Reading: DCF for Startups

An alternative approach is to value the firm under two different scenarios: A going-concern scenario as well as a liquidation scenario. The resulting firm value is then a probability-weighted average of the valuations under the two scenarios:

Firm value = Going concern value × survival probability + Liquidation value × (1 - survival probability).

A few points are worth noting:

• The going concern value factually assumes that the firm will make it through the valley of death and become a mature company. Under this assumption, the expected future cash flows of the firm are capitalized at the "normal" WACC for mature comparable firms.
• The liquidation value estimates how much the providers of capital will receive if the firm does not make it and will be liquidated instead. For a startup company, this liquidation value is often (very close to) zero. For a more mature company, the liquidation value could roughly be approximated by the book value of debt net of liabilities. In any event, a separate valuation is required to estimate the liquidation value.
• The survival probability indicates how likely it is, from today's perspective, that the firm will make it. We will discuss the possible determinants of this probability further down.

To illustrate this approach, let us go back to our hypothetical firm:

• Going concern value: At the beginning of this section, we have already estimated the going concern value of the firm: The present value of the expected free cash flows, capitalized at the "normal" WACC is 4.8 million.
• Let us assume that the liqudation value of the firm is 0.5 million (this is simply an assumption to illustrate the valuation method).
• Finally, let us assume that the survival probability of the firm is 20%.

Based on these assumptions, we can now incorporate the additional risks of the startup firm in the original valuation:

Firm value = Going concern value × survival probability + Liquidation value × (1 - survival probability) = 4.8 × 0.2 + 0.5 × 0.8 = 1.36 million.

Consequently, this approach would imply a firm valuation of roughly 1.4 million. Again, the fact that the startup company is much riskier than an established firm has a rather significant impact on the resulting valuation.

Assessing the survival probability

In addition to the previously discussed challenges of estimating free cash flows and the WACC, this valuation approach also requires us to estimate the firm's survival probability. To help with this estimate, Bob Zider recommends in his 1998 Harvard Business Review article to split the survival probability into eight components and then assess the success probability of each component separately on a scale from 0 to 100%. The 8 components he recommends are:

• Company has sufficient capital
• Management is capable and focused
• Product development goes as planned
• Production and component sourcing goes as planned
• Competitors behave as expected
• Customers want product
• Pricing is forecast correctly
• Patents are issued and are enforceable

Failure in one dimension will lead to company failure. We can find the joint probability of success by multiplying the 8 individual probabilities.

This approach nicely illustrates that success is the result of many components! Even if the individual success probability of the 8 components is rather high, the probability that the firm will succeed on all 8 dimensions together is remarkably low. To see this, consider a hypothetical example of a firm that has a high success probability of 80% on each dimension: For such a firm, the resulting probability of joint success in each dimension is only 17% (namely 0.8⁸ = 0.17).

For your convenience, this Excel file helps you calculate the survival probabilities according to the approach proposed by Zider (1998).

The approach also illustrates why many businesses fail in the real life. You cannot compensate an apparent deficit in one dimension with an increased effort in another dimension! This, however, is exactly what we often observe in the real life. In reaction to bad news on the capital or the competition front, entrepreneurs often put in an extra effort in terms of product development. The above table shows that this behavior will not be rewarded with success, on average.