The First Chicago Method or Venture Capital Method is a context specific approach used by venture capital and private

equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach. Rather than completing a valuation of the company, the First Chicago Method takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios. Most often this methodology will involve the construction of:

An "upside case" or "best case scenario" A "base case" A "downside" or "worst case scenario"

The method is used particularly in the valuation of growth companies which often do not have historical financial results that can be used for meaningful comparable company analysis. Multiplying actual financial results against a comparable valuation multiple often yields a value for the company that is objectively too low given the prospects for the business. Often the First Chicago Method may be preferable to a Discounted Cash Flow taken alone. This is because such income-based business value assessment may lack the support generally observable in the market place. Indeed, professionally performed business appraisals go further and use a set of methods under all three approaches to business valuation. http://en.wikipedia.org/wiki/First_chicago_method
Valuation Basics

An important component of the venture capital investment process is the valuation of the business enterprise seeking financing. Valuation is an important input to the negotiation process relative to the percentage of ownership that will be given to the venture capital investor in return for the funds invested. There are a number of commonly used valuation methods, each with their strengths and weaknesses. The most commonly used valuation methods are:

Comparables The Net Present Value Method The Venture Capital Method

Comparables Similar to real estate valuations, the value of a company can be estimated through comparisons with similar companies. There are many factors to consider in selecting comparable companies such as size, growth rate, risk profile, capital structure, etc.

Hence great caution must be exercised when using this method to avoid an apples and oranges comparison. Another important consideration is that it may be difficult to get data for comparable companies unless the comparable is a public company. Another caveat when comparing a public company with a private company is that, all other things being equal, the public company is likely to enjoy a higher valuation because of its greater liquidity due to being publicly traded. Net Present Value Method The Net Present Value Method involves calculating the net present value of the projected cash flows expected to be generated by a business over a specified time horizon or study period and the estimation of the net present value of a terminal value of the company at the end of the study period. The net present value of the projected cash flows is calculated using the Weighted Average Cost of Capital (WACC) of the firm at its optimal capital structure. Step 1: Calculate Net Present Value of Annual Cash Flows Cash Flow for each future period in the time horizon or study period of the analysis is defined as follows: CFn = EBITn*(1-t) + DEPRn CAPEXn .CNWCn Where: CF = cash flow or free cash flow n = the specified future time period in the study period EBITn = earnings before interest and taxes t = the corporate tax rate DEPRn = depreciation expenses for the period CAPEXn = capital expenditures for the period .NWCn = increase in net working capital for the period It should be noted that interest expense is factored out of the cash flow formula by using EBIT (earnings before interest and taxes). This is because the discount rate that is used to find the net present value of the cash flows is the WACC. The WACC uses the after tax cost of debt, which takes into account the tax shields that result from the tax deductibility of interest. By using EBIT in the cash flow calculation, double counting of the tax shields is avoided. Step 2: Calculate the Net Present Value of the Terminal Value The terminal value is normally calculated by what is often referred to as the perpetuity method. This method assumes a growth rate g of a perpetual series of cash flows beyond the end of the study period. The formula for calculating the terminal value of the company at the end of the study period is:

TVt = [CFt*(1 + g)]/(r g) Where: TVt = the terminal value at time period t, i.e. the end of the study period CFt = the projected cash flow in period t g = the estimated future growth rate of the cash flows beyond t The Venture Capital Method Most venture capital investment scenarios involve investment in an early stage company that is showing great promise, but typically does not have a long track record and its earnings prospects are perhaps volatile and highly uncertain. The initial years following the venture capital investment could well involve projected losses. The venture capital method of valuation recognizes these realities and focuses on the projected value of the company at the planned exit date of the venture capitalist. The steps involved in a typical valuation analysis involving the venture capital method follow. Step 1: Estimate the Terminal Value The terminal value of the company is estimated at a specified future point in time. That future point in time is the planned exit date of the venture capital investor, typically 4-7 years after the investment is made in the company. The terminal value is normally estimated by using a multiple such as a price-earnings ratio applied to the projected net income of the company in the projected exit year. Step 2: Discount the Terminal Value to Present Value In the net present value method, the firm's weighted average cost of capital (WACC) is used to calculate the net present value of annual cash flows and the terminal value. In the venture capital method, the venture capital investor uses the target rate of return to calculate the present value of the projected terminal value. The target rate of return is typically very high (30-70%) in relation to conventional financing alternatives. Step 3: Calculate the Required Ownership Percentage The required ownership percentage to meet the target rate of return is the amount to be invested by the venture capitalist divided by the present value of the terminal value of the company. In this example, $5 million is being invested. Dividing by the $17.5 million present value of the terminal value yields a required ownership percentage of 28.5%. The venture capital investment can be translated into a price per share as follows.

The company currently has 500,000 shares outstanding, which are owned by the current owners. If the venture capitalist will own 28.5% of the shares after the investment (i.e. 71.5% owned by the existing owners), the total number of shares outstanding after the investment will be 500,000/0.715 = 700,000 shares. Therefore the venture capitalist will own 200,000 of the 700,000 shares. Since the venture capitalist is investing $5.0 million to acquire 200,000 shares the price per share is $5.0/200,000 or $25 per share. Under these assumptions the pre-investment or pre-money valuation is 500,000 shares x $25 per share or $12.5 million and the post-investment or post-money valuation is 700,000 shares x $25 per share or $17.5 million. Step 4: Calculate Required Current Ownership % Given Expected Dilution due to Future Share Issues The calculation in Step 3 assumes that no additional shares will be issued to other parties before the exit of venture capitalist. Many venture companies experience multiple rounds of financing and shares are also often issued to key managers as a means of building an effective, motivated management team. The venture capitalist will often factor future share issues into the investment analysis. Given a projected terminal value at exit and the target rate of return, the venture capitalist must increase the ownership percentage going into the deal in order to compensate for the expected dilution of equity in the future. The required current ownership percentage given expected dilution is calculated as follows: Required Current Ownership = Required Final Ownership divided by the Retention Ratio

Source: University of New Brunswick http://www.venturechoice.com/articles/valuation_methods.htm

The First Chicago method of valuation is another approach that is commonly used by appraisers. Under this methodology, a small number of discrete scenarios are valued using a discount rate that reflects the cost of capital for the venture. The objective is to select and weight the scenarios in a manner that provides unbiased estimates of expected cash flows and is of those cash flows.

The venture capital group of First Chicago Corporation developed the First Chicago method. Scherlis and Sahlman (1987) describe it as a methodology developed to address valuation biases inherent in the Venture Capital method. Valuation using this methodology is made in the context of an outside individual investing in the venture as part of a well-diversified portfolio. Thus, the investor could be a public corporation investing on behalf of it stockholders, a venture capital fund investing on behalf of its limited partners, or even a business angel who is committing a small fraction of their wealth to the venture. A typical First Chicago method approach: 1. Select a terminal year for the valuation. 2. Estimate the cash flows during the explicit value period based on a small number of discrete scenarios. Normally, the valuation is based on a "optimistic scenario" for the venture, a "most likely scenario" and a "pessimistic scenario". 3. Compute the continuing value of the venture by applying a multiplier to the financial projection. The multiplier for the optimistic scenario should reflect the expected capitalization for a company that has achieved the level of success reflected in the scenario. The multiplier for the most likely scenario may be different from the optimistic scenario. 4. Compute the expected cash flows of the venture by discounting the expected cash flows, including the expected continuing value at their opportunity cost of capital. 5. Based on the present value, compute the fraction of ownership the investor should require in exchange for contributed capital. Advantages & Disadvantages Advantages of the First Chicago method include:

Use of discrete scenarios is a simple and easy to apply method of determining both the risk and expected return of a venture. The intent is to value expected cash flows. The technique reduces the uncertainty associated with a single fair market value determination by allowing for several scenarios representing differing levels of success of the company. Because information about total risk is derived, the method provides a basis for valuing complex financial claims.

Disadvantages of the First Chicago method include:

Use of discrete scenarios discards information about the risk of the venture that could be useful, especially for valuing complex claims. No guidance is provided about how to determine the discount rate(s) to be used in the valuation. Here I use my own methodology that includes standard components along with some widely accepted subjective components.

http://www.charlesthardy.com/Valuation_Home/Valuation_Fundamentals/Valuing_Early _Stage_Companies/First_Chicago_Method/first_chicago_method.html e Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since. It is one of the useful methods for establishing the pre-money valuation of pre-revenue startup ventures. The concept is simplysince: Return on Investment (ROI) = Terminal (or Harvest) Value Post-money Valuation (in the case of one investment round, no subsequent investment and therefore no dilution) Then: Post-money Valuation = Terminal Value Anticipated ROI So, lets address each of these: Terminal Value is the anticipated selling price (or investor harvest value) for the company at some point down the road; lets assume 5-8 years after investment. The selling price can be estimated by establishing a reasonable expectation for revenues in the year of the sale and, based on those revenues, estimating earnings in the year of the sale from industry-specific statistics. For example, a software company with revenues of $20 million in the harvest year might be expected to have after-tax earnings of 15%, or $3 million. Using available industry specific Price/Earnings ratios, we can then determine the Terminal Value (a 15X P/E ratio for our software company would give us an estimated Terminal Value of $45 million). It is also known that software companies often sell for two times revenues, in this case, then, a Terminal Value of $40 million. OKlets split the difference. In this example, our Terminal Value is $42.5 million. Anticipated ROI: Angel investing is risky business. Based on the Wiltbank Study, investors should expect a 27% IRR in six years. Most angels understand that half of new ventures fail and the best an investor can expect from nine of ten investments is return of capital for a portfolio of ten. Consequently, the tenth investment must be a home run of 20X or more. Since investors do not know which of the ten will be the homerun, all investments must demonstrate the possibility of a 10X-30X return. Lets assume 20X for purposes of this example. Assuming our software entrepreneurs needs $500,000 to achieve positive cash flow and will grow organically thereafter, heres how we calculate the Pre-money Valuation of this transaction: From above: Post-money Valuation = Terminal Value Anticipated ROI = $42.5 million 20X Post-money Valuation = $ 2.125 million

Pre-money Valuation = Post-money Valuation Investment = $2.125 $0.5 million Pre-money Valuation = $1.625 million http://billpayne.com/2011/02/05/startup-valuations-the-venture-capital-method.html