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Incorporating a Discounted Cash Flow model for Startups Valuation

In valuation, ordinarily, the majority of the work is based on what has happened. A big part of valuation is to estimate future cashflows. Common Industry practice for valuation is to value a company using the Discounted Cash Flow (DCF) Method or the Comparable Company Analysis, using transaction comparable (similar companies being bought or sold in the open market), and trading comparable (similar companies being traded in the stock market). The method mentioned later, in a way, is a benchmarking kind of approach that uses similar transactions and similar publicly traded companies to compute a multiple, off of which a company’s valuation can be computed.

In the case of startups, the lack of enough historical data and comparable companies gives rise to a lot of complexities. It becomes much more difficult to value such companies. A valuer will feel more comfortable valuing a company with a decent number of years under its belt. But when a situation arises where there is almost no, or very little data to look back to, a valuer may feel some level of discomfort putting a value on a young startup.

So how should we look at valuing such companies, with almost no historical data and comparable companies?

The answer lies within the subjective nature of valuation. 


Subjectivity answers all problems

Subjectivity in valuation means that there is no one way of looking at things. This also means it is possible to make appropriate research-based assumptions to make future projections when dealing with startups.

A DCF model can incorporate synthetic growth rates and discounting assumptions to arrive at reliable a valuation of startups.


More understanding, more reliable valuation

The only way to arrive at a more reliable value for a startup is to understand the start-up itself. It is fairly easy to adjust the valuation of a startup, it can easily be dialed up or down. To provide a more reliable and realistic value for a startup, a valuer needs to be diligent when synthesizing these growth and discount rates. The more in-line the assumptions are with how the startup plans to go about its business and the vision that the startup carries, the more reliable and reasonable will be its valuation. Especially in the emerging technology space, consistency between numbers and narrative may be the difference between a successful investment decision or a poor investment decision. If the narrative and the projected numbers are not consistent with each other, then the valuation might as well be good for nothing.

A startup’s value is based on its potential and not solely on how the company has previously performed (if it has been in operation). Sometimes potential of a business to earn in the future may overpower a valuer’s view of the current situation of the startup, which also is not an appropriate approach to take for valuation. To get a holistic view of the business, a valuer needs to look at what has happened (if in operations, the historical data), what is happening (present data and statistics), and what is the direction that the startup is going towards, which involves future business strategies and vision of the firm.


How to incorporate DCF Valuation for Startups

Be it for a matured public company or a Startup, the premise of DCF valuation is established by making appropriate projections for Free Cash Flows, the cashflows that remain after fulfillment of all the short-term payment obligations, till perpetuity. Later the cashflows projected are discounted back to the present value using a discounting factor computed based on the Weighted Average Cost of Capital (WACC), or the Cost of Capital (Ke), which is usually the case since most startups are equity funded. Calculation of these involves making several important growth assumptions and considerations for equity premiums and discounts.


Important First Step for DCF valuation of a Startup

Building a Financial plan and model along with synthesized growth and discount rates.

In the case of startups with no history, valuation starts off by making a financial plan and financial model for the business. This will govern future projections. The process of making a financial model involves extensive communication with the client regarding financial milestones and their feasibility, key revenue and expense drivers, product roll-out strategy, Capital expenditure plans (Capex Assumptions), Expenses involved in business process, Capital structure and sources of capital, etc.

Once a valuer is done formulating the financial model, the next step involved is forecasting future revenues and expenses (using previously synthesized growth assumptions) for key drivers of the business.

Essential “Ingredients” that a valuer needs to majorly focus on while valuing a startup using DCF is making more reliable and accurate financial forecasts which is the backbone of the whole valuation model. Some of the suggestions to make more reliable projections for a startup are as follows:

  1. Get a better hold of the business and its major drivers- A valuer must understand that only crunching in numbers won’t cut it for a startup. You need to understand the business and identify the key revenue and expense drivers. In the majority of startup cases, it is not that tough. Since the number of products is usually limited to only a couple of products, it is relatively easier. There is a need to establish a strong relationship between the future volume projection for sales and the price at which the product is being, or will be offered. Since we are talking about startups, scalability and the changes that follow must also be thought of concern in the valuer’s head.
  2. Accuracy of data – The presence of accurate and reliable historical data is every valuer’s dream come true when valuing startups. A valuer must ensure that the data provided by the client is accurate and not window-dressed.
  3. Regular communication and discussions with core management and owners - It becomes essential in the case of startups to have regular access to the owner’s, as well as management’s vision for the business. Assumptions made about future projections should always be challenged while discussing with the management so that more reliable projections can be synthesized.

After the projections are synthesized, we discount all the projected cashflows using either WACC or Ke which will depend on the capital structure of the startup. In the case of Startups, there is a significant factor of risk involved. So, a lot of industry research, analysis, and understanding is required to compute risk premiums and discounts if any. Thus, the Computation of discount rates becomes critical in case of extremely subjective valuations, such as Startup Valuation.

The formula for the calculation of WACC and Ke is as follows:


Weighted Average Cost of Capital

WACC = ( E / C × Re ) + ( D / V × Rd × ( 1-Tc ) )

E=Market value of the firm’s equity              Re=Cost of equity                            V=E+D
D=Market value of the firm’s debt                 Rd=Cost of debt                               Tc=Corporate tax rate


Cost of Equity 

Ke = Risk-Free Rate of Return + Beta × ( Market Rate of Return - Risk-Free Rate of Return )

Computation after discounting the cashflows using the appropriate discount rate is fairly simple. After we arrive at the present value of projected cashflows we adjust for items such as Cash & Cash Equivalents, Debt, etc to arrive at the fair value of the business.


Concluding thought

A valuer must tread carefully while valuing a startup using DCF Method because it involves a lot of synthesized assumptions. And synthesizing these assumptions requires a lot of research-backed explanations for their consideration.

Dealing with startups presents a wide range of problems that are not usually easily solvable. It takes time to value a startup. The majority of the time that a startup valuation takes is the research part. Discussing different aspects of the business with the management, understanding the industry, understanding the market and audience to be catered to, understanding the product, exploring future prospects for the product, etc helps a valuer to deal with the majority of the difficulties that arise while making key assumptions. The more experienced and aware the valuer, the more reliable the projections become. Knowing what the business has to offer right now and what that business can potentially offer in the future as well as the journey in between becomes very important since the business is yet to stand its ground, and put its roots in the market.

We are not prescribing any method for startup valuation. What we imply from all this is that it is possible to use standard approaches, though carefully, to value a business that is young and mouldable.

In a recent post on our website, we have dived into different startup valuation methods and their technicalities. To read more about different methods of startup valuation, click here.