In principle, in every valuation method based on discounting future anticipated flows of free cash flows, earnings, dividends, or residual income, the discount rate has a crucial effect on the derived value and may determine the fate of investments, since a change in the interest rate used for discounting may stamp a project as unprofitable. Obviously, the discount rate used by venture capital funds to discount the future value of cash flows also has a crucial effect on the value of the assessed company and hence on the percentage of ownership which the investors will require.
Historically, the discount rate by which venture capital funds calculate the value of companies lies in the range of 20 80% per year, depending on where the company stands in its lifecycle. This rate is materially higher than the customary discount rate for equity investments or for investments in other traded securities, even if the latter are very risky.
This section reviews the reasons which drive venture capital investors to use such a high discount rate. See Figure 9-1.
Figure 9-1. The Discount Rate Used by Venture Capital Investors in Each Investment Round
Why VCs Use a Higher Discount Rate
Following are several possible reasons why venture capitalists usually use a much higher discount rate than the rate derived from the CAPM model described earlier:
An inability to hedge the risk In venture capital investments, the overall risk, both systematic and specific, is very high. Venture capital investments obviously entail a very high specific risk, which includes the risk involved in the technology and in its prospects of becoming commercial. By creating a highly diversified investment portfolio, most of the specific risk may be hedged at the level of the fund, which invests in a large number of investments (although these are often concentrated in a single industry), or at the level of the investors in the fund, namely, the large institutional entities which make many different investments. However, since the fund cannot usually hedge all of the specific risk of each individual investment, since the portfolio of the fund itself, particularly industry-specialized funds, is not well diversified, fund managers use a higher discount rate, although the investors in the fund who have a well-diversified portfolio should use a different cost of capital to measure the performance of the fund itself.
In addition, a venture capital investment is also exposed to a large extent to the systematic risk (market risk). For instance, the terminal value of an investment greatly depends on the level of prices on the market several years down the line. The fund is usually unable to exit its investment before an IPO or a sale of the company. Furthermore, market risks could cause an investment never to mature or meet projected returns. High tech companies, especially small companies with no resources, are very much exposed to changes in the market and to recessions. A recession, and/or a significant decline in the stock market, usually also translate into a slack IPO market which does not allow capital to be raised for other companies in the fund's portfolio and burdens the fund with their financing needs.
Illiquidity premiums The discount rate used by venture capital funds also includes a premium for illiquidity (liquidity is defined here as the ability to exchange an asset for cash at its full value within a reasonable period of time).
Projection errors and information gaps vis- à-vis the entrepreneurs A high discount rate compensates potential investors for errors in forecasting the company's future cash flows. As opposed to objective valuators who are equally likely to err upward or downward in their projections, the cash flows projected by entrepreneurs as presented to the investors are naturally inclined toward optimism. Therefore, an assessor relying on such figures may cut down the flows forecasted by the entrepreneurs and discount them with a reasonable rate of return, or increase the rate of return and use it to discount the projected cash flows. Theoretically, however, the correct manner of treating this issue would be to examine several scenarios while attributing probabilities to their respective likelihood of materializing and then discounting them according to the correct rate of return for cash flows carrying a similar level of risk (which is rarely more than 30% per year).
Premium for the added value of venture capitalists A high discount rate may also constitute a mechanism by which companies pay a premium for investors who can contribute added value to the company. According to this theory, the company pays investors who can contribute added value with part of the return it generates. This added value is calculated directly in the form of a premium on the discount rate, which reflects an additional rate of return required in order to indemnify the fund managers. Venture capital investors are often active and involved in the company's decision-making processes, in the hiring and termination of managers, in directing the management, and in cultivating their investment in general. For instance, the fact that a certain investor or fund has invested in a certain company assists in opening doors, attracting customers, and facilitating the raising of additional capital.
Changes in the Discount Rate over Time
Investors lower the discount rate they use as the company matures. The reason for this lies in several factors. One could argue that the bigger the company, the smaller is its systematic risk since its growth rates are more moderate and its expenses lower in relation to the turnover. In addition, the investment becomes more liquid as the company grows and succeeds since there are more potential buyers for its stock. Furthermore, as the company develops, it hires its own skilled management team and is less dependent on the assistance of venture capitalists. Therefore, the payment for the added value contributed by such investors is reduced. In addition, the uncertainty with respect to the company's terminal value also decreases as it develops and accumulates an operating history, which may be used to judge how far it meets targets stated in the business plan.