Monday, February 23, 2015

Venture Capital Discount Rates: Precisely Wrong or Roughly Right?

The standard  Discounted Cash Flow valuation approach discounts an investment’s expected cash flows at their risk adjusted cost of capital. This rate is usually estimated using a Portfolio Theory based approach like CAPM. These models concentrate on Systematic Risk not total risk. Idiosyncratic Risk can be diversified away. Hence investors can expect no compensation for holding it. An example is a resort island which has two firms-one selling suntan lotion and the other umbrellas. Holding shares in just one firm exposes you to weather risk (idiosyncratic).If you hold shares in both you are no longer exposed-you have diversified the risk. Nonetheless, you remain exposed to systematic risk of a tsunami.

Some take this to mean idiosyncratic risk can be ignored. For passive minority investments in larger more stable going concern firms this is a good enough approximation. For VC type startups idiosyncratic –total risk cannot be ignored. These firms are not and may never be going concerns due to their failure to execute their business plans. This risk is unique not systematic. In fact failure rates for startups is very high-greater than 50% in the first five years of existence. The firm never realizes on it growth potential, which represents the majority of startup firms’ value, if it fails. Furthermore, liquidation values for VC investments are usually low. This is because the assets are primarily intangible meaning they have limited value if the firm ceases to exist. Thus, the key to value creation is management’s ability to exploit the firm’s idiosyncratic opportunities. Successful venture capitalists can identify these unique undiversified winners.

The standard DCF approach utilizing portfolio theory understates the discount rate and over states value. This is why many venture capitalists use arbitrarily high discounts rates of 25%+ instead of the lower academically determined rates. The rates VC’s use vary depending on the stage of the investment with earlier stage investments having higher rates than later stage follow-on investments.
Another measure of failure risk is the Cash Burn Rate. This is the cash raised and remaining from the prior funding round divided by cash operating losses. Firms with high burn rates need access to get additional funding to fund continued losses. This access can be difficult to measure. It depends largely on VC market condition which can turn on a dime. One possible reason for the current buoyant VC valuations is inexperienced investors may be using low discount rates ignoring failure and refinancing risks.

Academics dismiss the venture capitalists’ ad hoc approach. They argue that instead of raising the discount rate you should adjust the cash flows downward to reflect their uncertainty. The problem with startups is how to make such adjustments when you lack historical operating history. Instead of the false precision from cash flow adjustment the rough approach of increasing the discount rates may not be so bad after all. As Keynes noted-it is better to be roughly right than precisely wrong.


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