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# Discount rate for the valuation of your company or startup

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Understanding discount rate: definition, formulas, importance for negotiation and useful sources to find the right one for the valuation of your company or startup.

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### Discount rate for the valuation of your company or startup

1. 1. Understanding DISCOUNT RATE for the valuation of your company or startup
2. 2. ENTREPRENEURS HAVE TO CONVINCE POTENTIAL INVESTORS THAT: > REQUIRED RETURNDISCOUNT RATE The compensation for the risk the investor is taking The value growth the company needs to achieve to justify the initial investment.
3. 3. A coefficient used to calculate today’s value of future cash flows, accounting for the uncertainty (Risk) of not receiving all or part of the future cash flows. WHAT IS THE DISCOUNT RATE? Risk Discount Rate=
4. 4. Receiving \$100 today is not equal to receiving \$100 tomorrow WHY DO WE NEED THE DISCOUNT RATE? INFLATION RISK* The value of money decreases with time at a macro level The money today is certain, while in the future anything could happen *For the application of discount rate for valuation, we will mostly focus on this factor.
5. 5. The value of \$100 today is not equal to \$100 tomorrow IF THE RISK IS NOT EQUAL
6. 6. TODAY’S VALUE OF \$100 RECEIVED IN 1 YEAR IS \$100 (1+discount rate)n Discounted value = where n is the amount of years in the future In this example, one
7. 7. IN THE SAME WAY FOR A GENERAL CASH FLOW Current cash flow (1+discount rate)n EXAMPLES Discounted value = Value of \$10,000 in 1 year: \$10,000 / (1+0,10*) = \$9,090.90 Value of \$10,000 in 2 years: \$10,000 / (1+0,10*)2 = \$8,264.46 where n is the amount of years in the future *Assumption: discount rate of 10%
8. 8. A COMPANY IS JUST A SERIES OF CASH FLOWS Future cash flow at year n (1+discount rate)n Company value = sum of: For infinite n years
9. 9. HOW TO ESTIMATE THE DISCOUNT RATE
10. 10. The money could be invested somewhere else. If another opportunity has less risk and same return or same risk and more return the money will go to that one. In equilibrium any opportunity must have a similar risk/return ratio. ANY INVESTMENT HAS AN OPPORTUNITY COST
11. 11. Weighted Average Cost of Capital (WACC) The WACC estimates risk of the company comparing it to risk and returns of the market. It takes into account equity and debt as a sources of capital and weights them based on their % on the total financing of the company INTRODUCING THE +% of financing that is equity Cost of Equity * % of financing that is debt Cost of Debt*
12. 12. +% of financing that is equity Cost of Equity * % of financing that is debt Cost of Debt * However, being the debt of private companies and start-ups (when present) not tradable, WACC can be assumed equal to the cost of equity, often calculated with the Capital Asset Pricing Model – CAPM – formula
13. 13. Capital Asset Pricing Model – CAPM – formula The theoretical rate of return of an investment with “no risk” of financial loss. Usually well performing government bond are considered for this element (10 years Treasuries for US and EU Bonds for EU) Cost of Equity = Risk free rate + beta Market risk premium *
14. 14. Capital Asset Pricing Model – CAPM – formula 10 years Treasuries returns today the 2.3% per year See up to date data at: http://data.cnbc.com/quotes/US10Y See EU Bonds here: http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=143.FM.M.U2.EUR.4F.BB. U2_10Y.YLD Cost of Equity = 2.3% + beta Market risk premium *
15. 15. Capital Asset Pricing Model – CAPM – formula Cost of Equity = 2.3% + beta Market risk premium * The beta indicates how the industry of the company relates to the market in terms of risk. If the industry is more volatile than the market, then the risk but also the expected returns are higher, and vice versa.
16. 16. Capital Asset Pricing Model – CAPM – formula Cost of Equity = 2.3% + 1.34 Market risk premium * From the list of betas of NYU Professor Aswath Damodaran: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html we can get a sample beta for the Software (Internet) Industry of 1.34, other industries are also available at the link
17. 17. Capital Asset Pricing Model – CAPM – formula Cost of Equity = 2.3% + 1.34 Market expected returns( )- Risk free rate This is the premium return required by investors to take the risk on the public market: Market risk premium *
18. 18. Capital Asset Pricing Model – CAPM – formula Cost of Equity = 2.3% + 1.34 We can use the Market Risk Premium for the U.S. Market of 6.25% 6.25% * Again from NYU Professor Aswath Damodaran http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
19. 19. CAPM RESULTING DISCOUNT RATE 10.67% = 2.3% + 1.34 By just crunching the numbers we get to a yearly discount rate of 10.67% 6.25% * DISCLAIMER: Startups and early stage companies often carry other risks and sometimes a percentage is added to the WACC based on the experience of the valuator. On Equidam, discount rates are estimated by taking into account also number of employees, profitability and other variables and they are always up to date.
20. 20. FOR STARTUPS and SME, THIS IS NOT ENOUGH TO TAKE INTO ACCOUNT ALL THE RISKS INVOLVED. Additional factors such as Failure rate and Illiquidity should be added
21. 21. Failure rate The probability of failure of startups and small companies is generally higher than the one of larger companies. For this reason, an additional discount or and increased discount should be considered when valuing these types of companies. Failure rates for small companies can be retrieved by the Statistics Bureau of your country. Illiquidity discount Private companies have an additional difference when compared to public ones. The investment an investor makes is illiquid. In other words, selling the participation is going to take time, and could bring the price down. This additional risk has to be compensated with an additional discount or added to other discount factors.
22. 22. DISCOUNT RATE IN NEGOTIATIONS
23. 23. WHAT ARE YOU REQUIRED TO KNOW, THEN? No-one expects you to be a financial expert. What you need to know is that the discount rate reflects the risk and lowers the current price so that investors can invest and potentially receive a fair return. There is no need to compute every single formula, however understanding the BASIC FINANCIAL PRINCIPLES will give you and edge and ensure the right outcomes of your investment discussions. DISCLAIMER: Equidam automatically collects and applies the most suitable discount rate, so that you can avoid computing the formulas.
24. 24. Our role, as entrepreneurs, is to give investors the information that allows them to best estimate the risk and be confident they are making the right choices. Investors do not have the full picture when they try to asses the company’s risk, simply because they are not in it on a daily basis.“
25. 25. YOU NEED TO CONVINCE POTENTIAL INVESTORS THAT: > REQUIRED RETURNDISCOUNT RATE The compensation for the risk the investor is taking The value growth the company needs to achieve to justify the initial investment.
26. 26. YOU CAN DO THIS BY: INCREASING PERCEIVED RETURN REDUCING PERCEIVED RISK As stated, investors know less about the company than you. Make sure your transfer your knowledge on the future risks, the risks that are not there, and the future potential