I founded startups, I successfully raised money for some, and I successfully sold some, in spite, I was never comfortable valuing a startup. I used exit multiple method, Berkus approach, comparison value methods and others, and never was comfortable with the valuations that were coming out of those methods.
As discussed above one of the most popular methods is the exit multiple method. Most VCs use this method. For ex: if a software startup is expected to earn $5 million by the end of the fifth year and let us say P/E multiple for software companies is 15. Then the exit value of the startup at the end of the 5th year will be $5 million*15= $75 million. Later the exit value is discounted by the required rate of return of the Venture Capital company to come to the present value. Let us say the required rate of return of the VC is 40%. Then the present value = estimated exit value/(1+required rate of return) ^n. Where 'n' is the exit year. In our case n = 5. So, the present value of the startup = $75 million/ (1+40%) ^5 = $13.9 million.
As an investor and investment advisor for some part of my career, I have spent considerable time using DCF (Discounted Cash Flow) to value companies. I believed that DCF was a superior method to estimate the value as compared to other methods.
Why do most VCs shun the DCF method, when it is a better method to value startups? There are three main reasons: 1) most startups have negative earnings and carry little to no tangible assets 2) most startups are based on ideas that are yet to see market success, making it hard to estimate the future cash flows 3) there are very few comparable companies making it hard to come up with market-related information.
Can DCF be used to value startups? Yes, it can be used, but with much caution and tweaking. For example, we cannot always assume that startups are going concerns, one of the fundamentals on which DCF depends.
Also, for the founders, valuing their ventures using DCF is a good way of constructing value that can be communicated to investors better than other methods as the DCF method depends on the assumptions that drive the value.
Let us now examine how to value a startup using DCF.
Step1: Estimating the Free cash flows to the firm (FCFF):
Generally, for some years in a startup’s life, earnings and cash flows can be negative, so it is a good idea to project cashflows for a longer period so that we have positive cash flows later years. Free cash flows to the firm (FCFF) is (EBIT(1-T) – reinvestments). EBIT(1-T) can be taken as % of revenues, or we construct a projected income statement to get EBIT(1-T). Where 'T' is tax rates.
For a startup, it is a challenge to forecast future revenues. To forecast revenues, we need growth rates. The best revenue growth rate is the historical growth rate of the startup itself. If for some reason getting the historical growth is hard, we can look at past startups that have similar characteristics to our current startup for the growth rates. Whatever method you use, your assumption on growth rates needs to realistic. Also, unless the startup has a sustainable competitive advantage (such as patents), the growth rates should taper to the industry average in just two to three years.
(Reinvestment rate = Expected growth/ Return on Invested Capital). Return on Invested Capital can be calculated as Sales/Capital invested to generate the sales. If it is hard to estimate the reinvestment rates using the above method, we can simply look at the industry’s reinvestment rates.
Once we have EBIT (1-T) and reinvestments, we get Free cash flows to the firm (FCFF).
Step 2: Estimate the discount rate or rate of return:
Estimating the rate of return is a challenge given that startups have little historical data to calculate betas. If there are any comparable companies, then we can consider the average of betas of the comparables. If we do not have comparables, we should estimate the beta of the startup using the volatility in its earnings and financial leverage. Once we have the beta, we can calculate the cost of equity. If the startup has debt, then we can use future interest coverage ratios to calculate the cost of debt, as the current operating margins can be negative. Once we have the cost of equity and cost of debt, we can calculate the rate of return using the same method we use for mature companies.
However, unlike in established companies, we need to estimate the rate of return for each year until the startup reaches sustainable margins and growth.
Step 3: Estimate the terminal value:
Once we have Free cash flows to the firm (FCFF) and Rate of return, we need to get the terminal value and it should be calculated like how we do for a mature company. However, we need to keep in mind that terminal value should be calculated only once we reach the stage of sustainable growth and margins.
DCF value can be calculated once we have estimated FCFFs, Rate of return for each year until the sustainable rate of return is reached and the Terminal value. Present Value of Terminal value can be arrived at by discounting the Terminal value using the sustainable rate of return.
Step 4: Consider the case that startups may not be a going concern:
Unlike established companies, we cannot assume that startups are going concern. Hence when valuing a startup using DCF, we need to make sure we take the probability of survival into consideration.
So, the value of the startup = probability of survival * discounted cashflow value of the startup + (1 - not surviving) * liquidation value of the company.
Experience of investing in a sector for a long time can serve to arrive at the probability of survival for the startup. Another method is to use government historical data on startups to come up with the probability of survival. For ex: only 1 in 5 software companies survive beyond 10 years. So, the probability of survival will be 20% for a software startup
Coming up with the liquidation value of the startup can be a challenge. If a startup has tangible assets, the market value of those assets will become part of the liquidation value. Many startups also have valuable patents, their value can be added to the liquidation value.
I will be interested to know why should one prefer other methods over DCF. Comments welcome.
