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What is the appropriate discount rate for a startup DCF valuation?

Feb 20 2017
Several year ago, following a discussion with a local investment banker about the DCF valuation of a client where the topic of appropriate discount rate was a hot issue, I wondered what others were using and if there was a "right" rate.

For those that don't live and breathe financial jargon, a DCF (discounted cash flow analysis) is a method of calculating the present value of a future benefit and they are often used whenever someone needs to figure out a justifiable valuation for something that doesn't have a ready market value (and sometimes looking for valuation mistakes in things that do).   There are several other common valuation methods as well, including: Comparable Sales, Replacement Cost, Book Value, but for certain applications a DCF is very helpful.

The most common reason I will use a DCF is for determining pre/post money valuations for startups, since they by definition have little more than pro-forma financials.

In preparing a DCF for a startup I need to know the expected cash flows and the appropriate discount rate.  I can pull the expected cash flows from the pro-forma financial statements, but the discount rate is really mine to decide.  As a definition, the discount rate is:  "the rate of return that could be earned on an investment in the financial markets with similar risk." (Wikipedia)

With that rate in mind, I have typically used 27% as my discount rate for startup companies.  Why 27%...because the Marion Kauffman Foundation published a report in November of 2007 based on their research that indicated a national average IRR (internal rate of return) of approximately 27% on angel investments.  I haven't seen anything since then that would purport to be a better number, so that is still what I use.

Of course a lot has changed in the economy since November 2007, so I wonder what others are using for a discount rate now or if that metric still holds true?
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Joshua Watkins

Mr. Watkins is the Managing Member at Watkins Law Firm, LLC.  His legal practice has primarily focused on working with private companies as general counsel. As general counsel his duties typically include an array of tasks such as: in-house day-to-day activities, advising the company’s board of directors on their oversight responsibilities, planning and preparing complex corporate transactions, commercial litigation, tax planning, oversight of the corporation’s compliance with federal and state regulations, legal budget management, and specialized outsourcing of legal matters to other counsel when appropriate.

When counsel to emerging start-up companies, Josh often brings critical expertise in the many types of capital formation activities, including entity and structure choices, fundraising processes, and securities compliance.

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