Post 4 - Why does the conventional DCF not work for valuing a start-up/young firm?
The quick fix - Venture Capital Method of valuation for start-ups
Previously, as elaborated in my previous posts in this thread, the conventional DCF falls apart when it comes to valuing a start-up/young firm
A quick (and a dirty) fix to the above problem is the VC Method where
1) Estimate revenue or earnings in the near future of the start-up (typically the period when the VC plans to make an exit)
2) Calculate the valuation (Equity Value or Enterprise Value) at the end of forecast period by
a) Multiply earnings with average P/E ratio of the publicly traded companies in that sector closely matching the start-up
i.e. Equity Value = Forecast PE * Expected earnings
b) Multiply similar revenue multiple with the revenue of the startup at the end of forecast period
i.e. Enterprise Value = Forecast EV/Sales * Expected Sales
3) The derived estimated valuation has to be discounted back to present value using a discounting factor.
The discounting factor would be typically more compared to the one used in publicly traded firms.
This discounting factor is targeted rate of return of the VC investor and is set high enough to capture the foreseen/perceived risk of operating the business and chances of its survival.
Equity Value (today) = Equity Value at end of forecast period/ (1+Target rate of Return)^n
4) Because this is the valuation of the start-up before the VC invests his/her money in the business it is known as Pre-Money Valuation of the start-up
5) VC investors receive an equity share of the business in exchange for their investments. To understand the proportion of their ownership in the business, the new capital they bring in the business is added to the Pre-Money valuation to get Post-Money Valuation of the firm
Post-Money Valuation = Pre-Money Valuation + Capital Infusion
Equity ownership of the VC investor = New Capital Infused/Post - Money Valuation
As I mentioned this is a quick fix and has some shortcomings, I will cover the same in my next post.