What's the average discount rate for a early-stage technology company?

My bank works with very early stage companies, and I'm currently looking through some of the models and trying to understand them. WACC is calculated to be ~9% using beta derived by doing comps on capIQ. It looks like we then applied a 80% "liquidity and size" premium. This seems insanely high for me. A 89% discount rate? Is this normal when valuing early stage companies? And if so, how does one figure out how much of a premium/discount to apply?

Comments (9)

Best Response
Aug 16, 2012 - 1:17pm

Honestly, it's high, but it's not as crazy as you think.

These companies are relying largely on equity, which is more expensive. And they are undeveloped, which means uncertainty, which means selling equity is expensive. Think about it: some high growth, early stage "disruptive" tech startup needs $100,000. This company has huge potential future growth, but really needs this funding. They settle on a valuation of $2mm, and the VC takes a 40% stake for his $100,000. In 9 months, the company is worth $8mm. Sucks to suck, but start-ups are an uncertain business, and nobody is going to give you a deal.

Conceptually, cost of equity = risk free rate + risk premium. Start-ups fail frequently. Early investors expect to (and are) compensated handsomely for the risk they take.

"There are three ways to make a living in this business: be first, be smarter, or cheat."
  • 2
Aug 16, 2012 - 1:25pm

I guess that makes sense. I'm having trouble understanding how these valuations aren't complete bullshit still. Even with a 90% discount, enterprise value is over $60MM for a company with two years of projected negative FCF. And somehow they have managed to raise over $10MM already.

The long term growth rate also seems high/has an obviously significant affect on enterprise value. I know that for most normal companies long term growth would be around the rate GDP is growing at. Do early stage tech companies have much higher growth rates too?

Aug 16, 2012 - 1:46pm
arguewithatree:
I guess that makes sense. I'm having trouble understanding how these valuations aren't complete bullshit still. Even with a 90% discount, enterprise value is over $60MM for a company with two years of projected negative FCF. And somehow they have managed to raise over $10MM already.

The long term growth rate also seems high/has an obviously significant affect on enterprise value. I know that for most normal companies long term growth would be around the rate GDP is growing at. Do early stage tech companies have much higher growth rates too?

Yes. You'll probably want to use a multi-stage growth model, which assumes different growth rates over time. A good resource: http://pages.stern.nyu.edu/~adamodar/

"There are three ways to make a living in this business: be first, be smarter, or cheat."
  • 2
Aug 16, 2012 - 1:46pm
arguewithatree:
I guess that makes sense. I'm having trouble understanding how these valuations aren't complete bullshit still. Even with a 90% discount, enterprise value is over $60MM for a company with two years of projected negative FCF. And somehow they have managed to raise over $10MM already.

The long term growth rate also seems high/has an obviously significant affect on enterprise value. I know that for most normal companies long term growth would be around the rate GDP is growing at. Do early stage tech companies have much higher growth rates too?

Yes. You'll probably want to use a multi-stage growth model, which assumes different growth rates over time. A good resource: http://pages.stern.nyu.edu/~adamodar/

"There are three ways to make a living in this business: be first, be smarter, or cheat."
  • 2
Aug 16, 2012 - 2:01pm

Valuation discount rate? (Originally Posted: 02/06/2013)

a biotech firm that does not generate revenue. they have a product that may generate 1M in revenue if it's successful. However, there is a 10% failure risk. Currently the discount rate is 15% based on the WACC (cost of equity and debt etc) valuation. Should I adjust/increase the discount rate to reflect the risk?

Aug 16, 2012 - 2:02pm

I could be wrong, but with a DCF, I believe in theory you're supposed to project the statistically most probable operating results, ie the one in the middle of the bell curve, which will factor in business specific risks. Then discount at a rate that only factors in systemic risk, ie the CAPM-derived rate. So don't factor in the failure risk. But with biotech where it's "all or nothing" this probably doesn't apply...I'm no expert so I'm also curious to hear what the WSO gurus have to say about this...

Aug 16, 2012 - 2:03pm

I don't typically work on companies in that industry so maybe it is one of those that has multiples that are crazy high, but IMO a start up company that has yet to produce anything with a 15% discount rate seems awfully low. Most companies I work on have discount rates in that range, and they have been around for decades with proven profitability and stability. Not sure what the revenue means in terms of the discount rate? Alone, it doesn't affect the discount rate.

Aug 16, 2012 - 2:04pm

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