Determining cost of capital when valuing start-ups

PrintMailRate-it

published on 20 February 2024 | reading time approx. 3 minutes


Start-up companies often differ from mature companies in terms of their risk profile. In order to derive discount rates for valuations, risk adjustments to the classical cost of capital according to the Capital Asset Pricing Model (CAPM) or the use of return requirements of financial investors have become established. Risk adjustments can be made using the VC beta or the adjusted market return. A pluralistic valuation approach and an overall assessment seem to make the most sense.



Special features of start-ups

The valuation of young companies and innovative business ideas (start-ups) poses a particular challenge. This is because start-ups have characteristics that make the usual analyses and approaches to valuing established companies more difficult. These include a lack of corporate history, new or difficult-to-define markets, often a dynamic competitive situation, and a high degree of dependence on the founders and their innovative strength. In addition, risk assessment through benchmarking with other companies or the capital market is much more difficult.


Life cycle assessment procedures

The valuation approach, and therefore the need to calculate discount rates, for start-ups is usually determined by their stage in the life cycle.

In the pre-seed phase, the focus is on developing the product idea and marketing and sales concepts, leading to a business plan. In the subsequent seed phase, the company is formally incorporated and market develop­ment begins. In these early stages, uncertainty is particularly high and it is almost impossible to derive quan­ti­ta­tive valuation parameters. Start-up valuations are based on heuristics and experience. For the first time, the VC method, which is widely used by venture capitalists, can be applied from the seed stage onwards.

In the subsequent development and growth phase, significant investments in sales, marketing and product development are required. Quantitative valuation methods such as the DCF method, the VC method, the PORI (Price of Recent Investment) method, or the trade and transaction multiplier methods are increasingly suitable for this stage of the start-up and also for the later maturity phase with lower, sustainable growth. As a result, it is now increasingly necessary to deal with discount rates.


Derivation of the discount rates

In calculating the risk-adjusted cost of capital, risk premiums are applied to the discount rate that go well beyond the scope of the Capital Asset Pricing Model (CAPM), which can be used to value established com­pa­nies and established business models. In addition to cash flow adjustments for management, product, in­sol­ven­cy and other market criteria, these risks include illiquidity considerations, fit criteria (professional and personal fit between the financier and the start-up) and value-added criteria.

Adjustments may be made to the CAPM, for example, to determine premiums. Approaches include the use of venture capital-specific beta factors derived from venture capital investments (VC beta) or the adjustment of the market return as part of the calculation of the market risk premium specific to this asset class.

When using the VC method, the beta in the CAPM is adjusted for start-up-specific risks. Technically, the derivation is not based on listed peer group companies, but on the returns of start-ups. These are derived from valuations from financing rounds and exits of comparable companies. It should be noted that these betas usually cover a wide range, which usually only allows for trend statements on start-up-specific capital costs. Empirical studies estimate venture capital betas in the range of 1.9 to 2.8 (see e.g. Cochrane (2005)). The adjusted market rate method is based on a modified CAPM. In this model, the expected market return in the CAPM is replaced by an average expected return for start-ups at a certain stage of their life cycle. The derivation can be based on the returns achieved or expected by financial investors. Empirical studies show expected returns in the range of 16 percent to 18 percent.

The application of the risk premiums calculated in this way always requires the consideration of default risks in the financial surpluses.

The alternative return requirements, on the other hand, are usually flat and depend on the investor's risk appetite and the stage of the start-up's life cycle. They are particularly high in the early stages and decrease significantly over the life cycle as the uncertainty in forecasting financial surpluses decreases. However, return requirements are not directly observable, but can be determined periodically through empirical studies.

The following table provides an overview of empirical studies on the return requirements of financial investors as a function of the life cycle of the start-up (the KFW German PE Barometer shows return expectations instead of return requirements).


​                                      
​Seed Stage      
​Start-up Stage 
​Early Stage         
​Expansion Stage
​Later Stage/ Pre-IPO
​Plummer (1987)
​50%-70%​40%-60%​35%-50%​25%-35%
​Sahlman (1990)​50%-70%​40%-60%​30%-50%​20%-35%
​Hake (1998)​80%
​60%​50%​40%​30%
​Bygrave et al. (1999)​70%-80%​60%-70%​40%-50%​30%-40%​20%-30%
​Timmons (1999)50%-100%
​50%-100%​40%-60%30%-40%​20%-30%
​Rams/Remmen (1999)
​>60%​> 60%​40%-60%25%-40%​30%
​Murphy et al. (2002)>​80%
​50%-80%​40%-60%​30%-50%​25%-35%
​Böhmer (2003)80%-100%
​50%-70%​40%-60%
​30%-40%​20%-30%
​White (2003)40%​40%​30%-50%
​30%-50%​20%-30%
​Frei/Leleux (2004)​70%-100%
​50%-70%​40%-60%​35%-50%​25%-40%
​Achleitner et al. (2004)39,5%
​25,6%​17,8%
​Damodaran (2009)
​50%-70%40%-60%
​35%-50%​25%-35%
​Boemle/Carsten (2010)​80%
​60%​50%​40%​30%
Based on KfW. German PE Barometer (2013)
​20%​17%
​Hahn (2013)​80%​80%​60%
​40%-60%​30%-40%
​Anshuman (2013)​50%-100%​50%-100%​40%-60%​30%-40%​20%-30%
​Zellmann/Prengel/ Lebschi (2014)26,5%-50% Median: 40% ​22,5%-32,5% Median: 30% ​15%-25% Median: 22,5%
​Everett (2017)​25%-60%​25%-55%​15%-50%​15%-50%​15%-50%
​Prengel/Honold/ Hümmer (2018)​15%-40% Median: 27,5% ​14%-30% Median: 22% ​4%-20% Median: 12%
​Honold/Hümmer/ Reiche/Wacker (2021) (Betreffend CVC)​12%-30% Median: 21% ​10%-29% Median: 19% ​6%-20% Median: 14%
​Honold/Hümmer/ Reiche/Wacker (2021) (Betreffend VC)​20%-48% Median: 38% ​20%-40% Median: 28% ​20%-30% Median: 23%


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

It can be seen that as a start-up's business model progresses and becomes more concrete over the course of its lifecycle, the uncertainty decreases and thus the required returns decrease as well. This decrease is due to factors such as the growing stability and size of the company, the establishment of a track record and, ul­ti­ma­te­ly, the reduction in the risk of insolvency.

The difference between risk-adjusted cost of capital and return requirements is that the latter include explicit compensation for default effects. The returns demanded by financial investors are therefore appropriate discount rates if no explicit default risk adjustments have been made in the projected cash flows (or exit values) of the start-ups. However, required returns can also be converted to expected returns.

In all cases, however, it is important to note that the risks of the start-up must be consistently separated between financial surpluses and the discount rate in order to avoid double-counting of risks.


Conclusion

Start-up companies often differ from mature companies in terms of their risk profile. In order to derive discount rates for valuations, risk adjustments to the classical cost of capital according to the CAPM model or the use of return requirements of financial investors have become established.

Risk adjustments can be made using the VC beta or the adjusted market return. VC betas can be derived from the returns of start-ups based on exits or financing rounds. Empirical studies have found betas between 1.9 and 2.8. For the adjusted market return, empirical studies show an average expected return of 16 percent to 18 percent across all stages of the life cycle. When using the DCF method, the risk-adjusted cost of capital must be reduced over time to reflect the decreasing level of risk as the start-up moves to a more mature, stable business model.

When using return requirements, attention must be paid to the classification of the start-up in the life cycle between the seed or early stages and the growth and maturity stages. Return requirements decrease significantly as the start-up matures. For the seed phase, empirical studies show a range of 50 percent to 80 percent, for the maturity phase approximately 15 percent to 30 percent.

It may be useful to take a pluralistic view of the valuation of a start-up by calculating different valuation techniques and methods for deriving the discount rate and assessing the results in the overall context.

Deutschland Weltweit Search Menu