If you approach a Venture Capitalist or a Business Angel, you will probably hear that “I need to be compensated for the risk I’m taking” or “I want a larger return than that”. But, what does it mean? What’s the link between discount rate and required return and how it is related with the amount of equity you will have to grant them to seal the deal?
The value of one euro today is not comparable to the same euro in a future period. This is why the Discounted Cash Flows method (DCF) is one of the most used in the valuation of companies in general. The discount rate applied in this method is higher than the risk free rate though. The Risk Free Rate is indeed observable in the market but can be applied only to those streams of cash flows which are expected to manifest in the future with certainty. That doesn’t include startups. The usual benchmark for Risk Free Rate- cases, in Europe, is the return on the German Bund (bond), whose coupons and final repayment are considered to be 100% sure. In financial terms, the implied correlation of this type of investments with the overall economic conditions is a null value. Whatever will happen, the cash flows are certain.
Valuing Uncertainties
For almost all other types of investments, uncertainty about their effective realization leads to higher discount rates. Why is that? Because the implied risk needs to be accounted for, that is, priced, in the value an investor would be willing to pay for that kind of investments today. Investors on average avoid or minimize risk. Suppose you can pay EUR 95,- now and you will receive EUR 100,- in two years with certainty, or that you can pay EUR 95,- and receive EUR 100,- in two years but with uncertainty. To encourage people to invest, the final outcome should be higher than EUR 100,- or, conversely, the price paid lower than EUR 95,-. This is exactly the principle of the discounted cash flows under uncertainty.Suppose your startup has been valued EUR 200,- and you are willing to sell 10% equity (EUR 20,-). Unfortunately the BA you’re dealing with ask 20% equity for the same price. What does it entail for the valuation?
Ceteris paribus
Basically, he is requiring a larger price for the risk. Ceteris paribus, the discount rate he is implicitly applying, is much higher than the one used in your valuation, entailing half of the “present value” (PV) you estimated. He is asking compensation for the several factors which might jeopardize the earnings of the business. Suppose the next year you will earn EUR 30,- and today the value is EUR 25,-. The expected return implied (that is equivalent to the discount rate) is 20%. It might be the case that the investors don’t feel satisfied and thus asks for a 30%. This entails a PV of around EUR 23,-. The net effect is that the right on the future value of EUR 30,- is purchased at a lower price and this might have been the initial value you attributed to your startup. This is the intuition behind the DCF valuation tool.
Firm specific risk v.s. diversification
But what kind of risk is the investor effectively bearing? That is to say, is the price for it applied by the VC or BA fair? You should be aware that their valuation of the risk is usually arbitrary and it tends to overestimate the discount applied. This is especially true when they spot some opportunities in the businesses which haven’t been figured out by the entrepreneur. Basic concepts of financial theory can help your argumentation for a lower discount rate.
One of these concepts is diversification. The only risk that increases the required return for investors should indeed be the non- diversifiable one, while the idiosyncratic or firm specific risk should not be priced. Suppose you run an insurance company. You provide policies against robbery to individuals. This kind of risk is idiosyncratic since the events are uncorrelated each other. If someone is robbed there are no consequences or links to the probability of someone else being robbed.
So to reduce the exposure you can just insure the largest amount of people you can. This is diversification. On the one hand you clear the premium of 1.000 policies while on the other you will, on average, reimburse 10 robbed clients. But what if you insure for earthquakes? You have a 99% chance to clear your premium most of the time but when the event occurs, you will have to reimburse all the clients in the area damaged. This kind of risk is not diversifiable. How does this relate to you investors’ risk taking?
Determining the systematic risk
You as entrepreneur can reasonably guess that your VC or BA has many other investments in startups. His wealth is not entirely tied to the fortune of the startups. So why should he be fully compensated for the specific risk inherent your business? Investors generally are aware of the ignorance about this topic and can play with it.
Assuming the investors are perfectly diversified, the systemic risk carried by your startup should be measured according to the common relation of the expected cash flows with the expected variations of the broader economic environment. The correlation is usually rather low and it ranges between 0.1 and 0.25. This means that more than 70% of the uncertainty concerning the startups future cash flows, are due to firm specific factors which a professional investor is able to diversify away.
The valuation of the company should take into consideration only the systematic, not the company specific risks. This same concept cannot be applied to the entrepreneur. He is usually investing a substantial part of his wealth in the venture and he thus deserves to receive a reward for the risk he bears. The cost of capital/required return for them should therefore be higher compared to that of a professional investor or wealthy individual.
P.S. Do you need to project the future of your company? Take a look at our post on Startup Projections.
so I noticed in our report but also in reports for other startups that Equidam uses discount rates of 60,04% a year (not 60,00% 🙂 ). I do understand all the above mentioned theories and principles, but I wonder if you could elaborate a little bit on how you people arrive at 60% (seems quit high, certaintly if you take into account that it is based on wacc, so debt financing involved as well (which is much cheaper). Thnx for your reply!
I am asking because I don’t have a good answer towards investors on this matter.
Hi Teun,
yes those “high” discounts are part of our venture capital method. Compared to a general DCF, where you would use WACC, the VC method a single higher discount that is supposed to take into account all the different types of risks of companies in their early stages. The math is quite simple because those discounts just stem out of the required return that investors have a different stages of development of companies. If you were a vc, you would have a portfolio of say 10 companies. Out of those only one would perform really well (statistically). What you aim for is for that company to justify your investments in all the other 9. That means that it has to grow quite considerably, generally 10x but with a lot of volatility. As you do not know which one it is going to be beforehand (when you are investing), you invest only in companies that can generate for you that 10X return. Return is just the forward looking calculation of a discount. How much should we discount 100$ in 10 years in order to get a 10X return? That calculation is where the 60% comes from.
ok, I understand the 10x factor. But if it is so that VC method takes into account “all the different times of risks of companies in their early stages” shouldn’t you make a difference between start ups in the seed stadium (just ideas) and the scale-ups? (with proven concept and actual sales/turnover)? Just a suggestion…..
Hi Teun, we do indeed, when the stage of the company gets more mature, the discount decreases up to a minimum of about 48%!
Hi Daniel,
What would the calculation look like for the 60%?
best,
Florian
Hi Florian,
It’s just a reverse compound growth calculation. Basically if something grows at 10% per year, by the end of the second year they’ve grown X*(1+10%)*(1+10%), so X*(1+10%)^2.
In 10 years, that is (1+10%) at the power of 10. The reverse of that calculates the growth percentage given the end result. If the end result is 10X in 10 years, the calculation is 1*(1+x)^10 = 10 so (1+x)^10=10/1 so x = 10^(1/10)-1 where ^(1/10) is the tenth root.
So a company that grows at 60% per year for 10 years and start with a value X would be worth X*(1+60%)^10 = 109,85X!
So what is your suggested discount rate for startups?
The discount rate varies according to the risk of the specific startup. For startups a lot of the risk is proxied by the stage that they are in and the milestones they have already achieved, so we base a lot of our risk estimates on these parameters!