4. Handling Additional Risks

4.4. Cash Flows with Different Risks

The last issue we need to discuss with regards to the cost of capital of startups concerns the riskiness of specific cash flows within the same year, in particular potential differences between the uncertainty associated with cash inflows and outflows.

In many situations, one could argue that some cash flows (mostly outflows) are less uncertain than others (mostly inflows). In such situations, the less uncertain cash outflows should be discounted at a lower cost of capital than the more risky cash flows.

Take the case of a firm that is developing a new drug against cancer. In its going concern valuation (that is, when we model the scenario that the firm actually makes it to market and beyond), the firm will plan for cash outflows such as clinical studies and the construction of production facilities. 

For simplicity, let us assume that the firm has similar characteristics as the hypothetical company that we have considered in the previous sections. In particular:

  • A normal WACC of 10% (ignoring the specific risks of startups)
  • A survival probability of 20%
  • A potential liquidation value of 0.5 million
  • The following cash flow profile


 (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 have valued the firm under these specific assumptions before and found a going concern value of 4.8 million and an overall firm value of 1.36 million.

Now let us adjust the situation a little bit. Let us assume, for simplicity, that the cash flows of year 1 and 2 (cash out of 1 million each) reflect cash outflows for a clinical study (year 1) and the construction of production facilities (year 2). Let us also assume that the firm has already received binding offers from the counterparties so that there is no uncertainty associated with these two cash flows. In this case, the appropriate discount rate of the first two cash flows in the going concern valuation is the risk-free rate of return!

Assuming a risk-free rate of 2% p.a., the going concern valuation of the firm, therefore, is:


Going Concern Value = \( -\frac{1'000}{1.02}-\frac{1'000}{1.02^2}+\frac{500}{1.1^3}+...+\frac{5'000}{1.1^7} \) = 4'618.


Because we apply smaller discount rates to negative first two cash flows, the going concern value of the firm drops from 4.8 to 4.6 million. Consequently, the overall value of the firm drops to 1.32 million. In this particular example, the impact of different cash flows risks was therefore not very substantial. Still, when valuing startups, we should always check whether there are cash flows in the projections that are less uncertain than others. If the answer is yes, we might consider an approach as outlined above to account for the different risks.