“I need to be compensated for the risk I’m taking”
“I want a larger return than that”
These are typically statements that you would hear from a VC or an angel investor. But, what do they mean? What’s the link between discount rates and required returns? And how are these related with the amount of equity you will have to grant them to seal the deal? In this article Stefani from Equidam will try to explain what discount rate means for the valuation of your startup.
The value of one €uro today is not comparable to the same €uro in a future period. This is why the Discounted Cash Flows method (DCF) is one of the most used in the valuation of companies in general. The discount rate applied in this method is higher than the risk free rate though. The Risk Free Rate is indeed observable in the market but can be applied only to those streams of cash flows which are expected to manifest in the future with certainty. That doesn’t include startups. The usual benchmark for Risk Free Rate- cases, in Europe, is the return on the German Bund (bond), whose coupons and final repayment are considered to be 100% sure. In financial terms, the implied correlation of this type of investments with the overall economic conditions is a null value. Whatever will happen, the cash flows are guaranteed.
For almost all other types of investments, uncertainty about their effective realization leads to higher discount rates. Why is that? Because the implied risk needs to be accounted for, that is, priced, in the value an investor would be willing to pay for that kind of investments today. Investors on average avoid or minimize risk. Suppose you can pay EUR 95,- now and you will receive EUR 100,- in two years with certainty, or that you can pay EUR 95,- and receive EUR 100,- in two years but with uncertainty. To encourage people to invest, the final outcome should be higher than EUR 100,- or, conversely, the price paid lower than EUR 95,-. This is exactly the principle of the discounted cash flows under uncertainty. Suppose your startup has been valued EUR 200,- and you are willing to sell 10% equity (EUR 20,-). Unfortunately the BA you’re dealing with ask 20% equity for the same price. What does it entail for the valuation?
Basically, he is requiring a larger price for the risk. Ceteris paribus, the discount rate he is implicitly applying, is much higher than the one used in your valuation, entailing half of the “present value” (PV) you estimated. He is asking compensation for the several factors which might jeopardize the earnings of the business. Suppose the next year you will earn EUR 30,- and today the value is EUR 25,-. The expected return implied (that is equivalent to the discount rate) is 20%. It might be the case that the investors don’t feel satisfied and thus asks for a 30%. This entails a PV of around EUR 23,-. The net effect is that the right on the future value of EUR 30,- is purchased at a lower price and this might have been the initial value you attributed to your startup. This is the intuition behind the DCF valuation tool.
Firm specific risk v.s. diversification
But what kind of risk is the investor effectively bearing? That is to say, is the price for it applied by the VC or BA fair? You should be aware that their valuation of the risk is usually arbitrary and it tends to overestimate the discount applied. This is especially true when they spot some opportunities in the businesses which haven’t been figured out by the entrepreneur. Basic concepts of financial theory can help your argumentation for a lower discount rate.
One of these concepts is diversification. The only risk that increases the required return for investors should indeed be the non- diversifiable one, while the idiosyncratic or firm specific risk should not be priced. Suppose you run an insurance company. You provide policies against robbery to individuals. This kind of risk is idiosyncratic since the events are uncorrelated each other. If someone is robbed there are no consequences or links to the probability of someone else being robbed.
So to reduce the exposure you can just insure the largest amount of people you can. This is diversification. On the one hand you clear the premium of 1.000 policies while on the other you will, on average, reimburse 10 robbed clients. But what if you insure for earthquakes? You have a 99% chance to clear your premium most of the time but when the event occurs, you will have to reimburse all the clients in the area damaged. This kind of risk is not diversifiable. How does this relate to risk taking behavior of investors?
Determining the systematic risk
As entrepreneur you can reasonably guess that your VC or BA has many other investments in startups. His wealth is not entirely tied to the fortune of the startups. So why should he be fully compensated for the specific risk inherent your business? Investors generally are aware of the ignorance about this topic and can play with it.
Assuming the investors are perfectly diversified, the systemic risk carried by your startup should be measured according to the common relation of the expected cash flows with the expected variations of the broader economic environment. The correlation is usually rather low and it ranges between 0.1 and 0.25. This means that more than 70% of the uncertainty concerning the startups future cash flows, are due to firm specific factors which a professional investor is able to diversify away.
The valuation of the company should take into consideration only the systematic, not the company specific risks. This same concept cannot be applied to the entrepreneur. He is usually investing a substantial part of his wealth in the venture and he thus deserves to receive a reward for the risk he bears. The cost of capital/required return for them should therefore be higher compared to that of a professional investor or wealthy individual.
Still unclear on the specifics of the DCF? Check out the rest of our articles on the Discounted Cash Flow!