# Reading: DCF for Startups

### 4. Handling Additional Risks

#### 4.3. Survival Probability and Hurdle Rates

The previous sub-sections have discussed two popular implementations of the DCF approach for startup companies. The conceptual difference between the two approaches is the following:

- When working with
**hurdle rates**, we implicitly**assume a specific probability of default for each individual period**. Consequently, the resulting present values of the annual cash flows are "expected values," in the sense that they already reflect the firm's failure probability. - The alternative method with the
**survival probability applies a probability of default to the whole business plan**. Consequently, the initial valuation (FCF @ "normal" WACC) reflects a potential valuation, which is then multiplied with the failure probability.

**When consistently implemented, both methods should technically lead to the same result**. We can show this using the previous example. Remember from before:

- Using the
**hurdle rates**, we have estimated a firm value of**1.87 million**. - We also know from before that the valuation that ignores the specific risks of the startup was
**4.82 million (going concern valuation).** - Finally, we have assumed that the firm will pay a
**liquidation dividend of 0.5 million**in the case of failure.

With this information, we can now compute the implied survival probability. From the previous subsection we know:

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

** **

Solving this expression for survival probability yields:

Survival probability = \( \frac{\text{Firm value}-\text{Liquidation value}}{\text{Going concern value}-\text{Liquidation value}} \)

When we plug the previous valuations in this expression, we find a survival probability of roughly 32%:

Survival probability = \( \frac{1.87 - 0.5}{4.82 - 0.5} \) = 31.7%.

**Put differently, based on our assumptions, our analysis using hurdle rates is consistent with a valuation framework that assigns a success probability of 31.7% to the whole business plan. **

As we have seen in the previous section, this overall success probability can be decomposed into 8 sources of success. If we assume that the firm does equally well on all 8 dimensions, a joint success probability of 31.7% implies that **each individual dimension has an expected success probability of more than 86%! **

This also helps us to put the hurdle rates we used into perspective. **While an initial hurdle rate of 30% might seem large, we now see that the implied probability of default is still fairly small.**