How to build up the discount rate for a startup
If you are valuing a startup chances are the company has not yet established a strong track record of significant earnings. The good news is business valuation is about the future expectation, not historic trends. So it is far more important that you demonstrate the earnings upside as the company grows.
That’s one reason startups are usually valued based on their earnings forecast. Along with the expected earnings there is risk since we are talking about outcomes some time in the future.
Calculating the discount rate is the typical way to assess the company’s risk. With the earnings forecast and discount rate available you can determine the startup value using the discounted cash flow method.
Next to the earnings forecast the central question is: how do you calculate the discount rate for a startup? The good news is that the build up model lets you determine this key valuation factor in much the same way as for any other company.
Discount rate build up model
This makes sense if you take a look at the formula for the discount rate build up. Each element in the equation remains fully applicable to a startup.
Factor 1: risk free rate of return
An alternative risk free rate of return is important because it establishes the minimum rate of return any investor can get without incurring the risk of default. No rational investor will accept returns below this from any business let alone a startup.
Factor 2: equity investment risk premium
Next, the equity premium indicates what an investor can get by spreading risk across a well diversified portfolio of company stocks. It makes sense that this additional risk is a factor in an investment in any particular business as well.
Factor 3: company size premium
The company size risk premium is a consideration by investors of the additional risk small companies represent. Since startups usually start small, this risk element is part of the equation.
Factor 4: industry risk premium
Startups have limited resources early on, so they must focus on what they do best to succeed. This usually means that they aim to excel in a specific industry sector. Hence, the industry risk premium applies here as well.
Factor 5: company specific risk premium
The last part of the discount rate build up formula is company specific risk premium. This is one element of your discount rate you need to pay special attention to. It enables you to characterize the startup across a set of key risk parameters.
How well your startup performs across any of these may make a big difference to its value. Notice some of the soft factors that come into play here: quality of the management team and employee skill sets and motivation.
In addition to the hard financial numbers and market position, it is the people behind the startup that make it a success. Even the most appealing business plan is just a vision initially. The startup team needs to do its best to make the plan a reality.
Given the large variation in outcomes for startups, careful assessment of the company specific risk factors can make a major difference to the overall discount rate. If the company plans to run a higher risk scenario to get to its objectives, it will need to show superior earnings to justify it to its investors.
The point is that different business strategy scenarios are likely to result in different earnings forecasts and discount rates for the startup. Most of your differences will be captured by the company specific risk factor.
This is one reason startup valuations usually include a number of scenarios. A good format is to provide business valuations for the best case, worst case and most likely case expected outcomes.