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If you own a startup, you may have come across net present value (NPV) when discussing raising capital with investors. NPV is a tool investors use to evaluate the profitability of a given investment. You can also use NPV to gauge potential projects your startup will deploy its capital towards. This article will explain the concepts behind NPV and how it is used in practice so you can understand its relevance for your startup.
What is Net Present Value (NPV)?
NPV is a tool used to account for the time value of money. Behind NPV is the idea that money in the future is worth less than it is now.
To illustrate this principle, ask yourself if your startup would loan another business money for free. Outside of an act of generosity, your answer is probably not. You would not loan £100 for a year only to be paid £100 in a year’s time. Instead, you would expect to receive interest payments throughout the loan or upon repayment of the principal amount. At 10% interest, this would be £10.
Put another way, we might say that obtaining £110 in a year is worth £100 now. £100 is the present value of £100 in a year.
Investment Characteristics
NPV is relevant in investments because significant capital investments usually have the investors deploy a large capital sum upfront. Investors subsequently expect the investment project to generate a stream of cash flows directed towards them.
In many cases, investors will seek to exit their investment at the end of a specified period. If the investor obtains more at the end of their investment when they exit, they make capital gains. This happens when an early equity investor sells their stake following an initial public offering.
However, many investment projects do not give investors a return on capital investment. Sometimes, they may not receive any of their cash back at the end of the investment period. In these cases, the goal of the investment is to generate a sufficient stream of cash flows over the investment period that makes it a competitive investment.
In all cases, investors or your startup’s management need a way to determine the investment’s current value. This is because they need to know if it is worth it to lock up their money right now to obtain the benefit of the investment in the future.
Continue reading this article below the formCase Study
Suppose your startup wants to purchase a patent from another business. The business will sell it to you for £1m. Due to intellectual property laws, the patent will last five years, after which it will expire. This will make it worthless, so you cannot recover any capital investment at the end of the period.
Nevertheless, you estimate the patent will help your startup generate £200,000 (after expenses) each year over the next 10 years. Below is a table outlining the outflows and inflows that your startup will incur if it purchases the patent:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cashflows | (£1m) | £200k | £200k | £200k | £200k | £200k |
(Note: you pay £1m right now (Y0), and the £200,000 each year accrues by the end of each subsequent year).
The question now is, what is the present value of this investment? Intuitively, we might say it is £1m. You invest £1m now and get the equivalent of £1m over the next five years. But that cannot be right because we know that the time value of money means that £100 now is worth more than £100 in the future.
The same principle applies here. As a general rule, we know that we should get back more in the future for the same amount of money we put down now. Therefore, this is not a good investment.
Further Considerations
Assume that the patent will cost £1m but generate the following cash flows:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cashflows | (£1m) | £275k | £275k | £275k | £275k | £275k |
In other words, you invest £1m now to obtain the sum of £1.375m over the next five years. To determine whether this is a good investment, it is worth considering the following factors.
Risk
What is good depends on what your other options are. Say your startup can purchase £1m in risk-free government bonds and obtain £1.1m over five years. £100,000 over five years equals £20,000 per year (on average), and £20,000 per year against £1m is a 2% return yearly. Therefore, you should expect a 2% return on your £1m.
Alternatively, £1.375m is better than £100,000 of course. But how certain are you that the patent will generate at least £275k each year? Oddly, you will be less certain of that fact than obtaining £100,000 by buying £1m in government bonds.
Opportunity Cost
At the same time, if you could buy another patent for £1m that has the same chance of paying £300,000 as the first patent of generating £275,000, the second patent is the better option. But if there is a higher risk that the patent may generate less than the expected investment, it may not be worth it.
Inflation
Finally, we should factor in inflation because that will erode any returns you receive. In other words, 5% inflation each year means that £275,000 in the first year is only worth £261,250 the next year (from our present vantage).
What is the Discount Rate?
Therefore, when asking if an investment is good, you should consider:
- the risk involved;
- alternative options to invest your capital to receive at least the same return; and
- inflation.
These answers will help us come up with the discount rate. The discount rate is the figure that we discount the future cash flows against expressed as a percentage.
Once you have the discount rate, you can calculate the present value of any future cash flows by using the following formula:
Present Value = Future Cash Flows (1 + r)^n
Financial analysts can help you arrive at a suitable discount rate by quantifying and weighing the importance of these various factors.
Returning to Our Case Study
Assume that you arrive at a discount rate of 20%, which is a common minimum discount for startups. Applying the discount rate to the £1m patent that generates £275,000 each year allows us to determine the NPV of the adding the sum of each future cash flow:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cashflows | (£1m) | £275k | £275k | £275k | £275k | £275k |
| Present Value | (£1m) | £257k / (1 + 20%)^1 | £257k / (1 + 20%)^2 | £257k / (1 + 20%)^3 | £257k / (1 + 20%)^4 | £257k / (1 + 20%)^5 |
Restated:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Cashflows | (£1m) | £275k | £275k | £275k | £275k | £275k |
| Present Value | (£1m) | £229,167 | £190,972 | £159,144 | £132,620 | £110,516 |
The sum of these future cashflows is: £822,428. This is the net present value of the investment project. This figure is less than the initial outlay, so it is not a good investment.
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Key Takeaways
Net present value (NPV) is essential for financial decision-making, especially for startups. NPV accounts for the time value of money, showing that future cash flows are worth less than present ones. Accordingly, NPV aids investors and managers in assessing the profitability of investments and projects by comparing present and projected cash flows. Start startup managers and their investors can make reasoned decisions about their investments through an appropriate discount rate by factoring in:
- risk;
- opportunity cost; and
- inflation.
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