Reading: DCF for Startups

So far, we have discussed practical approaches to estimate the cash flows and discount rates of startups; the blue and the green elements of the DCF journey:

The logical next step is to think about the third key element of the DCF approach: Continuing value. 

In the context of startups, modelling continuing value is especially important. Often, the financial plan covers in great detail the period from product development to market entry until shortly after break even. Thereafter, quality of the available information often declines drastically and the forecasts are replaced by a “hockey stick” that assumes a more or less constant growth rate going forward. Since the forecast period does usually not extend far beyond the point where the firm is expected to generate positive cash flows, the value contribution of the forecast period is often negative so that the “hockey stick” accounts for more than 100% of firm value.

Clearly, it is the reality of many startups that positive cash flows are expected to occur only in the distant future. We cannot change this reality. But we have to make sure that we follow some simple rules and economic principles when modelling the “hockey sticks.” By doing so, we can hopefully avoid some obvious mistakes and thereby make the resulting valuation somewhat more reliable. That’s the topic of this chapter.

In principle, there are three popular ways to estimate the "Continuing Value" (of startups):

• Liquidation value
• Exit multiple
• Perpetual growth model (possibly with a Competitive Advantage Period)

In what follows, we briefly discuss some implementation issues of these three valuation approaches.