The Flaws of Startup Valuation Methods & First Chicago Methods
Investors valuate startups based on assumptions.
Multiple-based valuation assumes that companies in the same industry with a similar growth rate will create similar value.
Comparable company analysis assumes that two different companies working on the same problem to a certain level have a similar growth trajectory.
DCF assumes that the discount rate and cash flows are stable.
However, all these assumptions have flaws.
Early-stage startups take time to generate revenue.
No two companies are exactly the same.
Investors can nominate an expected discount rate, but the long term cash flows are far from predictable.
First Chicago Methods is a variation that combines Multiple based valuation and DFC in a few steps.
- First, define best, base, worst scenarios and probability of each scenario
- Second, work out the exit valuations based on multiples
- Third, discount the exit valuation to the present valuation
- Finally, get a weighted present valuation that includes all the scenarios
Advantages of this method:
- This method makes it possible to use multiples methods without existing revenue.
- It’s easier to predict the company state at the exit point than all the future cash flows.
- The multiple at the exit stage could be more relevant than the early stage.
Additional complexity:
- The weighted probability will be subjective, more of a gut feeling than an accurate calculation. It is impossible to get it 100% right.
