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FUTURE VALUATION OF STARTUPS
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This observation gives us a clue to the answer to a problem that puzzled me in the early 1980s, when I was fairly new in the val1
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We use column K, because K6 shows this is the column for 5 percent growth
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CHAPTER 9 Increasing the Value of Your Business
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uation profession I noticed that when I valued a high-growth, high-tech firm as of the then current date and rolled the valuation forward to future dates, the value of the firm increased approximately by the discount rate each year, which seems logical I could not understand how a firm with forecast sales in Year One of $1 million and in Year 10 of $500 million could ever come to be worth the billions of dollars that large, publicly held firms were The value simply did not increase fast enough Finally, the answer dawned on me When we are standing at time zero and forecasting for all of eternity, the firm is a highrisk startup There is a substantial probability that it will fail, and that probability is captured by the high discount rates that business valuators and venture capitalists use in the Discounted Cash Flow valuations It is typical to use a discount rate of 30 percent when fully accounting for the probabilities of failure and less-than-full success, and it s common to use a discount rate in the 50 to 75 percent range when discounting the cash flows forecast by the ever-optimistic entrepreneur2 But when a company survives for five years and makes its forecasts, it is no longer a high-risk startup, and its discount rate comes down to normal business levels Often, businesses backed by venture capital are on the Initial Public Offering track, and the discount rate can come down from 30 percent to as little as 12 to 16 percent This has an enormous impact on the valuation of the company Now that you understand the fundamental mechanics of future valuation, let s go to the big payoff: understanding how to manage your business to maximize its value over time We will begin that by reviewing Equation 64 from 6, the shortcut Gordon Model formula, which we repeat below as Equation 91 For our analytic purposes, it has the benefit of eliminating the square root term in the numerator of the exact midyear Gordon Model formula Thus, it is a simpler formula to analyze
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For an extensive discussion of the topic, see 12 of Quantitative Business Valuation, ibid
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PART ONE Business Valuation
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VALUATION IN THE FUTURE
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In this section I will: 1 Make a slight modification to the shortcut Gordon Model equation, discussed in 6, to use as our future valuation formula 2 Analyze the meaning of the future valuation formula 3 Make strategic statements about how you need to manage your business to maximize value There will be a moderate amount of mathematics to deal with It is not important that you understand the algebra Follow it as best as you can What is important is to understand the implications of the final future valuation equation and what it means to you in managing your business
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Future Valuation Formula
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There was a fair amount of mathematics to develop our shortcut valuation formula in 6, which I reproduce below as Equation 91 The equation says that the value of a mature business with constant growth in its forecast economic cash flows is approximately equal to 110 times forecast economic net income times the Payout Ratio times the end-of-year Gordon Model multiple, which equals one divided by the discount rate minus the constant growth rate3 The equation: FMV0 110 Inc1 Payout Ratio1 1 r0 g0 (91)
One difference between this formula and Equation 64 is a subscript zero under the FMV, discount, and growth rates, to signify that this is our valuation as of now, which I call time zero Also, I added a subscript 1 under the economic net income forecast for Year One and the Payout Ratio to indicate that it
For simplicity in this discussion, we are ignoring the discount for lack of marketability and the control premium Adding those factors would likely raise the valuation by about 6 percent
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