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If your startup is looking to raise startup financing, you may come across discussions of discount cash flows (DCFs) in the context of valuing your startup. DCFs are complex financial models that incorporate important financial concepts when putting a price on your startup. They incorporate the time value principle of money into the valuation. This is tailored according to the risk-return profile of the investor running the model. This article will explain how a discount cash flow works to value your startup.
Principles and Assumptions Underlying Discount Cash Flows
Time Value of Money
DCFs incorporate the principle of the time value of money (TVM) into the modelling. In effect, this principle states that money now is worth more than the same sum in the future. TVM allows for investors to account for three factors that influence the strength of a given investor:
- Opportunity cost, which measures to what extent investing in your startup is more lucrative than investing in an alternate venture.
- Risk profile, which measures the premium your investor expects to extract from the investment given the risks associated with startup investments.
- Inflation and interest rates, these economic factors determine wider market forces. These factors usually influence how other expected rates of return figures are calculated. This is because as inflation increases, so do interest rates. Accordingly, higher interest rates require investors to seek higher returns on their investments.
Rates of Return
All investors have a minimum rate of return they expect. Your investors will expect quite high rates of return. This expectation is due to the risk and opportunity cost of investing in startups being higher versus other investment opportunities.
To illustrate, an investor could purchase UK government bonds and expect a 5% return on its investment. If it purchases £1m of gilts, it can expect to have £1,050,000 when the bond matures. Given the UK government is unlikely to default on its repayment; this investment is essentially risk-free for the investor. Therefore, investors will seek at least a 5% return on other investments.
However, your startup is far more likely to default on its debt than the UK government. As such, your investors will require a higher rate of rate on their investment. This to compensate for the risk they incur in investing in your startup.
Most startup investors expect at least a 20% return on their investment. The exact rate of return depends on the objectives of the investor.
Creating a Discount Cash Flow
A DCF involves the following steps:
1. Determining the Time Period
Startup investors expect to invest in a company for at least a few years. The typical time horizon is five years.
This is important because a DCF forecasts the startup’s performance into the future. Investments with a horizon of longer than five years may not model beyond the fifth year because it is harder to predict cash flows beyond this period.
2. Forecast Future Cash Flows
Using past performance, startups with a sufficient degree of sales can predict future free cash flows into the future.
Free cash flows refer to the amount of cash a business has on hand after expenses and other accounting treatments have been subtracted from total sales.
For instance, suppose your last year’s sales were £100,000. And your last year’s free cash flow was £25,000. Assuming you intend to increase sales by 5% each year and free cash flow is 25% of sales, your future cash flows would be as follows:
| 2023 | 2024 | 2025 | 2026 | 2027 | 2028 |
| £25,000 | £26,250 | £27,560 | £28,940 | £30,399 | £31,910 |
3. Determine Discount Rate
Your investors will have a required rate of return. This rate of return is applied against the cash flows to “discount” their future value and arrive at their present value. This incorporates the TVM and required rate of return. The discount rate also factors in the amount of cash the business needs to generate to fund existing debt and equity investors.
For instance, suppose the discount rate is 20%. This reflects the minimum value your startup needs to generate so that its investors receive the minimum required return on investment.
The discount formula seeks to convert the future value of a sum into its present value (PV). The formula for present value is:
1(1+r)n= PV
Where r is the discount rate (20% in this case), and n is the period of time into the future.
Based on an r of 20%, we get the following discount factors:
| 2023 | 2024 | 2025 | 2026 | 2027 | 2028 |
| 1 | 0.83 | 0.69 | 0.58 | 0.48 | 0.40 |
4. Apply the Discount Rate to Future Free Cash Flows
If we then apply these factors to the future cash flows, we “discount” their present value as such:
| Period | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 |
| Future free cash flows | £25,000 | £26,250 | £27,560 | £28,940 | £30,399 | £31,910 |
| Discount Factor | 1 | 0.83 | 0.69 | 0.58 | 0.48 | 0.40 |
| Present Value | £25,000 | £21,788 | £19,016 | £16,785 | £14,592 | £12,764 |
By adding together the sum of discounted future cash flows, we can arrive at the enterprise value of your startup. This figure is £109,945, which may be a starting point for valuing your startup.
5. Factoring in the Terminal Value of Your Startup
A business’s terminal value is a single figure that represents all future cash flows beyond the forecast period. It then discounts this value into perpetuity. This captures the fact that a business typically generates wealth after the forecasted time period.
The formula for calculating the terminal value is:
FCF x 1(+g)(r – g)= Terminal Value
Where:
- FCF is the last free cash flow of the forecast period (£31,910);
- r is the discount rate (20%); and
- g is the expected perpetual growth (5%).
On our current model, this gives a value of £223,400.
The issue with terminal values for startups is that they are rarely accurate. In particular, the expected perpetual growth should increase over time because startups grow rapidly. Therefore, terminal values may not be factored into the valuation of an early-stage startup like yours.
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Key Takeaways
For startup investors and founders, understanding discount cash flows (DCFs) is crucial for valuing startups. DCFs incorporate the time value of money, reflecting the investor’s opportunity cost, risk profile, and prevailing interest rates. Investors typically seek higher rates of return for startup investments due to the associated risk. Creating a DCF involves several considerations. Firstly, you must determine the time period. Secondly, you must consider the forecasted future cash flows based on historical performance. Thirdly, you must determine the discount rate to calculate the present value of the startup. Fourthly, you must apply the discount rate to future cash flows. The sum of discounted cash flows provides the enterprise value of the startup. The terminal value accounts for future cash flows beyond the forecast period. However, terminal values for startups are challenging as they seldom accurately estimate the value of a startup.
If you need help understanding how a DCF impacts your startup, contact our experienced startup lawyers as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
DCFs are used to determine the value of a startup by incorporating the time value of money and discounting future cash flows. They help investors assess the potential returns and risks associated with investing in a startup.
Discount cash flows incorporate the risk profile of investing in startups by applying a higher discount rate. This higher rate reflects the additional risk investors assume when investing in startups compared to more established and lower-risk investments.
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