Because a new business has little to no history, and because it may be pursuing innovative products, services, or other business features, uncertainty about its future prospects is especially high. A capitalized earnings approach cannot be used, as new companies frequently report losses in the early years, and their present earnings (losses) may not be indicative of expected earnings. A discounted earnings or discounted cash flow approach is typically most appropriate. Many analysts favor using cash flows rather than earnings, because of the importance of cash management in start-up firms. Many start-ups fail because they quickly run out of cash. During the “dot.com” era, analysts often focused on the rate at which a start-up consumed cash, a phenomenon colorfully known as its burn rate.
When performing a discounted cash flow approach to valuing a new business, the analyst must decide on the estimate of cash flows to use. The entrepreneur’s forecasts are likely to be highly optimistic, reflecting his or her vision of a successful future. When using an entrepreneur’s forecasts, the analyst typically tries to neutralize the entrepreneur’s optimism with a high discount rate. A high rate reflects both the degree of risk involved and the expectations of capital providers for high returns to compensate for the risk. VCs might seek rates of return of 50% or more during the seed capital stage and 30–50% at later stages.
VCs are not long-term investors. They seek to cash out after 3–5 years. Their investments often take the form of specialized equity, such as a preferred stock issue with a high dividend rate and mandatory redemption at a specified future time, either at a high cash price or at a generous conversion into common shares. The latter option is appealing when the VCs anticipate an initial public offering of the start-up’s shares.
Venture capital investing is high risk. First-time start-ups have a 21% chance of succeeding. Even previously successful venture-capital-backed enterprises still only have a 30% chance of succeeding in the next venture. 1