`=3000000*1.5^4`); ownership 15.19%; post-money USD 19.75m; pre-money USD 16.75m. 4. Ownership 25.31%; post-money USD 11.85m; pre-money USD 8.85m. 5. 46.78% (`=10^(1/6)-1`) and 24.57% (`=3^(1/5)-1`). 6. 44.89% (`=((1.15^6)/0.25)^(1/6)-1`). 7. USD 1,666.7m (`=200000000/12%`). 8. More capital needed before exit, down rounds or flat rounds, larger option pool top-ups (also anti-dilution adjustments in favour of other investors, mba/mba-term-sheet-card). 9. The post-money multiplies the newest preferred price by all shares, but common and earlier preferred have weaker preferences and are worth less per share, so the sum overstates the fair value of equity. 10. The investor buys a minority claim with a target return that must cover the failures in its portfolio, and the round price is set by the investor's alternatives and competition, not by an intrinsic value estimate; a DCF on a success-case plan without probability weights also overstates expected value. ## Revision history | Version | Date | Author | Change summary | |---|---|---|---| | 0.1 | YYYY-MM-DD | [Your name] | First pass through the card | | 0.2 | YYYY-MM-DD | [Your name] | *Example:* Replaced Corvane inputs with own company and comparables | ## Standard and licence note Based on the venture capital method as presented in the venture finance literature (Sahlman and Scherlis 1987; Sahlman 1990) and on the empirical work listed above (Cochrane 2005; Gompers, Gornall, Kaplan and Strebulaev 2020; Gornall and Strebulaev 2020). The text, examples, numbers and questions are original; no textbook, teaching note or published case is copied or paraphrased, and Corvane Robotics, Fund I and Start-up S are fictional. The template is independent and not affiliated with or endorsed by any business school, fund or investor. Check current market data before you rely on any multiple or rate. Template licence: MIT.