Understanding DCF Valuation for Startups
Master Discounted Cash Flow analysis adapted for early-stage companies with high growth and uncertainty.
Why DCF for Startups is Different
Traditional DCF works great for mature companies with predictable cash flows. Startups require modifications due to negative cash flows, high uncertainty, and exponential growth patterns.
Traditional DCF
- • 5-10 years history
- • Positive cash flows
- • 8-12% discount rate
- • Linear growth
Startup DCF
- • 0-2 years history
- • Negative cash flows
- • 35-50% discount rate
- • Exponential growth
Modified DCF Formula
Enterprise Value = Σ [FCF_t / (1 + WACC)^t] + Terminal Value / (1 + WACC)^n
FCF_t = Free Cash Flow in year t
WACC = Weighted Average Cost of Capital (discount rate)
n = Forecast period (typically 5-7 years)
⚠️ Key Modifications for Startups
- 1. Revenue-based FCF: Use % of revenue for negative cash flow years
- 2. Scenario analysis: Create bull/base/bear cases
- 3. Higher discount rates: 35-50% vs 8-12% for mature companies
- 4. Exit multiple terminal value: More reliable than perpetuity growth
Step 1: Project Free Cash Flows
FCF Formula
FCF = EBIT × (1 - Tax Rate)
+ Depreciation & Amortization
- Capital Expenditures
- Change in Net Working Capital
Example: SaaS Company 5-Year Projection
| Year | Revenue | EBIT | FCF |
|---|---|---|---|
| 1 | $1.0M | -$0.5M | -$0.6M |
| 2 | $2.5M | -$0.3M | -$0.4M |
| 3 | $5.0M | $0.2M | $0.1M |
| 4 | $9.0M | $1.8M | $1.5M |
| 5 | $15.0M | $4.5M | $4.0M |
Step 2: Calculate WACC (Discount Rate)
WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1 - Tax Rate))
For early-stage startups with no debt, WACC = Cost of Equity
Cost of Equity (CAPM Model)
Cost of Equity = Risk-Free Rate + β × Market Risk Premium + Startup Premium
Risk-Free Rate: 10-year Treasury yield (~4-5%)
Market Risk Premium: Historical average ~7-8%
Beta (β): SaaS companies typically 1.2-1.5
Startup Premium: Additional 20-30% for early-stage risk
Example Calculation:
Risk-Free Rate: 4.5%
+ (Beta 1.3 × Market Premium 7%) = 9.1%
+ Startup Premium 25% = 25%
Total WACC: 38.6% ≈ 40%
Step 3: Calculate Terminal Value
Two methods for terminal value. For startups, Exit Multiple is more reliable than Perpetuity Growth.
Method 1: Exit Multiple
TV = Year 5 Revenue × Exit Multiple
Use industry-specific multiples (8-15× for B2B SaaS)
Example:
$15M × 10× = $150M
Method 2: Perpetuity Growth
TV = FCF_n × (1 + g) / (WACC - g)
g = perpetual growth rate (2-3% for mature companies)
⚠️ Risky for startups
Assumes stable growth forever
Step 4: Calculate Present Value
Complete DCF Example
| Year | FCF | Discount Factor (40%) | PV |
|---|---|---|---|
| 1 | -$0.6M | 0.714 | -$0.4M |
| 2 | -$0.4M | 0.510 | -$0.2M |
| 3 | $0.1M | 0.364 | $0.04M |
| 4 | $1.5M | 0.260 | $0.4M |
| 5 | $4.0M | 0.186 | $0.7M |
| Terminal Value | $150M | 0.186 | $27.9M |
| Enterprise Value: | $28.4M | ||
Sensitivity Analysis
Always test different scenarios. Small changes in assumptions can dramatically affect valuation.
| Scenario | WACC | Exit Multiple | Valuation |
|---|---|---|---|
| Bull Case | 35% | 12× | $42.5M |
| Base Case | 40% | 10× | $28.4M |
| Bear Case | 50% | 7× | $15.8M |
When to Use DCF vs Other Methods
✓ Use DCF When:
- • Company has predictable revenue (Series B+)
- • Clear path to profitability visible
- • 3+ years of financial history
- • Stable business model
✗ Avoid DCF When:
- • Pre-revenue or early traction
- • High business model uncertainty
- • Frequent pivots expected
- • Better methods available (Berkus, Scorecard)
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