What is the appropriate discount rate for a startup DCF valuation?

Following a recent discussion with a local investment banker about the DCF valuation of a client where the topic of appropriate discount rate was a hot issue, I wondered what others were using and if there was a "right" rate.

For those that don't live and breathe financial jargon, a DCF (discounted cash flow analysis) is a method of calculating the present value of a future benefit and they are often used whenever someone needs to figure out a justifiable valuation for something that doesn't have a ready market value (and sometimes looking for valuation mistakes in things that do).

The most common reason I will use a DCF is for determining  pre/post money valuations for startups, since they by definition have little more than pro-forma financials.

In preparing a DCF for a startup I need to know the expected cash flows and the appropriate discount rate.  I can pull the expected cash flows from the proforma financial statements, but the discount rate is really mine to decide.  As a definition, the discount rate is:

the rate of return that could be earned on an investment in the financial markets with similar risk. Wikipedia

With that rate in mind, I have started to use 27% as my discount rate for startup companies.  Why 27%...because the Marion Kauffman Foundation published a report in November of 2007 based on their research that indicated a national average IRR (internal rate of return) of approximately 27% on angel investments.  I haven't seen anything since then that would purport to be a better number, so that is still what I use.

Of course a lot has changed in the economy since November 2007, so I wonder what others are using for a discount rate now or if that metric still holds true?

Don't do "mandatory redemptions" in seed deals...

I had a conversation with one of our BAN company founders last night (I have a very understanding spouse) about term sheets and our preferred structure.  He was really asking about convertible debt vs. preferred equity, but we ended up talking more about share redemption requirements or puts and related change of control provisions.

We have had this discussion several times in our BAN meetings and my opinion is fairly clear...don't put mandatory redemptions and change of control provisions in seed stage deals.

Why?  Because it is a seed deal and they are inherently more fluid than later stage deals, so the flexibility is helpful.  Also, we are talking about $300-400k (not $3-30mm), usually in increments of $10-25k per investor, so it is almost always in everyone's best interest to have the founders tackle whatever obstructions may arise and have the investors "keep their day job."

As an investor, I would much rather focus on doing good due diligence and valuing the deal properly for the risk  involved (which btw explains part of why I prefer preferred stock deals rather than debt that punts valuation to the next round) than trying to force a deal to work that has developed issues.  Furthermore, if a deal is so sideways at the pre-revenue/seed level that someone else needs to come in and rescue it from the founders, then it is probably headed for the scrap pile anyway.

But, this is not just a theory that reduces the investor's risk of throwing good money after bad, I think experience is showing that by focusing on due diligence and hammering out the details rather than trying to contractually bind a minimum return, our BAN deals have a much higher chance of success both short term and long.

Debt, Equity and Control

This is an extension of my Friday post based on some timely reminders...

Many investors, eager to get started and get their company moving, will agree to terms that are not good business in the long run. It is understandable, and I have a partner that is fond of saying "we hope that is a problem" because if it is then the deal has probably been successful. Unfortunately, because of the inequity some deals will get sideways almost immediately and never reach their potential (or even launch).

The results tend to get even worse if a company tries to raise a second round after a poorly negotiated first round. In that situation, either the parties have to recast the deal or the deal will usual blows apart because the shorted party has the incentive eliminated.

Normally, if an early investor is worries about control, it is much better to bring them in as convertible debt and add a control provision giving them voting control until the debt is paid back at which point they convert to common ownership based on the negotiated pre-money valuation of the company and the capital amount they invested. That structure is a lot less likely to blow up and become inequitable over time and a lot less likely to mess up a follow on round of funding.

It is certainly real poker to negotiate an early round hard, with real risks on the other side as well, but the risks entrepreneurs take when they sign on to a bad deal is that they have really signed the death certificate for their company and just don't know it yet.

Company Valuations When Raising Capital...

There is a ton of information available on the internet about how to value a business enterprise. There is even a lot of information regarding the valuation of a pre-revenue startup during rounds of funding. Unfortunately, most of that information is not particularly helpful for startups unless they are in a major center of startup finance (i.e. Silicon Valley, Boston or NY), have a good track record, and plan to be working with the established players.

If you are a startup company with high aspirations in Hometown, USA (like most of the South), then that deal making process, including valuation, will probably be very different.

First off, there are not a ton of institutional players interested in pre-revenue deals, so angels play a larger role. Angels, however, are just people and people don't tend to write a binding prospectus with projections and investment philosophies, etc. when investing their own money. Instead they invest based on a much fuzzier standard that depends on a lot of qualitative factors, including things such as mood.

In many of the deals I know well, the focus tended to be on shorter term goals and getting the investment paid back while still providing an opportunity for the company to reach its goals. That often results in terms that are based a lot more on the stage of the business (pre-prototype, pre-revenue, pre-profitability, etc.) and will incorporate debt or debt-like features.

For example, BAN seems to be looking at deals with a post-money valuation of $1mm or so that includes an investment of a few hundred thousand dollars with a 1x participating liquidation preference. But those terms are really driven by the type of typical deal:

1. pre-revenue (or little revenue) and post-prototype,
2. reasonable cap-ex for launch,
3. large potential market,
4. clear near term profitability milestones,
5. 1-2 years to initial milestones,

and the desire to provide necessary funding, create a significant potential upside for the investors while maintaining functional control for the founder(s).

However, individual (as opposed to group) angel deals can have some really interesting (and convoluted) terms if the investor is being creative. Sometimes that can help a deal and sometimes they are just clunky, but if it gets the deal done...

Either way, if you are working on raising capital in "Hometown USA" be prepared to openly discuss the deal and be creative because the process probably won't be as cut and dried as the internet may lead you to believe.