First chicago method

The First Chicago Method or Venture Capital Method is a valuation method often used by venture capitalists and private equity professionals that combines elements of both a multiples-based valuation and a traditional discounted cash flow (DCF). [http://research.kauffman.org/cwp/appmanager/research/researchDesktop;jsessionid=IaIkfkTdY4dXKNiCWdGg61LY3d2P2Ke79urHnyuu4spdtbYuPfvo!484687239?_nfpb=true&_pageLabel=research_resourceDetail&keep=all&id=1133004&_nfls=false] The method is particularly useful in valuing high-growth companies. Many practitioners feel that the method is better than a straight multiples method for valuing high-growth companies because high-growth companies do not have significant current financial results. Mutliplying these results against a valuation multiple often yields an unrealistically low value for the company. This value does not take into account the intellectual property assets of the company and perhaps even more importantly, the option value of the company. I.e., while high-growth companies are often high-risk startups, the company's "risk" represents volatility in the traditional Black-Scholes option valuation method which can actually increase the value of the startup, or the "option" in Black-Scholes terms. The First Chicago Method is also often preferred to a Discounted Cash Flow method because:
1. Performing a good DCF usually involves a great deal of knowledge and surety about the financial details of a company's business--something which may not be possible for a high-growth or high-risk company.
2. DCFs are complex and involve a significant degree of assumption. Layering assumption on assumption has an increasing chance of rendering the resulting valuation nearly meaningless.
3. DCF valuations are complicated and time-consuming.

The First Chicago or Venture Capital Method by contrast is relatively simple and easy to perform. It hinges on only a few key assumptions: 1) the projected financials of the company (generally revenue), 2) the recent industry valuation multiples applied and 3) the terminal value or "exit" timing. Venture capitalists and private equity professionals will often use this method because finding these 3 inputs is relatively easy. Projected financials are critical and are created by understanding the market size, growth, and the assumed adoption or "uptake" rate of the company's revenue-producing products or services. Industry valuation multiples are available through commercial databases or Internet research. Industry practitioners generally assume exits will occur with 3-8 years, though with the recent dearth of IPO exits, most practitioners are assuming 4-7 years for exit timing and even 6-10 years for biotechnology companies.

References

1. Kauffman Foundation article on The First Chicago Method. [http://research.kauffman.org/cwp/appmanager/research/researchDesktop;jsessionid=IaIkfkTdY4dXKNiCWdGg61LY3d2P2Ke79urHnyuu4spdtbYuPfvo!484687239?_nfpb=true&_pageLabel=research_resourceDetail&keep=all&id=1133004&_nfls=false]