Determining the Cost of Capital in Start-up Valuation

Characteristics of Start-ups

The valuation of young companies and innovative business ideas (start-ups) presents a particular challenge. Start-ups exhibit characteristics that complicate the usual analyses and approaches used in valuing established companies. These include primarily a lack of company history, new or difficult-to-define markets coupled with often dynamic competitive situations, and a high dependence on the founders and their innovative capacity. Additionally, risk assessment through benchmarking with other companies or the capital market is significantly more difficult.

Valuation Approach Depending on Life Cycle

The valuation approach and thus the need to determine discount rates for start-ups typically depends on their stage in the life cycle.
In the pre-seed phase, the focus is on developing the product idea as well as marketing and sales concepts, which then culminate in a business plan. In the subsequent seed phase, the company is formally established and market development begins. In these early phases, uncertainties are particularly high and deriving quantitative valuation parameters is nearly impossible. Start-up valuations here are based on heuristics and experience. For the first time, from the seed stage onward, the VC method commonly used by venture capital investors can also be employed.
In the subsequent growth and expansion phase, significant investments in sales, marketing, and product development will be necessary. For this stage of the start-up and also for the later maturity phase with lower, sustainable growth, quantitative valuation methods are increasingly suitable, such as the DCF method, the VC method, PORI (Price of Recent Investment) method, or trading and transaction multiples methods. This increasingly necessitates dealing with discount rates.

Deriving Discount Rates

When determining risk-adjusted cost of capital, risk premiums are added to the base rate that go significantly beyond the scope of the Capital Asset Pricing Model (CAPM)—which can be used to value established companies and mature business models. These risks cover not only cash flow adjustments for management, product, insolvency, and other market criteria, but also considerations regarding illiquidity and fit criteria (professional and personal alignment between investor and start-up) as well as value-added criteria.
To determine these premiums, adjustments to the CAPM can be made, for example. Approaches include the use of venture capital-specific beta factors (VC beta) derived from venture capital investments, or adjusting the market return when calculating the market risk premium specifically for this asset class.
When applying the VC method, the beta in the CAPM is adjusted for start-up-specific risks. Technically, the derivation is not based on publicly listed peer group companies, but rather on returns from start-ups. These are derived from valuations from financing rounds and exits of comparable companies. It should be noted that these betas typically have a wide range, which usually only allows for trend statements about start-up-specific cost of capital. Empirical studies quantify venture capital betas in a range of 1.9 to 2.8 (see, for example, Cochrane (2005)). The adjusted market return method uses a modified CAPM. In this model, the expected market return in the CAPM is replaced by an average return expectation for start-ups at a specific phase of their life cycle. The derivation can be based on returns achieved or expected by financial investors. Empirical studies show expected returns in the range of 16% to 18%.
The application of risk premiums determined in this way requires in any case that default risks are accounted for in the financial surpluses.
The alternatively applicable return requirements, on the other hand, are usually flat-rate and are based on the investor’s risk appetite and the stage in the start-up’s life cycle. They are particularly high in early phases and decrease significantly over the life cycle as forecast uncertainty of financial surpluses diminishes. However, return requirements are not directly observable, but can regularly be obtained through empirical studies.
The following table provides an overview of empirical studies on return requirements of financial investors depending on the start-up’s life cycle (the KFW German PE Barometer shows return expectations instead of return requirements).

Source: Hellbardt/Prengel/Lebschi, 2018, p. 113, supplemented by Bygrave et al., Timmons, Rams/Remmen, White, Bomle/Carsten, Hahn, Anshuman, Prengel/Honold/Hümmer, Honold/Hümmer/Reiche/Wacker; Everett updated.

It is evident that as a start-up’s business model develops and becomes more concrete over its life cycle, uncertainty decreases and return requirements decline accordingly. This decline is attributable to factors such as the company’s growing stability and size, the establishment of a track record, and ultimately the reduction of insolvency risk.
The difference between risk-adequate cost of capital and return requirements is that the latter include explicit compensation for default effects. Return requirements of financial investors are therefore appropriate discount rates when no explicit default risk adjustments have been made in the projected cash flows (or exit values) of start-ups. However, return requirements can also be converted into expected returns.

It should be noted, however, that in all methods, the risks of the start-up must be consistently separated between financial surpluses and discount rate to avoid double-counting risks.

Conclusion

Start-up companies regularly differ from mature companies in their risk profile. For deriving discount rates for valuations, risk adjustments to traditional cost of capital based on the CAPM model or the use of return requirements from financial investors have become established.
Risk adjustments can be made using VC beta or adjusted market return. VC betas can be determined from start-up returns based on exits or financing rounds. Empirical studies show betas between 1.9 and 2.8 as examples. For adjusted market return, empirical studies show an average expected return of 16% to 18% across all life cycle phases as examples. When applying the DCF method, risk-adjusted cost of capital must be reduced over time to account for the decreasing risk content as the start-up transforms into a more mature, stable business model.
When using return requirements, attention must be paid to classifying the start-up in the life cycle between seed or early phases and growth and maturity phases. Return requirements decrease significantly with increasing maturity of the start-up. For the seed phase, an exemplary range from empirical surveys of 50% to 80% can be cited; for the maturity phase, approximately 15% to 30%.

It may be advisable to adopt a pluralistic perspective on start-up valuation by calculating different valuation methods and approaches for deriving the discount rate and assessing the results in the overall context.