Before we get into the specifics, consider this: why would you use the DCF-method to value a startup? The main advantage of the DCF-method is that it values a company based on its future performance. In other words, it’s ideal for a startup that hasn’t yet achieved any historical performance.
During the (pre-)seed stage, it is not uncommon for startups to generate no revenue at all while discussions about equity transfers, ownership percentages, and valuation begin. The DCF-method is then especially appropriate because it considers future performance rather than your startup’s current state. Please keep in mind, however, that using the DCF-method for startup valuation has its drawbacks.
What does the Discounted Cash Flow method entail?
The valuation method is based on future performance, and the value of future earnings is less valuable today than it will be in the future. Before we scare you away with the DCF-method formula, it’s important to understand the technique’s underlying assumptions. The DCF-method of startup valuation is based on two major assumptions.
Consider the following scenario: suppose you manufacture 3D printers. If you can turn your company into a viable business, these 3D printers will generate annual profits for years to come (after deducting all expenses). So, it stands to reason that the current value of your company should include the number of future profits, right? If your company is funded by an investor in exchange for a certain share today, this investor will also reap the benefits of future earnings. All that remains is for you to achieve your projected results.
Future earnings would be more valuable today (if you could have them today), but you must discount them for future periods due to uncertainty. This is due to the time-value of money. This may appear strange, but it is actually quite simple. Assume you have the option of receiving €1,000 today or €1,000 in a year. What would you choose? Hopefully, you’ll choose option one! The reason for this is that there is always some risk that I will not pay you the full amount in one year, despite what I told you.
To cut a long story short, when valuing a startup using the DCF-method, future earnings are discounted to their current value. This is due to the inherent risk of future cash flows (will they be realized?) and the deterioration of monetary value over time.
How does the Discounted Cash Flow method work?
Follow these simple steps to apply the DCF formula:
- Make financial projections for your company.
- Calculate the future “free cash flows”
- Calculate the discount factor
- Compiling the results of all your calculations
- Develop various scenarios and analyses
Because it considers future earnings, the DCF method is useful for startup valuation. Ideal for a startup where the majority of financial value is generated in the future. However, there are startup-specific disadvantages to using the DCF-method: the valuation is highly dependent on the quality of financial forecasts and input variable choices such as the WACC and growth rate.
Assume that, despite the disadvantages, you still want to value your startup using the DCF-method. Please do not rely too heavily on the end result of the calculations. Consider the valuation to be a ballpark figure and nothing more. Make sure to create different forecast scenarios so you can see what happens to the valuation when things go better or worse than expected. Even better, use a variety of valuation techniques to obtain a range of valuations. You can then calculate an average or median value and use it when speaking with potential investors.
We would like to emphasize that a DCF valuation is not the same as your firm’s actual sales price when seeking equity funding! Despite your efforts and research into various valuation techniques, the value of (a share of) your startup is ultimately determined by negotiations with an investor and the share he/she receives in exchange for investing in your company. As a result, don’t rely too heavily on the outcomes of a mathematical exercise.
Instead, use it to gain a better understanding of your company’s potential and value. An investor is likely to have a different opinion about the value of your company than you do, so approach such discussions with an open mind. Valuation techniques are simple to learn, but your negotiation skills may be more important.