Building A Discount Rate For Early Stage Companies

It is necessary to assess the risk profile associated with multiple factors, especially those critical to the success of early-stage companies when estimating their value. Analyzing peer companies in an industry with similar characteristics, assessing the management team, analyzing the industry dynamics, designing market penetration strategies, as well as considering consumer appetite are some factors that contribute to determining the risk level. For conventional approaches to determining risk and discount rates (Capital Asset Pricing Model [‘CAPM’], Build-up Model, Fama French model), market prices for securities issued by the firm are required. Furthermore, these models only consider market risks, i.e., risks that cannot be diversified. During the early stages of a company’s development, these assumptions are often challenged. First of all, most young companies do not have publicly traded bonds and are not publicly traded. It is therefore impossible to run a regression of past returns, to calculate equity beta, or to use market interest rates on debt. Investors in early-stage companies are often either completely invested in the company (founders) or only partially diversified (venture capitalists). Consequently, it is not prudent to assume that only market risk is important since other firm-specific risks such as product risk, failure risk, execution risk and industry risk are better indicators of a company’s uncertainties.

The venture capital approach to discount rate computation

For early-stage companies, the venture capital approach is one of the most widely used methods for computing discount rates because conventional approaches may present challenges. As a proxy for the discount rate, potential venture capitalists’ target rates of return are considered. Due to their inclusion of target returns demanded by venture capital investors from portfolio companies as well as the probability of their success, venture capital rates facilitate assessing the viability of a business venture.