# Reading: DCF for Startups

### 4. Handling Additional Risks

We have seen that investing in a startup company typically entails additional risks compared to investing in a more established firm. Examples of such additional risks are:

- More pronounced technical challenges
- Funding problems
- Survival
- Poor diversification of the owners
- Illiquidity of the investment (inability to sell over a prolonged period of time)
- etc.

The question is how to incorporate these additional risks in the valuation of the startup firm. Practitioners usually choose between one of the two following approaches:

**Add additional risk premia to the cost of capital**to capitalize future cash flows- Use the cost of capital for established firms (see previous section) and then
**apply discounts to the resulting "normal" valuation**to reflect the value implications of the additional risks.

The following two sub-sections discuss these methods in more detail. In doing so, **we look at a hypothetical firm** that is expected to generate the following cash flow profile over the next 7 years (in thousands). For simplicity, we assume that the firm ceases to exist after 7 years.

(thousands) |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |

Free Cash Flow | -1'000 | -1'000 | 500 | 1'000 | 2'000 | 3'000 | 5'000 |

We also assume that comparable listed firms operate at a **cost of capital of 10% (WACC)**. Consequently, under the assumption that our firm has the same risk profile as its comparable listed firms, the DCF-value of the company is 4.8 million:

DCF-Value with Benchmark Risk = \( -\frac{1'000}{1.1} - \frac{1'000}{1.1^2} + ... + \frac{5'000}{1.1^7} \) = 4'824.

Now let us consider how this valuation changes when we incorporate the specific risks of a startup company.