What's the formula to estimate a discount rate for high-risk, high-reward startups?

The discount rate for high-risk, high-reward startups is a crucial factor in valuation models. Essentially, the discount rate represents the return investors require to compensate for the risk associated with investing in these startups. In my experience, there's no one-size-fits-all formula for estimating the discount rate, as it depends on various factors such as market conditions, industry trends, and the specific characteristics of the startup. However, commonly used methods include the Capital Asset Pricing Model (CAPM) and the Build-Up Method, which consider factors like the company's beta, market risk premium, and risk-free rate to determine an appropriate discount rate.

The discount rate is a financial metric used to calculate the present value of future cash flows, reflecting the opportunity cost of investment and inherent risks. For high-risk, high-reward startups, estimating the discount rate often involves the Capital Asset Pricing Model (CAPM) or the Weighted Average Cost of Capital (WACC), adjusted for the specific risk profile of the startup. This includes considering the volatility of expected returns, the startup's stage of development, and its sector's inherent risks. Analysts may increase the base rate derived from CAPM or WACC by a risk premium to account for the heightened uncertainty associated with these ventures.

The formula to estimate a discount rate for high-risk, high-reward startups is: Discount Rate=[Risk Free Rate+Beta×(Market Rate of Return−Risk Free Rate)] It is usually based on the Capital Asset Pricing Model (CAPM). It involves adding the risk-free rate to the product of the startup's beta (a measure of its risk) and the market rate of return minus the risk-free rate. Adjustments are made for the startup's higher risk profile, usually by using a higher beta and potentially a higher risk-free rate.

Think of it this way: a high-risk, high-reward startup might warrant a steeper discount rate compared to a stable, established company. Investors demand higher returns to compensate for the uncertainty. Ultimately, the chosen discount rate hinges on the riskiness of the startup, your investment preferences, and comparable investment options. It's a crucial input that significantly impacts the final valuation, highlighting the importance of careful consideration and informed judgment.

Generally speaking, the valuation of start-ups is theoretically no different than for any other company; that is, looking at future cashflows to be discounted to the valuation date. The challenge with start-ups is, that solid business plans won't often exist, so this complicates estimating cashflows. Cashflows itself are risky due to the nature of the start-up. Hence, the discount rate needs to adequately reflect that risk for discounting, in order to be consistent. In that case, reverting back to listed companies (CAPM) won't cut it, as the risk of a NASDAQ company is completely different than the risk of a start-up. That is why in practice pragmatic approaches are often applied.

Discount rate isn't just a valuation number; it's a negotiation lever in startup funding. Lower rates paint a rosier picture, inflating valuation and reducing your equity stake. Conversely, higher rates reflect caution, lowering valuation but securing you a larger piece of the pie.

The discount rate for high-risk, high-reward startups is critical because it determines the present value of future cash flows, impacting the company's valuation and attractiveness to investors. From my experience, a higher discount rate reflects the increased risk associated with these startups, capturing factors like market volatility, uncertainty, and potential failure. Investors use the discount rate to assess whether the potential returns justify the risks involved in investing in such ventures. Therefore, accurately estimating the discount rate is essential for making informed investment decisions and ensuring alignment between risk and expected returns in high-risk startup investments.

Although I was indoctrinated to use the CAPM model while at Harvard Business School, frankly, I believe it is not fit for purpose for VC and especially early stage ventures. A better approach is to start with the end in mind. If all goes well, what type of exit would be realistic, how long would it take and how much capital (dilution!) is required. Now multiply this number by the likelyhood of this scenario happening and you can then tease out the pre-money valuation based on the target of the fund (e.g. 3x)

Estimating startup discount rates is an art, not a science. While CAPM offers a starting point, consider industry peers, stage of development, investor risk tolerance, and negotiation dynamics. Remember, it's about balancing risk and reward to reach a valuation that benefits both founders and investors.

While CAPM offers a framework, applying it to startups is tricky. Estimating beta, the key ingredient, is a challenge due to their lack of history, peers, and market prices. Investors often resort to industry averages, gut feeling, or alternative methods, highlighting the limitations but also the room for informed judgment in valuing these young ventures.

Given that the CAPM (in practice) reverts to capital market data of listed companies, this approach alone typically won't cut it for start-ups, as the risk of listed companies is completely different from start-ups. If the start-up isn't comparable to a listed company - which it typically isn't - the discount rate could pragmatically be adjusted for mark-ups. Return expectations by VCs for various start-up-stages might suggest a general bandwidth for discount rates. A scoring model taking into account key indicators (e.g., the teams' prior start-up experience, team pedigree, proof-of-concept, level of existing revenue, profitability break-even etc.) could help to narrow down that discount rate mark-up.

Beyond CAPM's framework, fine-tune startup discount rates! Consider stage, competitive edge, growth potential, exit strategy, and liquidity. Each factor influences risk and justifies premiums or discounts for a valuation that reflects the startup's unique story. Remember, informed judgment is key in navigating this art, not science, of valuing young ventures.

While the estimated discount rate unlocks a startup's present value, remember it's not a fixed number. It's a living reflection of risk, evolving with the company's journey, market shifts, and your own changing investment outlook. Treat it as a dynamic tool, not a rule. Revisit and refine it as the startup matures, competition changes, and your expectations adjust. New information is your guiding light. Don't be afraid to update the rate, ensuring your investment decisions are grounded in reality, not outdated assumptions. Remember, capturing a startup's true value requires agility and informed judgment, not blind adherence to a single number.

Most investors are not applying a discount rate per se, at least not to an early stage startup, but they are looking at the potential expected return multiple, given the high and low scenarios, and typically seeking a higher multiple for startups with high risk, deep tech or long time horizons needed to reach profitability.

DCF might make sense if you are evaluating a startup with a somewhat predictable cash flow. This means usually the startup has reached a certain level of maturity such as Post-Series A+. For Pre-seed/Seed and Deep Tech startups where cash flow forecasts are difficult (and they are mostly wrong anyway), DCF isn't as useful. It is more about the potential future revenue, growth rate, milestone achievements, and the team.

(a) For startups operating in or significantly exposed to volatile geopolitical regions, an additional premium is warranted. Reflecting on investments in tech startups in emerging markets, I've adjusted the discount rate upwards by 3% to 7%, depending on the country's risk profile, to account for potential political and economic instability (b) Startups at the forefront of innovation face unique challenges, including unproven business models and rapid technological obsolescence. Drawing from an investment in a pioneering renewable energy startup, I incorporated an innovation risk premium, which was determined by evaluating the adoption curve and potential regulatory hurdles specific to the new technology.

Before giving an opinion, I think it's important to qualify the term Start Up. In the collective imagination, it's a company in a phase between pre-seed and series B, undergoing hypergrowth and often not yet profitable. So how do you apply a discount rate to a company with a negative CF? I'd still like to see BPs applied to the letter to start-ups with international ambitions. Let's get back to rational formulas and stop overvaluing companies that have been unprofitable for 15 years with discount rates over 40%.