Reading: DCF for Startups

The second approach is to model continuing value with an exit multiple. This procedure is very popular among venture capitalists and will be discussed in much more detail in the  section The Venture Capitalist (VC) Approach.

The procedure is very simple: Instead of conducting an intrinsic valuation such as the DCF approach, we conduct a relative valuation by applying a market multiple (e.g.,  EV/EBITDA) to the firm's forecasted value driver at the end of the forecast period (e.g., EBITDA in 7 years). We call it "Exit Valuation" because it is particularly popular among investors with a limited investment horizon of, say, 5 to 7 years. These investors want to know at which valuation they can expect to exit their investment. To find out, they look for information about the prices at which other investors could exit from similar companies.

Before discussing some implementation issues of exit multiples, let us quickly take a look at an example. We go back to the previous hypothetical company, for which we have estimated a value of 1.87 million for the explicit forecast period of 7 years. Now let us assume the following:

• The relevant valuation multiple is the EV/EBITDA ratios. Similar transactions have recently taken place at an EV/EBITDA multiple of 6. That is, the exit value was six times EBITDA.
• According to the financial plan, our firm expects to generate an EBITDA of 7 million in year 7.

With this information, we can now estimate the firm's exit value in 7 years:

Exit Value₇ = EV/EBITDA of comparable transactions × Firm's EBITDA₇ = 6 × 7 = 42 million.

This is an exit value in 7 years. Given a present value factor of 0.239 for year 7 (according to the previous page), the present value of this exit value is 10 million:

PV(Exit Value₇) = Exit Value₇ ×  PV Factor = 42 ×  0.239 = 10.04 million.

Consequently, the overall value of the firm is roughly 12 million:

Firm Value = PV(Forecast Period) + PV(Exit Value) = 1.87 + 10.04 = 11.91 million.

The numbers imply, that the overwhelming majority of firm value results from the expected exit value in year 7. Such a result is actually the rule rather than the exception. As we will see in the section The Venture Capitalist (VC) Approach, many investors actually solely look at exit values. It is therefore especially important to be careful when estimating these exit values.

In the next course section on the Venture Capitalist Approach, we will discuss in more detail the four key challenges we face when estimating exit multiples (especially in the case of startup firms):

• Are there comparable firms? 
• What is the "correct" value driver? 
• What are comparable valuation situations? 
• How can we apply a valuation multiple that reflects today's market environment to a transaction that is expected to take place in the distant future?

In sum, this section has briefly discussed what exit multiples are, how we can apply them in the context of startup valuation, and what we have to keep in mind when using this valuation method. Because this method is fairly simple and not very time consuming, we should always implement it; even if in some instances it might just be a reality check for an alternative approach to estimate continuing value.