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Determining Rates of Return for Early-Stage Companies

A discounted cash flow method is a common valuation technique in which the value of a company is estimated based on the present value of its future economic benefits. Often, distributable cash flow is used as the measure of economic benefit because it represents the earnings available for distribution to investors after considering the reinvestment required for a company’s future growth.  But what about the discount rate (also interchangeably referred to as the required rate of return) used to present value these cash flows?

Alternative methods to the modified capital asset pricing model (i.e., CAPM) are generally more appropriate for valuing early-stage companies with few sales and extremely high-growth aspirations because there is often little relationship between developments in the stock market and the investment characteristics of the company. Many investors benchmark against rates of return of venture capitalists.  Therefore, being familiar with this perspective helps owners of early-stage companies prepare higher quality valuations, more effectively communicate with potential buyers, and ultimately negotiate with more confidence in their capital raising initiatives.

Various studies of venture capital investment expected rates of return for early-stage companies from the initial “startup” phase through the “expansion” phase, which are described below, are illustrated in the tablet:

Startup – These companies are usually less than one-year old and have not sold their products or services commercially.  Thus, the capital provided is used for early product development and prototype testing, as well as for test marketing in experimental quantities.  Additionally, since the company is very young, further study of market penetration potential, development of a management team, and refining a business plan is often needed.

First Stage – These companies have promising enough prototypes that further technical risk is considered minimal.  Likewise, market studies must appear attractive enough so that management is comfortable investing additional funds into R&D and/or limited manufacturing.  Typically, companies in this stage have yet to achieve profitability, and capital is needed to begin commercial manufacturing and sales.

Second Stage – Second stage financing is generally used for expansion purposes.  Companies in this stage have a viable product and acceptable profit levels, but may not know quantitatively what speed of penetration will occur, or what the ultimate limits of penetration will be.  Additionally, internally-generated cash flow is likely insufficient to meet all expansion requirements.

Bridge / IPO – At this point, companies are profitable, growing significantly, and have eliminated much of the downside investment risk.  However, more working capital is required than can be generated from internal cash flows alone; hence the need for additional capital.

However, there are important nuances within each stage in addition to many other factors which may enhance (or detract from) the attractiveness of an investment in a particular company. Please contact us with any questions or if you would like additional information.

Article written by:
Curtis Farrow
Manager, Valuation Services