The Logic of the VC Method for Startup Valuation

Venture capital investing is fundamentally a high-risk, high-reward game where most investments fail, but the winners must generate sufficient returns to compensate for these losses. The Venture Capital (VC) Method is one of the most practical valuation approaches because it directly incorporates this investor reality, answering the crucial question: “What price can an investor pay today to achieve their required return, given the significant risks involved?”

Our implementation of the VC Method stands out for its data-driven, stage-specific approach that accounts for both the probability of success and expected dilution. Let’s explore how this methodology works and why it provides valuable insights for both founders and investors.

The Logic of the VC Method

The VC Method is a practitioner-favored approach that directly incorporates the return expectations of venture capital investors. VCs invest with the expectation of achieving high returns upon exit (e.g., acquisition or IPO) to compensate for the high risk and illiquidity of their investments and the likelihood that many portfolio companies will fail.

The basic formula for the VC Method is elegant:

Present Value (Post‑Money) = Terminal Value / (1 + Required ROI)n

Where n is the number of projected years used to find the terminal value. The pre‐money valuation is then calculated by subtracting the planned investment amount from this post‐money valuation.

What differentiates our implementation is how the Required ROI is calculated, using data‐driven inputs that reflect both the realities of startup success rates and the dilution investors can expect through subsequent funding rounds.

Calculating Terminal Value

When using the Venture Capital method on Equidam, we calculate the terminal value by projecting the company’s EBITDA in the final forecast year and applying a relevant industry multiple (you may also use a revenue multiple, via our Advanced Multiples section).

For example, if a startup is expected to generate €2M in EBITDA in year 5 and the industry multiple is 10x, the potential exit value is €20M.

This provides the estimated exit value, which we then discount back to present value using a high discount rate that reflects the expected VC return.

Breaking Down Our Required ROI Calculation

1. Fund Multiple

   This represents the overall return multiple that a venture capital fund aims to achieve across its entire portfolio (e.g., 3-5x the total capital invested). Earlier-stage investments target higher multiples (5x) due to greater risk, while growth-stage investments target more modest returns (3x).

2. Success Rate

   This acknowledges the hard reality that most startups fail. The data shows a clear progression in success probability: only about 6% of idea-stage startups succeed, increasing to around 33% by the growth stage. These figures represent averaged data from Dealroom and Pitchbook on startup success rates.

3. Target Multiple

   Calculated by dividing the Fund Multiple by the Success Rate. For example, at the Idea Stage:

   • Fund Multiple: 5.0
   • Success Rate: 5.94%
   • Target Multiple: 5.0 ÷ 0.0594 = 84.25×

   This means that for successful investments to compensate for the ~94% that fail, each winner must return 84.25x the invested capital.

4. Retention Rate

   This accounts for dilution from future funding rounds. As startups raise additional capital, existing investors get diluted. We use Carta data showing that seed rounds typically dilute by 20%, Series A and B by 17% each, and later rounds by 8-9.5%.

   The compound effect of this dilution is reflected in the stage-specific retention rates, which range from 42% for idea-stage companies (meaning an investor will retain only 42% of their initial ownership percentage by exit) to 84% for growth-stage companies.

5. Multiple / Retention

   This adjusts the Target Multiple to account for future dilution. For example, at the Idea Stage:

   • Target Multiple: 84.25×
   • Retention: 0.42
   • Multiple / Retention: 84.25 ÷ 0.42 = 201.31×

   This means that while the investor needs each successful investment to return 84.25x, dilution means they need the company’s overall exit value to be 201.31x the post-money valuation of their investment.

6. Required ROI

   Finally, this is calculated as the annual compound growth rate needed to achieve the Multiple/Retention value over an eight-year period (the typical time to exit for venture-backed startups, according to research by Ilya Strebulaev).

   For the Idea Stage, a Multiple/Retention of 201.31x translates to a Required ROI of 94.08%.

Combining Terminal Value with Required ROI

To get today’s valuation, we take the terminal value and discount it back over the investment horizon using this ROI based on the number of projected years. The higher the ROI, the lower the present value. This discounted amount becomes the post-money valuation, and by subtracting the capital to be raised, we get the pre-money valuation—the value of the business today from the investor’s perspective.

Practical Implications for Founders and Investors

For Founders

Understanding this methodology provides critical insights:

1. The Stage Effect: The valuation discount applied to early-stage companies (via higher Required ROIs) isn’t arbitrary but reflects real data on risk and dilution.
2. The Progression Path: As your startup moves through stages, reduced risk and dilution directly translate to more favorable valuations. This explains why hitting meaningful milestones can dramatically impact valuation.
3. Negotiation Framework: Rather than arguing about the final valuation number, founders can focus discussions on the underlying assumptions – is your startup truly at the “Startup Stage,” or have you progressed further? Does your traction suggest a higher success probability than the average?

For Investors

The methodology provides a structured approach to determining entry price:

1. Risk-Adjusted Returns: Rather than relying on crude market multiples, this approach ensures that the valuation directly connects to the probability-weighted return profile necessary for venture economics to work.
2. Portfolio Construction: Understanding the dramatic difference in required returns across stages helps in constructing a balanced portfolio and setting appropriate expectations for different investments.
3. Valuation Discipline: In hot markets, this approach can provide discipline against the momentum trap where prices become disconnected from fundamentals.

A Holistic Approach

It’s worth noting that while the VC Method provides a crucial investor-return perspective, our approach doesn’t rely on it exclusively. Our valuation methodology employs five distinct valuation methods, including qualitative assessments (Scorecard and Checklist methods) and two variants of Discounted Cash Flow analysis.

This multi-method approach provides a more balanced view by integrating different perspectives – qualitative potential, projected cash flows, and investor return requirements. The weights assigned to each method adjust automatically based on the company’s stage, ensuring that the most relevant metrics drive the valuation at each development phase.

The Value of Transparency

The beauty of understanding the VC Method as implemented here lies in its transparency. Rather than treating valuation as a black box or relying solely on market comparables, this approach explicitly connects investment risk, success probability, dilution expectations, and required returns.

For founders, this transparency transforms valuation from a sometimes adversarial negotiation into a structured conversation about risk, potential, and the path forward. It helps set realistic expectations and focuses attention on the milestones that will meaningfully reduce risk and increase value.

For investors, it provides a disciplined framework that aligns investment decisions with portfolio return requirements, helping to maintain discipline in both hot and cold markets.

Ultimately, valuation should be about finding a fair balance that supports the long-term health and success of the startup while providing investors with appropriate compensation for the risks they take. Our approach to the VC Method, combined a their broader multi-method framework, represents a thoughtful attempt to achieve this balance through data-driven, transparent reasoning.