Using the First Chicago Method to determine an accurate DCF-based valuation for a startup
Determining a valuation for a startup is an inherently challenging and subjective exercise. The first challenge is deciding which valuation model to use (discounted cash flow, relative valuations like a price-earnings multiple valuations, asset valuation, future maintainable earning valuations etc.).
In my opinion, the best valuation methodology for a business remains the Discounted Cash Flow (DCF) model, where cash inflows and outflows are forecast for a 5-year implicit period, a terminal cash-flow value is calculated to capture value beyond the implicit period, and these cash flows are then discounted at a rate unique to the business called the weighted average cost of capital.
For a startup (or any business in its early stages for that matter), the challenge is determining the cash inflows and outflows for the 5-year implicit forecast period. This becomes more challenging when we’re dealing with a technology startup, where this forecast needs to include expected cash inflows and outflows from a digital product (eg. an online platform, software) that either hasn’t been tested in the market at all or is in the early stages of an experimental roll-out.
There are several possible outcomes for this tech startup’s cash flows, ranging from wildly successful product uptake resulting in high revenues and cash flow growth to mediocre uptake with little revenue. An effective solution to this cash flow uncertainty would be to build several DCF’s, under different scenarios, and then combine these DCF’s by assigning a percentage probability to each scenario. And that’s exactly what the First Chicago Method (FCM) does.
The FCM makes use of the traditional DCF method, but caters to the unpredictability of startup companies by using three separate DCF calculations for three scenarios, or outcomes: Best Case, Base Case and Worst Case.
The Best Case is usually the scenario that the management team of a startup would expect, and is in line with the company’s internal plan and projections i.e. it is quite optimistic. It assumes, for the most part, that things go according to management’s plan. Importantly, it also shouldn’t be overly optimistic, and should reflect the outcome that would be achieved if management hit all of their product and business development milestones.
The Base Case is a case that factors in things like inefficiencies, reasonable product development delays, sticky market uptake and other extraneous circumstances, but assumed that the company’s growth path is more or less maintained in spite of these setbacks.
The Worst Case scenario assumes a breakdown in the company’s business model resulting in minimal product uptake in the market. Under this scenario, expected business growth drivers fail to take off and revenue is limited to existing products that have a proven track record.
Once a DCF has been compiled under all three scenarios, each scenario is assigned a percentage probability of occurrence, and the DCF’s are aggregated using their respective probabilities.
As a formula, the final valuation would be calculated as follows, assuming a 20% probability of Best Case, 60% probability of Base Case and a 20% probability of Worst Case:
Final valuation = (Best Case DCF value x 20%) + (Base Case DCF value x 60%) + (Worst Case DCF value x 20%)
When I performed a FCM DCF valuation for EduOne during our Series A fundraising process, I had the following insights, which might be useful to others:
Don’t be trigger happy with the Best Case scenario. The Best Case scenario should cater to a cash flow forecast that reflects flawless execution by the management team with almost no product delays, combined with good market uptake. The Best Case should not include any “Black Swan” or once-off events of incredible good fortune (eg. an unlikely deal with a multinational that results in an additional 100,000 users overnight).
The Worst Case scenario really is the worst case scenario. No matter how unlikely it may seem (let’s face it, if you’re an entrepreneur, you’re probably a natural optimist with a high conviction level on the success of your startup), the Worst Case should reflect a true failure scenario, where the majority of business growth drivers do not bear any fruit. Remember, you have the opportunity to temper the affect this value has on the final valuation by assigning an appropriate probability percentage to it.
As a final thought, after completing a FCM DCF, it might be useful to calculate a Market Multiples valuation as well. The best Market Multiples valuation for a technology startup (particularly if the entity is loss-making, as is usually the case during the early high-growth stage), is a Revenue Multiple valuation. The challenges here, of course, are different to that of a DCF, most notably the lack of data on comparable private companies in the market, which is critical to determining the Multiple factor. That being said, it’s important to compare the final valuation under the FCM to a Market Multiple valuation, to ensure that your final valuation isn’t out of whack with the market.