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Post 3 - Why does the conventional DCF not work for valuing a start-up/young firm?



Diversity in equity claims:

In most of the cases of publicly traded firms with one class of shares, all equity claims on the firm are equivalent. We can simply divide the value of equity proportionately amongst the claims to derive value per claim


In case of start-ups/young firms, the fact that equity is raised from private investors as against issuing shares in public market results in non-standardized equity claims


Putting it simply, agreements with equity investors in different rounds of financing can be very different


Next there can be large differences across equity claims on cash flows and control rights with some claim holders getting preferential rights over the rest


Finally, equity investors in each round of financing demand and receive rights protecting their rights in the subsequent funding rounds


This diverse nature of equity claims requires us to value preferential cash flow and control claims and protective rights built into some equity claims and not others increasing the complexity


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.


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