more-arw search

Q&A Forum

Does DCF even make sense for startup company investments? If so, what discount rate would you apply?

I have a board member who wants me to run a DCF of an investment in a new product we are considering. My concern is that, like many startup endeavors, the assumptions will be SWAGs and that the DCF will not actually answer many questions for us and may actually mis-guide us given how speculative the assumptions will be. Have you found DCFs to be useful in this kind of case? If so, what discount rate would you apply?

Answers

Topic Expert
Tom Pai
Title: CFO consultant
Company: Sunstone Group
(CFO consultant, Sunstone Group) |

Yes, DCF can be a useful tool for assessing a project or new product concept. If the company needs to make an investment of "X" for a project or new product line. A relevant question is, "is it worth the investment?" DCF is one of the tools we can use to decide whether is worth doing. This is useful for mature companies as well as startups.

Of course there are a lot of assumptions that need to be made about costs, timing, and revenue. Run various outcome scenarios with different assumptions. This will help you bracket the likely outcomes. With these in hand, you can then decide, "is it worth the investment?"

In terms of discount rate. The question you have to ask is, "what's my cost of capital?" As a startup, you can't just borrow money at Prime Rate (currently 3.25%)like an established company. For a startup, it's probably very high since your investors are expecting a ROI in the 30-40-50% range. That would be rate you ought to be using for the discount factor; your true cost of capital.

Hope this helps.

Scott Lane
Title: CFO and CRO
Company: TPG Credit Management
(CFO and CRO, TPG Credit Management) |

Agree with comment above regarding usefulness of DCF approach and running scenarios (recommend high, low, and base case scenarios).

On the discount rate, agree it would be high as it should match the risk profile of you company and its related cash flows to investors (including illiquidity). If you want a technical formula for deriving / documenting your approach to the discount I recommend applying the capital asset pricing model (CAPM) which is generally accepted in finance.

Topic Expert
Joseph Ori
Title: CEO
Company: Paramount Capital Corporation
(CEO, Paramount Capital Corporation) |

I also agree with the above, that any corporate investment, even for a start-up, should be analyzed with a DCF analysis. The discount rate should be the firms weighted average cost of capital, which is the cost of debt, if any, in the capital structure, times 1-tax rate, the cost of preferred stock, if any, at the dividend divided by the stock price and the cost of common stock using the CAPM. The costs of each component of the capital structure are weighted and the total is the WACC. This is the rate used to discount the investment free cash flows and calculate the terminal value. Please see the Proformative learning platform Training session titles, What is Your Corporate Cost of Capital, for a more detailed analysis of above.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

DCF is useful in a stable/mature environment where all the variables can be reasonably and reliably projected/ascertained. In a start-up environment all of these variables go out the projections toilet. How many startups have pivoted from their original business models or even the product itself thus making the DCF (if they used it for funding justifications) worthless? Even a slight change in business models will do this. This is why most VCs/funders give more value to the team (ability to adapt and execute) than the idea/product or business model as a basis for their investment.

This is also the reason why PEs use DCF more than VCs and angel funders. For succeeding/late rounds, the DCF may be used with certainty.

So to answer the question....IMO, DCF is not appropriate or useful in a startup (generally speaking) environment.

I actually had an experience with a potential foreign investor wanting me to do a DCF for a startup. I told him "nicely" that this only reflects their inexperience with investing in startups and that they are treating the startup as a mature company. Needless to say, that DCF requirement went away.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

As an additional note or commentary.... add a DCF on your pitch deck or subsequent presentation documents and the probability that you will get laughed at (ok...you will get snickers) or NOT get the investment increases considerably.

Serge Wind
Title: Instructor, Department of Finance
Company: NYU School of Professional Studies
(Instructor, Department of Finance, NYU School of Professional Studies) |

I am a strong advocate of using the most-widely accepted procedure to assess the proposed contribution of an investment in a new product – the Discounted Cash Flow (DCF) approach, specifically as represented by the measure known as net present value (NPV).

Arguably, the most important long-term decision for a company is assessment of a major investment – characterized by large initial expenditures, followed by several periods of cash inflows. Regardless of the age, status (startup or mature), or size of the company, it would appear to be courting disaster not to engage in estimating the likely revenues, costs, expenses and expenditures in equipment or working capital associated with the proposed investment. Some of the estimates may be guesstimates, but I have never run into an instance where a company officer or director preferred not to have some idea of the likely net impact of the investment.

In order to create value for the owners of the business, the investment has to earn a return greater than a hurdle rate – the relevant cost of capital for the degree of risk associated with your company and project. I would strongly suggest utilizing the measure which is favored by nearly all practitioners and analysts – the DCF-based net present value (or, equivalently, the internal rate of return). Yes, you will have to estimate incremental cash flows for each time period, along with a relevant cost of capital for your company, and – instead of adding the cash flows from different periods – you will be adding the discounted cash flows which are all stated in the same year’s dollars.

However, the concern you expressed is really not over the recommended DCF approach, but rather with the reliability of the estimates of future cash flows. The latter almost always is the area of greatest concern. And there are two ways to address your concern over “SWAGS”. First, undertake sensitivity tests by varying your best estimates of key cash flows and determining the effects on the NPV and whether the NPV still exceeds zero dollars. This will likely increase your understanding of which key forecasted items, and their possible volatility, are critical to the success of your investment. Alternatively, it will make you realize the contribution required from unspecified technology or a marked change in your business plan to market your new product successfully. Second, obtain the best estimates by getting written commitments from the person(s) responsible for the product and its costs and anticipated revenues. Having “skin in the game” tends to produce a remarkable focus in generating the most realistic estimates given current expectations.

Isn’t that what your board member is requesting before s/he approves the product investment?

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Here is a Quora discussion on DCFs which reflects the the same general thought as I have initially posted:

http://www.quora.com/Do-venture-capitalists-use-DCF-analyses-to-evaluate-valuations-for-early-seed-stage-startups

Sergei Cheremushkin
Title: unemployed
Company: unknown employer
(unemployed, unknown employer) |

Mark, your concerns are well-founded. DCF is almost useless and, what is worst, misleading in the given context. For an investment in a new product there is too high level of uncertainty. Usually the most uncertain variable is sales. Therefore, cash flow is unpredictable; whatever discount rate you choose, you will not be able to verify it. In such circumstances calculating NPV, PI, IRR or other DCF-based measures would be a mere formality. Results would be doubtful.

However, when investing in a project, management must examine carefully controllable variables, such as size of investments, operational costs. My suggestion is to consider in the first place fixed and variable costs and estimate the break-even point. It provides understanding of the sales volume needed to earn profit. The decision criteria is simple. Reject the project, if the probability of reaching break-even point is below the chosen threshold point. Accept the project, if there is high probability that the firm will exceed break-even point and has potential to earn attractive contribution margins and to expand.

If the market is highly competitive, management should be sure that it is realistic to sell the number of units needed to reach the break-even point. From the outset management should consider marketing efforts and the amount of marketing budget for raising customer awareness, developing new sales channels, advertising and promotion.

7581 views
Topics
Products and Companies

Get Free Membership

By signing up, you will receive emails from Proformative regarding Proformative programs, events, community news and activity. You can withdraw your consent at any time. Contact Us.

Business Exchange

Browse the Business Exchange to find information, resources and peer reviews to help you select the right solution for your business.

Learn more

Contribute to Community

If you’re interested in learning more about contributing to your Proformative community, we have many ways for you to get involved. Please email content@proformative.com to learn more about becoming a speaker or contributing to the blogs/Q&A Forum.