# First Chicago method

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{{Short description|Method of Startup Valuation}}
{{refimprove|date=December 2008}}

The '''First Chicago method''' or '''venture capital method''' is a [business valuation](/source/business_valuation) approach used by [venture capital](/source/venture_capital) and [private equity](/source/private_equity) investors that combines elements of both a [multiples-based valuation](/source/Valuation_using_multiples) and a [discounted cash flow](/source/discounted_cash_flow) (DCF) valuation approach.<ref>[https://www.venionaire.com/first-chicago-method-valuation/ Venture Valuation - First Chicago Method]. [Venionaire Capital](/source/Venionaire_Capital).</ref> 

The First Chicago method was first developed by, and consequently named for, the venture capital arm of the [First Chicago](/source/First_Chicago_Bank) bank, the predecessor of [private equity](/source/private_equity) firms [Madison Dearborn Partners](/source/Madison_Dearborn_Partners) and [GTCR](/source/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](/source/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](/source/Harvard_Business_School) (Case Collection, 288-006)</ref>

==Method==
The First Chicago method takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios; see {{slink|Corporate finance#Quantifying uncertainty}}. 
Most often this methodology will involve the construction of:
* An "upside case" or "best-case scenario" (often, the [business plan](/source/business_plan) submitted)
* A "base case"
* A "downside" or "worst-case scenario"

Once these have been constructed, the [valuation](/source/valuation_(finance)) proceeds as follows.<ref>See, for example, Schumann (2006).</ref> 
#First, for each of the three cases, a [scenario specific](/source/Scenario_planning), ''internally consistent'' forecast of [cashflow](/source/cashflow)s  is constructed for the years leading up to the assumed [divestment](/source/Divestment) by the private equity investor.
#Next, a divestment price - i.e. a [Terminal value](/source/Terminal_value_(finance)) - is modelled by assuming an [exit multiple](/source/Terminal_value_(finance)) consistent with the scenario in question. (The divestment may take various forms.)
#The cash flows and exit price are then [discounted](/source/present_value) using the investor’s [required return](/source/Required_rate_of_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](/source/probability) corresponding to each scenario (as estimated by the investor). The value of the investment is then the [probability weighted sum](/source/Weighted_mean) of the three scenarios.

==Use==
The method is used particularly in the valuation of [growth companies](/source/growth_company) which often do not have historical financial results that can be used for meaningful [comparable company analysis](/source/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 method may be preferable to a discounted cash flow taken alone. This is because such income-based business value assessment may lack the support generally observable in the market place. Professionally 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](/source/ValuAdder) </ref>

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

==See also==
*[rNPV](/source/rNPV): cash flows, as opposed to scenarios, are probability-weighted.
*[Expected commercial value](/source/Expected_commercial_value)
*[Valuation using discounted cash flows #Determine equity value](/source/Valuation_using_discounted_cash_flows)

==Notes==
{{reflist}}

==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](/source/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}}

Category:Venture capital
Category:Madison Dearborn Partners companies
Category:Fundamental analysis
Category:Valuation (finance)

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