Reading: DCF for Startups

The second major challenge lies in the estimation of the appropriate risk-adjusted discount rate for startup firms. Remember from the module Cost of Capital and Valuation, that estimating the cost of capital, in principle, involves the following steps:

• Estimate the firm's beta from past stock returns. If the firm's equity is not traded, use comparable firms.
• Use the firm's target future financing policy to adjust the beta from the previous step
• Measure the credit spread that is associated with the firm's credit rating to estimate the cost of debt
• Measure the firm's marginal tax rate
• Compute a weighted average of the after-tax cost of debt and the cost of equity using the weights implied by the firm's target financing policy.

For startup companies, these steps pose some additional challenges:

• Startups are generally not (yet) listed on a stock exchange. So there is no historical stock price information that would allow us to estimate the firm's beta.
• More importantly, for a truly innovative startup, there might also be no listed comparable firms available! Think, for example, of Facebook. Were there any "similar" firms on the market during the infancy of the company? Probably not.
• Even if there were listed "comparable" firms available, these firms generally have a fundamentally different risk profile, even though they operate in the same industry. They are, for example, more mature, have lower financing risk, better liquidity, and less uncertainty about the business model and its prospects. Put differently, startups have other and generally higher risks than their listed peers. Investors will require compensation for these additional risks. We ignore these additional risks for the moment. The next section will then address this important issue in more detail.
• Startups generally have no clear and stable financing policy in place.
• More importantly, they generally have no credit rating, which complicates the estimation of the cost of debt.
• Finally, they also tend to have volatile revenues (if they have revenues at all), which will pose a challenge to estimate the marginal tax rate for the years to come.

Using Firm IRR Instead of WACC

Because of the above challenges, many practitioners avoid estimating the cost of capital altogether. Instead, they estimate the rate of return the business plan promises to its investors, the so-called Internal Rate of Return (IRR), and then compare that IRR with their Hurdle Rate, that is, the minimum rate of return they want to earn on similar investments.

Example

Consider a hypothetical company that requires an investment of 1 million today and promises the providers of capital a cash flow of 3 million in 5 years. Instead of estimating the value of the firm by discounting the future cash flow at the appropriate rate of return, the investor could estimate the investment's IRR. The IRR is the annual rate of return at which the investment just breaks even with a net present value (NPV) of 0:

Firm value = \( - 1 + \frac{3}{(1+IRR)^5} = 0 \).

Solving the above equation for IRR yields:

IRR = \( (\frac{3}{1})^{(\frac{1}{5})} - 1 \) = 24.57%.

Put differently, the investment promises an annual rate of return of roughly 25%. Now the investor has to decide whether such a return is adequate for the risk the investment brings about. If the investor's minimum required rate of return (hudle rate) is smaller than 25%, he will be tempted to invest in the company. In contrast, if the hurdle rate is higher than 25%, the company does not appear to be a financially attractive venture.

Note that, while the IRR prevents us from having to formally estimate the cost of capital, the investor will still have to decide whether the promised IRR is sufficient to compensate for the riskiness of the investment. Hence, even with the IRR, there is no way around a consideration of the risk-return trade-off!

Also note that Excel offers a rather convenient function "IRR," which allows us to quickly compute the IRR of a cash flow profile. This Excel file shows the solution of the above example using the IRR function. It also shows to common mistakes people make when using that function, and how to easily avoid them!

Starting Point for a Rough Estimate of the Cost of Capital 

Investors need to solve the risk-return trade-off, even when working with an IRR. A very practical starting point to estimate the firm's risk-adkusted cost of capital is the following:
 

Use the unlevered cost of capital (k_A) from a set of comparable firms that operate in the same or in a related industry. The online tool "WACC from Industry Peers" provides acceptable first-pass estimates of the typical cost of capital in a firm's industry.

When doing so, two things are worth noting:

• First, remember that the unlevered cost of capital ignores the potential tax benefits of debt financing. However, in the case of a real startup, this does not seem to impose a severe bias, as these firms generally have no access to debt financing and, more importanly, no earnings that can be shielded against taxes. If you value a more mature startup, you can estimate its synthetic rating using metrics such as the interest coverage ratio and then proceed to estimate the "standard" WACC. 
• More importantly, also note that when you estimate the unlevered cost of capital using listed comparable firms, you implicitly assume that your firm has the same risk characteristics as the comparable firms. Put differently, you implicitly assume that your company is already listed on a stock exchange, with all the associated costs and benefits.

Valuing the firm's free cash flows with the unlevered cost of capital from comparable firms will give you an estimate of the value of the startup company under the assumption that it is (already) listed on a stock exchange. Hence it reflects a potential value of the company. The logical next step is to think about how the riskiness of the startup firm in question differs from the riskiness of the typical peer and to incorporate this differential risk assessment in your valuation. This important issue is the topic of the next section.