First Chicago method: Difference between revisions

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{{Short description|Method of Startup Valuation}}

{{refimprove|date=December 2008}}

The '''First Chicago Methodmethod''' or '''Ventureventure Capitalcapital Methodmethod''' is a context specific [[business valuation]] approach used by [[venture capital]] and [[private equity]] investors that combines elements of both a [[Valuation using multiples|multiples-based valuation]] and a [[discounted cash flow]] (DCF) valuation approach. <ref>[https://www.venionaire.com/first-chicago-method-valuation/ Venture Valuation - First Chicago Method]. [[Venionaire Capital]].</ref>

The First Chicago Methodmethod was first developed by, and consequently named for, the venture capital arm of the [[First Chicago Bank|First Chicago Corporation Venture Capital]] bank, the predecessor of [[private equity]] firms [[Madison Dearborn Partners]] and [[GTCR]].
<ref>[https://news.gcase.org/2011/04/01/how-to-value-your-deal-like-an-investor/ How to value your deal like an investor]. [[Global Entrepreneurship Institute]]. December 2007.</ref>

It was first discussed academically in 1987.

<ref>

William A. Sahlman and Daniel R Scherlis (1987). [https://www.hbs.edu/faculty/Pages/item.aspx?num=6515 ''A Method For Valuing High-Risk, Long-Term Investments: The "Venture Capital Method"''].

[[Harvard Business School]] (Case Collection, 288-006)</ref>

==Method==

The First Chicago Methodmethod takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios; see [[Corporate_finance#Quantifying_uncertainty{{slink|Corporate finance#Quantifying uncertainty]] under [[Corporate finance]]}}.
Most often this methodology will involve the construction of:

* An "upside case" or "best-case scenario" (often, the [[business plan]] submitted)

* A "base case"

* A "downside" or "worst-case scenario."

Once these have been constructed, the [[valuation (finance)|valuation]] proceeds as follows.<ref>See, for example, Schumann (2006).</ref>

*#First, for each of the three cases, a [[Scenario_planning |scenario specific]], ''internally consistent'' forecast of [[cashflow]]s - see [[Financial_modeling#Accounting| discussion]] under [[Financial modeling]] - is constructed for the years leading up to the assumed [[Divestment#Divestment_for_financial_goals |divestment]] by the private equity investor.

*#Next, a divestment price - i.e. a [[Terminal value (finance)|Terminal value]] - is modelled by assuming an [[Terminal_value_(finance)#Exit_Multiple_Approach |exit multiple]] consistent with the scenario in question. (Of course, theThe divestment may take various forms - see [[Private_equity#Investments_in_private_equity|Investments in private equity]] under [[Private equity]].)

*#The cash flows and exit price are then [[present value|discounted]] using the investor’s [[Required rate of return|required return]], and the sum of these is the value of the business under the scenario in question.

*#Finally, each of the three scenario-values are multiplied through by a [[probability]] corresponding to each scenario (as estimated by the investor). The value of the investment is then the [[Weighted mean|probability weighted sum]] of the three scenarios.

==Use==

The method is used particularly in the valuation of [[growth company|growth companies]] which often do not have historical financial results that can be used for meaningful [[comparable company analysis]]. Multiplying actual financial results against a comparable valuation multiple often yields a value for the company that is objectively too low given the prospects for the business.

Often the First Chicago Methodmethod may be preferable to a Discounteddiscounted Cashcash Flowflow taken alone. This is because such income-based business value assessment may lack the support generally observable in the market place. Indeed, professionallyProfessionally performed business appraisals go further and use a set of methods under all three approaches to business valuation.<ref>[http://www.valuadder.com/valuationguide/business-valuation-three-approaches.html Business valuation using the Market, Income and Asset Approaches.] [[ValuAdder]] </ref>

Variations of the First Chicago Methodmethod are employed in a number of markets, including the [[private equity secondary market]] where investors project outcomes for portfolios of private equity investments under various scenarios.

==See also==

*[[rNPV]]: cash flows, as opposed to scenarios, are probability-weighted.

*[[Expected commercial value]]

*[[Valuation using discounted cash flows #Determine equity value]]

'''==Notes'''==

==External links and references==

'''Notes'''

{{reflist}}

'''Links'''

==References==

*Ann-Kristin Achleitner and Eva Lutz. (2008). [http://ssrn.com/abstract=1133004 First Chicago Method: Alternative Approach to Valuing Innovative Start-Ups in the Context of Venture Capital], [[Social Science Research Network]] Accepted Paper Series.

*James L. Plummer. (1997). [https://web.archive.org/web/20121224010823/http://www.qedresearch.biz/Lit%20pub%205.pdf A Primer on Venture Capital Financial Calculations], 23rd Annual Venture Capital Institute.

*C.P. Schumann (2006). [https://web.archive.org/web/20120417052406/http://www.cpschumannco.com/storeimages/MonteCarloArticle.pdf Improving Certainty in Valuations using the Discounted Cash Flow Method], ''Valuation Strategies Magazine'', September/October 2006.

{{private equity and venture capital}}

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[[Category:Venture capital]]

[[Category:Madison Dearborn Partners companies]]

[[Category:Cash flow]]

[[Category:Fundamental analysis]]

[[Category:Valuation (finance)]]