Question

When using the Venture Capital Method, how does an increase in the target return rate affect the calculated pre-money valuation of a startup?

Accepted Answer

An increase in the target return rate causes the pre-money valuation of a startup to decrease. To understand why, you must first define the components of the Venture Capital Method. The post-money valuation is determined by dividing the expected exit value of the company—the price the investor expects the company to be worth when sold or taken public—by the target return rate. The target return rate represents the annual percentage gain the investor requires to compensate for the high risk of the investment over a specific time horizon. Because this calculation uses the return rate as a denominator, a higher return rate mathematically shrinks the resulting post-money valuation. The pre-money valuation is then calculated by subtracting the investment amount from the post-money valuation. For example, if an investor expects an exit value of ten million dollars and requires a return factor of ten, the post-money valuation is one million dollars. If the investor increases their required return factor to twenty, the post-money valuation drops to five hundred thousand dollars. Since the investment amount remains constant, the resulting pre-money valuation falls by the same amount as the post-money valuation. Therefore, a higher required return rate acts as a hurdle that reduces the current value of the startup today.

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When using the Venture Capital Method, how does an increase in the target return rate affect the calculated pre-money valuation of a startup?