19.04.2022, English Articles

Company valuation with the venture capital method

Popular, simple - but often too inaccurate!

An article by Martin Stürmer, auditor and tax consultant in Germany

Recently, one reads and hears in the world of business valuation, especially in connection with the valuation of startups, again and again about the so-called venture capital valuation. In this article, we will explain what this means and whether this method is suitable for valuing your company. 

Principles of company valuation in german law

There are various different methods of valuing companies. Depending on the approach and method, the value of the company can vary greatly, which is why the choice of the right valuation method is already of crucial importance in business valuation. The classic valuation methods in Germany are: 

  1. Classical capitalized earnings value method IDW S1
  2. Discounted cash flow (DCF) method
  3. Simplified capitalized earnings value method
  4. EBIT and sales multiples method
  5. Net asset value method
  6. Stuttgart method

You can find more detailed information on the various methods on our page on company valuation: Company and share valuation in Germany

Problem: Valuation of startups 

The valuation of startups is a special case in business valuation. Since they do not yet have a turnover, especially at the beginning of their business, startups are particularly dependent on forecasts and estimates. For this reason, or despite it, shares of a startup often achieve an incredibly high value with investors - without this being directly reflected in the current figures of the company. 

In practice, the dicounted cash flow method, the multiplier valuation and the IDW S1 method play a special role in the valuation of startups. Finally, however, the venture capital method already mentioned comes into play time and again. 

The Venture Capital Method 

The venture capital method (VC method) was first described by Prof. Bill Sahlman at Harvard Business School in 1987. It is a valuation method to determine a company value of a startup venture before entering in front of investors. The basis is the liquidity result at the planned exit from the perspective of the investor.

The company value is calculated backwards from the planned exit proceeds at the time of the sale or IPO and the return expected by the investor between the entry and the sale. Depending on the risk assessment, the expected return is usually between 25% and 100%.

The procedure in the venture capital company valuation

As described, the expected exit proceeds are first determined. This is based on a business plan and the key figures to be determined, such as sales, EBIT, EBITDA, etc. The so-called multiples method is used. The selected key figure (e.g. EBIT) is multiplied at the expected time of the sale (e.g. in 6 to 8 years) by an industry and transaction multiplier customary for the company to be valued, and the expected exit proceeds are thus determined.

Based on this, the future value of the investor's investment is determined on the basis of its expected return using compound interest. The amount of the investor's participation is calculated by dividing the future value of the investment by the determined future enterprise value.

Advantages and disadvantages of the venture capital method 

It is clear from the calculation system that the actual determination of the company value using the multiplier method is very general and simplistic and does not take into account the respective company-specific characteristics of the valuation object. In individual cases, the valuation may therefore incorrectly reflect the value of the company. 

Nevertheless, this method is becoming increasingly popular in practice due to its simple application and the cost savings often associated with it. 

Furthermore, it must be taken into account with the venture capital method that it involves the determination of the value of the company before and after the investor's entry, the consideration of which is based on financial mathematics. In terms of valuation theory, a concrete company valuation oriented to the individual case is clearly preferable according to the regulations of IDW S 1, since both objectified values and subjective company values are determined here, and financing structures or return requirements of investors are also taken into account. Those who want to avoid risks and an incorrect valuation should therefore be careful when applying the venture capital method.