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.
j
No comments:
Post a Comment