First Chicago Method: Scenario-Based Startup Valuation
The First Chicago Method is a scenario-based valuation approach that addresses one of the biggest weaknesses of the traditional VC Method: its reliance on a single optimistic outcome. By explicitly modeling three scenarios — success, sideways, and failure — and weighting them by probability, the First Chicago Method produces a more realistic expected value for early-stage startups.
What Is the First Chicago Method?
The First Chicago Method is a startup valuation technique that values a company by estimating outcomes under multiple discrete scenarios, assigning probabilities to each, and calculating a probability-weighted expected value. The method was developed by First Chicago Corporation (now part of JPMorgan Chase) and became popular among venture capitalists and private equity investors in the 1980s.
Unlike the VC Method, which uses a single optimistic exit projection and a high discount rate (30-70%), the First Chicago Method incorporates failure risk directly into the cash flow estimates. This allows for a lower, more theoretically correct discount rate — the opportunity cost of capital.
The First Chicago Method is particularly useful when:
- The startup faces significant uncertainty with a wide range of possible outcomes
- You want a more nuanced valuation than a single-point estimate
- You need to justify valuation assumptions to co-investors or a board
- The venture has identifiable milestones that could lead to distinctly different outcomes
First Chicago Method Scenarios: Success, Sideways, and Failure
The First Chicago Method typically uses three discrete scenarios that capture the range of outcomes for an early-stage venture:
| Scenario | Description | Typical Outcome |
|---|---|---|
| Success | The venture achieves or exceeds its business plan — strong growth, successful product-market fit, and an attractive exit | IPO or high-value acquisition at a premium multiple |
| Sideways | Moderate performance with no high-value harvest; the venture survives but doesn’t achieve breakout growth | Investors recover principal plus perhaps a preferred return, but no meaningful upside (acqui-hire, modest strategic sale) |
| Failure | The venture fails to achieve sustainable operations | Liquidation or fire sale; investors lose most or all of their principal (partial salvage value possible) |
The sideways scenario is often overlooked but critically important. Many startups neither become unicorns nor completely fail — they survive in a middle state where investors might recoup their investment but earn minimal returns. Ignoring this scenario overstates expected value.
First Chicago Method Formula
The core formula calculates expected value as the probability-weighted sum of scenario outcomes:
Where each scenario value is the present value of expected cash flows (including terminal/exit value):
The full textbook implementation can also incorporate interim cash flows (dividends, milestone payments) that are probability-weighted across scenarios before discounting. The simplified version above focuses on terminal exit value, which is appropriate for most early-stage startups where interim cash flows are minimal.
Because failure risk is already incorporated in the probability-weighted expected cash flows, you should discount at the opportunity cost of capital (typically 20-30% for early-stage ventures) — not the high 40-70% rates used in the VC Method. Using both pessimistic probabilities and a high discount rate double-counts risk.
First Chicago Method Example
Consider a Series A investment in a B2B SaaS startup. The investor is evaluating a $2 million investment for 20% ownership, with an expected exit horizon of 5 years. Based on comparable SaaS exits — companies like HubSpot (acquired companies at 5-8x revenue) and Salesforce (paying 7-12x for high-growth targets) — the investor models three scenarios:
Investment terms: $2M for 20% ownership | 5-year horizon | 25% discount rate
| Scenario | Exit Value | Probability | Present Value | Weighted Value |
|---|---|---|---|---|
| Success | $80M (8x revenue on $10M ARR) | 25% | $26.21M | $6.55M |
| Sideways | $8M (acqui-hire + IP sale) | 45% | $2.62M | $1.18M |
| Failure | $0.5M (asset liquidation) | 30% | $0.16M | $0.05M |
| Expected | — | 100% | — | $7.78M |
Investor’s expected stake value: 20% × $7.78M = $1.56M
Investment required: $2.00M
Conclusion: Negative expected NPV (-$0.44M). The investor should negotiate for higher ownership (≥26%) or a lower investment amount to achieve positive expected value.
Notice how different the result is from a pure success-scenario analysis. If you only look at the success case, the investor’s 20% stake would be worth $5.24M in present value terms — a seemingly excellent return on a $2M investment. But that analysis ignores the 75% probability of sideways or failure outcomes. The First Chicago Method incorporates all scenarios, revealing that the expected stake value is only $1.56M — less than the $2M investment. This is why probability weighting matters.
Estimating Scenario Probabilities
Assigning probabilities is the most subjective part of the First Chicago Method. Start with historical base rates, then adjust for company-specific factors:
| Stage | Success | Sideways | Failure |
|---|---|---|---|
| Seed | 10-15% | 25-35% | 50-65% |
| Series A | 20-30% | 35-45% | 30-40% |
| Series B+ | 30-40% | 35-45% | 20-30% |
Adjust probabilities based on:
- Team experience: Serial entrepreneurs with successful exits warrant higher success probabilities
- Market size and timing: Large, growing markets increase success odds
- Traction: Revenue, user growth, and retention metrics reduce failure probability
- Competitive dynamics: Strong moats and differentiation improve outcomes
- Capital efficiency: Lower burn rates extend runway and reduce failure risk
Always conduct sensitivity analysis on your probability estimates. Test how valuation changes if success probability moves from 25% to 15% or 35%. If small probability shifts dramatically change the investment decision, your conviction in those estimates matters more.
Valuing Each Scenario
Each scenario requires its own exit value estimate, often using different valuation multiples that reflect the different growth trajectories:
Success Scenario
Apply exit multiples from comparable high-growth company transactions. For SaaS companies, this typically means 8-15x ARR for strong performers — Zoom’s IPO valued it at roughly 40x ARR, while Slack’s acquisition by Salesforce was approximately 26x ARR. For other sectors, use EBITDA or revenue multiples from recent M&A and IPO data. The success scenario multiplier should reflect what the market pays for companies that achieve their growth targets.
Sideways Scenario
Use more conservative multiples reflecting modest growth. Options include:
- Book value or invested capital recovery
- Acqui-hire multiples ($1-3M per engineer)
- Distressed sale multiples (1-3x revenue)
- Liquidation preference recovery (principal + accrued dividends)
Failure Scenario
Estimate salvage value of remaining assets:
- IP and patent portfolio value
- Equipment and inventory liquidation
- Customer list or data assets
- Often zero or near-zero for early-stage startups
Selecting the Terminal Year
Choose a terminal year based on the likely harvest date in the success scenario — typically 5-7 years for venture-backed startups. This should align with typical VC fund lifecycles and realistic exit timelines for the industry.
First Chicago Method vs VC Method
Both methods are used to value early-stage companies, but they differ fundamentally in how they handle uncertainty:
VC Method
- Single optimistic scenario (success only)
- High discount rate (30-70%) to compensate for risk
- Simpler and faster to calculate
- Common in quick deal discussions and term sheet negotiations
- Risk adjustment is implicit in the discount rate
First Chicago Method
- Three scenarios with probability weights
- Opportunity cost of capital (20-30%)
- More nuanced, requires more assumptions
- Better aligned with expected-value investment decisions
- Risk adjustment is explicit in probability weights
In theory, the methods can yield similar valuations when calibrated consistently — the VC Method’s high discount rate is intended to compensate for the same failure risk that the First Chicago Method captures through probability weights. In practice, the methods often produce different results because practitioners apply them with different assumptions. The First Chicago Method’s advantage is that it makes those assumptions explicit and allows for sensitivity analysis on individual scenarios.
How to Calculate the First Chicago Method
Follow these steps to apply the First Chicago Method:
- Select the terminal year — Choose a realistic exit horizon (typically 5-7 years)
- Define scenarios — Establish success, sideways, and failure outcomes with specific exit values
- Assign probabilities — Use base rates adjusted for company-specific factors (must sum to 100%)
- Calculate present values — Discount each scenario’s exit value at opportunity cost of capital
- Compute expected value — Sum the probability-weighted present values
- Determine required ownership — Divide investment amount by expected company value
Common Mistakes
Avoid these frequent errors when applying the First Chicago Method:
1. Probabilities don’t sum to 100% — This is a mathematical requirement. If your three scenarios have probabilities of 30%, 40%, and 25%, you’re missing 5% of outcomes somewhere.
2. Ignoring the sideways scenario — Treating valuation as binary (success or failure) overstates expected value. The sideways outcome is often the most likely scenario.
3. Double-counting risk — Using pessimistic probability estimates and then also applying VC Method-style 40-70% discount rates. The whole point of probability weighting is to use expected cash flows with a reasonable cost of capital.
4. Optimistic bias in probabilities — Founders and enthusiastic investors systematically overweight success probability. Use industry base rates as an anchor.
5. Mixing company value and investor stake value — The First Chicago Method calculates expected company value. To find investor expected value, multiply by ownership percentage. Don’t confuse the two when evaluating a deal.
6. Using the same multiple across scenarios — A distressed sale or acqui-hire won’t command the same valuation multiple as a successful growth exit. Adjust multiples to reflect each scenario’s reality.
Limitations of the First Chicago Method
The First Chicago Method’s biggest weakness is that probability estimates are inherently subjective. Two reasonable analysts can assign very different probabilities to the same scenarios, leading to materially different valuations.
Three scenarios oversimplify reality — Actual outcomes exist on a continuous spectrum. The method forces complex uncertainty into three discrete buckets, which may miss important nuances.
Correlation and macroeconomic factors are ignored — The method treats scenarios as independent, but in reality, a recession might simultaneously increase failure probability and decrease success scenario exit values.
No explicit real options modeling — The method doesn’t directly value the option to abandon, expand, or pivot. For ventures where staging and optionality are central, consider supplementing with staged financing valuation approaches.
Discount rate selection remains subjective — While the opportunity cost of capital is more theoretically grounded than VC Method hurdle rates, reasonable estimates still vary significantly.
Frequently Asked Questions
Disclaimer
This article is for educational and informational purposes only and does not constitute investment advice. Startup valuations involve significant uncertainty, and the probabilities and outcomes used in the First Chicago Method are inherently subjective. Always conduct thorough due diligence and consult qualified financial and legal advisors before making investment decisions.
