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Post 2 - Why doesn't a conventional DCF not work for valuing a start-up/young firm?



Discounting Rates:

1) Start-ups or young companies may have their equity sourced from multiple sources coming at different times with different set of terms.


2) Different equity claims lead to different costs of equity for each one.


3) Cost of equity for an equity investor having first claim on the cash flows may be lower than the cost of equity for a follow on investor who has a claim on the residual cash flows.


This additional differential cost of equity for different set of equity investors adds to the complexity of the discounting rate calculations


Terminal Value

The terminal value calculations of a firm have an implicit assumption that the firm will exist till perpetuity with a stabilized and sustainable growth rate


1) In case of start-ups, because of massive failure rates, estimation of the probability of survival becomes a daunting task and thereby adds to complexity of the terminal value calculations.


2) It becomes difficult to estimate when the start-up will reach a stable growth phase due to the added competition pressures


I will continue on the other sections of the DCF in my upcoming posts and highlight the shortcomings of the conventional DCF for valuing a startup/young firm valuations. The link for the first post in this series is here.


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