First chicago method: Meaning, Criticisms & Real-World Uses

What Is the First Chicago Method?

The First Chicago Method is a comprehensive business valuation approach used primarily by venture capital and private equity investors to assess the worth of early-stage, high-growth companies. This method acknowledges the inherent uncertainty in projecting the future of nascent businesses by combining elements of both discounted cash flow (DCF) analysis and multiples-based valuation within a scenario analysis framework. Unlike traditional single-point valuations, the First Chicago Method develops multiple future scenarios—typically best-case, base-case, and worst-case—and assigns a probability to each, ultimately deriving a probability-weighted average valuation.

History and Origin

The First Chicago Method was developed by the venture capital arm of the First Chicago Bank. It emerged as a practical solution to the challenges of valuing rapidly evolving companies that often lack extensive historical financial data. The First National Bank of Chicago, founded in 1863, later became First Chicago Bank and had a significant presence in the financial industry. Its venture capital division pioneered this method, and it gained academic discussion and broader recognition starting in 1987. The²² approach evolved to address the unique risk and return profiles associated with early-stage investments, providing a more nuanced view of a company's potential value by considering a range of plausible outcomes.

Key Takeaways

The First Chicago Method is a hybrid valuation approach for early-stage companies, particularly those with uncertain future cash flows.
It involves creating multiple future scenarios—best-case, base-case, and worst-case—and assigning a probability to each.
Each scenario is valued independently, typically using a combination of discounted cash flow analysis and market multiples.
The final valuation is a probability-weighted average of the valuations derived from each scenario.
This method helps investors account for the inherent risks and potential upsides in high-growth investments.

Formula and Calculation

The First Chicago Method calculates a probability-weighted average of the valuations under different scenarios. The general formula is:

V = (V_{Best} \times P_{Best}) + (V_{Base} \times P_{Base}) + (V_{Worst} \times P_{Worst})

Where:

(V) = The final probability-weighted average valuation
(V_{Best}) = Valuation under the best-case scenario
(P_{Best}) = Probability assigned to the best-case scenario
(V_{Base}) = Valuation under the base-case (most likely) scenario
(P_{Base}) = Probability assigned to the base-case scenario
(V_{Worst}) = Valuation under the worst-case scenario
(P_{Worst}) = Probability assigned to the worst-case scenario

For each scenario, the valuation (V_i) typically involves projecting future cash flows and a terminal value (the company's value at a future exit point), which are then discounted back to the present.

Interpreting the First Chicago Method

Interpreting the First Chicago Method's output involves understanding that the resulting valuation is not a single definitive number but a probabilistic expectation of value. By weighting different outcomes, the method provides a more realistic assessment of a startup's worth, especially given the unpredictable nature of early-stage growth companies.

The as²⁰, ²¹signed probabilities reflect the investor's subjective judgment and market analysis of the likelihood of each scenario materializing. For instance, a high probability assigned to a worst-case scenario would significantly pull down the overall valuation, signaling higher perceived risk. Conversely, a strong base-case and optimistic best-case scenario with higher probabilities would indicate a more favorable outlook. This approach inherently builds risk assessment into the valuation, allowing investors to gauge the potential range of returns and losses.

Hypothetical Example

Consider a new software startup, "InnovateTech," seeking venture capital funding. An investor decides to use the First Chicago Method for valuation.

Step 1: Define Scenarios and Probabilities

Best-Case Scenario (Success): InnovateTech achieves rapid market adoption and secures a large acquisition by a tech giant in five years. Probability: 20%.
Base-Case Scenario (Moderate Growth): InnovateTech grows steadily and becomes profitable, leading to a modest acquisition or initial public offering (IPO) in five years. Probability: 60%.
Worst-Case Scenario (Struggle/Failure): InnovateTech faces strong competition and fails to gain significant traction, leading to a distressed sale or liquidation in five years. Probability: 20%.

Step 2: Value Each Scenario
Using detailed financial forecasting, including projected revenues, expenses, and a calculated exit value (based on industry multiples or other methods) for each scenario, the investor calculates the present value of the company under each case. This involves discounting future cash flows back to the present using an appropriate discount rate that reflects the startup's risk profile.

Best-Case Valuation ((V_{Best})): $50 million
Base-Case Valuation ((V_{Base})): $15 million
Worst-Case Valuation ((V_{Worst})): $2 million

Step 3: Calculate Probability-Weighted Average
Using the First Chicago Method formula:

V = (\$50M \times 0.20) + (\$15M \times 0.60) + (\$2M \times 0.20)

V = \$10M + \$9M + \$0.4M

V = \$19.4 \text{ million}

Based on the First Chicago Method, the investor arrives at a valuation of $19.4 million for InnovateTech, reflecting the weighted average of potential outcomes. This provides a more informed basis for investment decisions or negotiations, considering both the upside potential and downside risks.

Practical Applications

The First Chicago Method is predominantly used in the world of private equity and venture capital, particularly when evaluating early-stage companies and startups. These b¹⁷, ¹⁸, ¹⁹usinesses often lack the historical financial data and consistent cash flows that are foundational for more traditional valuation techniques.

Key ap¹⁶plications include:

Startup Funding Rounds: Venture capitalists apply the First Chicago Method to determine pre-money and post-money valuations for companies seeking seed, Series A, or later-stage funding. This helps them assess potential returns and risks before committing capital.
M¹⁵ergers and Acquisitions (M&A): For acquiring or being acquired, especially when dealing with younger, innovative companies, the method helps evaluate the target company's worth under various integration or market development scenarios.
Internal Strategic Planning: Companies can use this method internally to evaluate new projects, product launches, or significant strategic shifts by modeling different outcomes and their financial implications.
Portfolio Management: Private equity firms may use variations of the First Chicago Method to project the potential performance of their entire portfolio of investments under different economic conditions or industry trends, informing their overall investment strategy.
Risk Assessment: The explicit incorporation of worst-case scenarios and their probabilities allows investors to quantify and manage potential downside risks more effectively. This structured approach to uncertainty is a significant advantage when dealing with high-risk, high-reward ventures.

For a ¹⁴broader view of how the First Chicago Method fits within startup valuation, it is often considered alongside other techniques, as detailed by various financial experts.

Lim¹³itations and Criticisms

While the First Chicago Method offers a robust framework for valuing uncertain ventures, it is not without limitations. A primary criticism revolves around the subjectivity involved in its implementation.

Key dr¹²awbacks include:

Subjectivity of Scenario Definition and Probabilities: Defining the "best," "base," and "worst" cases, and then assigning precise probabilities to each, can be highly subjective and relies heavily on the judgment and biases of the analyst. This ca¹⁰, ¹¹n lead to significant variations in valuation outcomes if different assumptions are made.
Complexity and Data Requirements: The method requires detailed financial modeling and in-depth market analysis for each scenario, which can be time-consuming and resource-intensive, especially for companies with limited historical data.
S⁹ensitivity to Assumptions: The final valuation can be highly sensitive to changes in the discount rate, growth rates, cash flow projections, and exit multiples used for each scenario. Slight ⁸adjustments to these assumptions can significantly alter the outcome.
Neglect of Non-Financial Factors: Like many quantitative valuation methods, the First Chicago Method focuses primarily on financial projections and may not fully capture the value of intangible assets or non-financial aspects such as brand reputation, intellectual property, or the strength of the management team.
A⁷rbitrary Probability Assignment: While the method attempts to quantify uncertainty, the assignment of probabilities can feel arbitrary, leading some critics to argue that the precision implied by the final numerical valuation might be misleading given the imprecise inputs.

Despit⁶e these limitations, proponents argue that the First Chicago Method's structured approach to acknowledging and quantifying uncertainty makes it a superior choice for early-stage companies compared to single-point valuation models.

First Chicago Method vs. Venture Capital Method

The First Chicago Method and the Venture Capital Method are both widely used approaches in the venture capital and private equity industries for valuing early-stage companies. They are closely related, with the First Chicago Method often described as an extension or refinement of the basic Venture Capital Method.

The core Venture Capital Method typically focuses on the projected exit value (or terminal value) of a company at a future point in time, usually when the investor plans to exit (e.g., through an IPO or acquisition). This exit value is then discounted back to the present using the investor's required rate of return, which inherently includes a high risk premium due to the early stage of the investment. The formula for the Venture Capital Method is generally simpler, focusing on a single expected outcome.

In contrast, the First Chicago Method takes the Venture Capital Method a step further by incorporating multiple future scenarios—best-case, base-case, and worst-case—and assigning a probability of occurrence to each. This means ⁵that instead of relying on a single future projection, the First Chicago Method calculates a valuation for each scenario and then derives a weighted average of these valuations based on their assigned probabilities. This explicit consideration of a range of outcomes and their likelihoods makes the First Chicago Method more comprehensive in addressing the significant uncertainties inherent in valuing startups. While both aim to assess future potential, the First Chicago Method offers a more nuanced risk assessment by quantifying potential downsides and upsides.

FAQs

Why is the First Chicago Method particularly useful for startups?

The First Chicago Method is highly useful for startups because these companies often lack consistent historical financial data and have highly uncertain future prospects. By creating³, ⁴ and valuing multiple scenarios (best, base, worst), the method explicitly accounts for this uncertainty, providing a more realistic and comprehensive business valuation that traditional single-point methods might miss.

How are probabilities determined in the First Chicago Method?

The probabilities assigned to each scenario (best-case, base-case, worst-case) are typically determined through qualitative and quantitative market analysis, industry expertise, and subjective judgment of the investor or analyst. While there¹, ² are no hard and fast rules, these probabilities reflect the perceived likelihood of each scenario materializing based on market conditions, competitive landscape, management team capabilities, and other relevant factors.

Can the First Chicago Method be used for established companies?

While primarily designed for early-stage and high-growth companies with significant uncertainty, the underlying principles of scenario analysis and probability weighting within the First Chicago Method can be adapted for established companies. For mature businesses, it might be used to evaluate specific projects, strategic initiatives, or potential mergers and acquisitions under varying economic or industry conditions, though traditional valuation methods like Discounted Cash Flow (DCF) or Comparable Company Analysis might be more prevalent for their overall valuation.

What is the role of the discount rate in the First Chicago Method?

The discount rate in the First Chicago Method is crucial because it translates future cash flows and exit values into their present-day equivalents. For early-stage companies, this rate is typically very high to reflect the substantial risk associated with startups. It often incorporates elements like a high risk premium and may be derived from methods such as the Weighted Average Cost of Capital (WACC) or by considering the required return of venture capital investors.

First chicago method