Why Entrepreneurs and VCs Disagree in Valuing Start-up Firms: Imputing the Target Rate of Return using DCF vs. Option-Based Approaches

Abstract

Entrepreneurs and VCs often disagree on their valuation of start-ups. This article offers a new reason why. The Venture Capital (VC) method is a standard method for valuing startup firms. It requires an estimate of terminal firm value or Net Income, a comparable industry’s P/E ratio, and a target rate of return to be used as the discount rate. All of these quantities are subject to estimation risk, but the choice of the target discount rate is the most questionable. VCs typically use high target rates of return to compensate for the risk of the venture; a natural question is how to justify these high target rates of return. Discounted cash flow (DCF) methods, such as the VC method, assume that a start-up can be valued like any other standard capital budgeting project. However, start-ups have valuable embedded real asset options which are ignored by DCF methods. This article uses option pricing techniques to impute the appropriate target rate of return. It shows that the appropriate target rate depends on precisely what the VC is valuing. If the VC is valuing a stream of ordinary expected cash flows, as in the DCF approach, one target rate of return is implied. A different target rate is implied if the VC is valuing a start-up firm including its embedded real asset options. This article shows how to adjust target rates of return for insurance value and gives detailed illustrations of the magnitudes of the adjustment. <b>TOPICS:</b>Private equity, statistical methods, analysis of individual factors/risk premia, risk management