Understanding Startup and Company Valuations in Venture Capital
All belongings hold value. From homes to vehicles to furniture and collectibles, factors like age, wear and tear, upgrades, and demand can drastically change the valuation of these objects. On the other hand, it’s much more complex to put a price on the value of an intangible asset, such as the current and potential worth of a young, fast-growing startup.
Harvard Business School professor Bill Sahlman created what is known as the “Venture Capital Method” in the 1980s for determining a company’s valuation. Sahlman’s formula involves multiplying the company’s projected revenue with its projected margin and industry price-to-earnings to calculate its future value. Many VCs still utilize this formula and its variations for different types of organizations.
In venture capital, valuation determination is a market-driven system. Companies in specific sectors aim to accelerate their growth by raising capital from VCs with relevant industry expertise. The key financial terms of the investment are laid out in a term sheet including:
-How much a startup is worth
-Rights and protections afforded to investors
-How profits of the company are shared if it is sold or goes public
While valuations are among the many details described in in a term sheet, other items, such as board seats and who controls the company, are also factored into the negotiation.
“A company may receive multiple term sheets at various valuations as a company is fundraising,” says Andrew Ervin, Senior Vice President of Investment Operations at Alumni Ventures. “It’s not one person saying, ‘I’m going to go out and raise money at this valuation.’ Instead, it’s a market-driven system. If a VC is willing to put money to work at a given valuation, then that’s the price.”
Read the rest of the valuations deep dive on the Alumni Ventures blog.
Alumni Ventures (AV) provides smart, simple venture portfolios to accredited individuals. PitchBook listed AV as the third most active VC firm in the world in 2021.
