What is the appropriate discount rate for valuing a company?

In actuality, the discount rates of venture capital valuations are quite high. Much higher than what you would see in most WACCs of public equity models, accounting for the uncertainty of the ability for a company to monetize and to do so profitably (when and whether it will at all). This is how a software company that ends up generating $100M+ in high gross margin revenues 5 years after its Seed investment, may have had a Seed valuation of only $10M in year T, but the valuation of the company becomes $1B in year T+5. As the visibility into future cash flows becomes more clear, the discount rate comes down with a lower premium as it is derisked.

The appropriate discount rate for valuing a company relies on the Weighted Average Cost of Capital (WACC) or the Cost of Equity. WACC combines the cost of debt and equity based on their weights in the capital structure. Cost of Equity reflects the return shareholders expect. Both rates are influenced by the company's risk, market conditions, and the specific project or investment. Higher rates might suit riskier ventures; stable businesses may use lower rates. This rate choice affects the present value of future cash flows and, consequently, the overall company valuation.

In venture capital, the discount rate does not matter in the practical sense of negotiating or valuing a private market startup, especially at the early stages of its life. It could be used in late stage growth equity, when data is available, financial models are built, and there are clear indications of profitability (let alone free cash flow margins). However, discount rate does impact public equities in a meaningful way. When the rate is adjusted in a DCF, the price targets for stocks change and that can move the stock. Changes in stock prices affect the implied multiples that the market is willing to pay. These multiples are used in growth stage VC markets, which can impact valuation and downstream appetite for early stage VC.

In venture capital, the discount rate does not matter in the practical sense of negotiating or valuing a private market startup, especially at the early stages of its life. It could be used in late stage growth equity, when data is available, financial models are built, and there are clear indications of profitability (let alone free cash flow margins). However, discount rate does impact public equities in a meaningful way. When the rate is adjusted in a DCF, the price targets for stocks change and that can move the stock. Changes in stock prices affect the implied multiples that the market is willing to pay. These multiples are used in growth stage VC markets, which can impact valuation and downstream appetite for early stage VC.

Speaking solely of discount rates I would prefer 3X *bank rate. However investing doesn’t not depend only on discount rates because it about growth. We can find many cases where investing is done without discount because there is a chance of creating a large company or a monopoly or first to market.

The CAPM method is at best a broad estimate. Returns available in the equity market are aggregate measures. The risk premium used should take into account company size, industry, liquidity and stage of development. For example, the rate for a biotechnology company should be benchmarked against returns from biotechnology companies. Even then, rate should be adjusted to reflect liquidity, stage of development and other factors that drive risk.

El Método CAPM, piedra angular en valoración, fusiona la estabilidad de la tasa libre de riesgo con la dinámica de la prima de riesgo, siendo un crisol de precisiones. La fórmula (Tasa de descuento = tasa libre + beta * Prima de riesgo del mercado) revela su poder en la evaluación de activos, donde la sensibilidad al mercado marca la diferencia. Este método va más allá de números; es una herramienta refinada para decisiones financieras sustentadas en la complejidad del riesgo.

Theoretically yes. Practically no. The above lines assumes that my investment is the last and then we go for an IPO / sell out. This seldom is true. As investors we are aware of our limitations to fund. And we always measure risks. So in above case the discount will be much lower in real life as we wish to strengthen the company asap and not only strangle them with discount rates. Even if we get half of this we strike.

From a perspective where high discount rates can feel restrictive for startups, there's a fine balance to maintain. These rates are crucial in venture capital for assessing risks and returns, but they can also put immense pressure on startups to prioritize rapid scaling over sustainable growth. This focus on meeting ambitious targets, driven by investor expectations, might sometimes overshadow the importance of strategic development and innovation. It's vital, therefore, to apply these rates with an understanding of their impact, ensuring they support rather than hinder the long-term success and health of startups. Balancing financial rigor with a supportive growth environment is key for the overall ecosystem.

There are a lot of ways for VC firms to generate their desired target. They can structure their investment so that it includes priority returns. The economics of a VC transaction can thus be varied so that the actual equity ownership need not mirror the final return achieved with a VC investment.

Obviously the above discussion on discount rates refers to non listed corporates. Listed corporates are available at a deep discount only in an extended recession. As for discounts in unlisted companies we also have to look at previous funding / market rates / growth rates / new product development / competing companies. Each of the above factor can change the discount rate by 100 percent. For instance if the investee is about to go to market post my investment ; my discount rates will be ve small because I want to leverage probably first mover.

Start with the fact that the vast majority of startups fail. VC's typically don't invest at startup stage, but still, in general 30% - 40% of VC backed companies fail. Leaving aside all other factors, If a VC invests in 4 startups, 1 of which fails in order to make up for that failure the VC needs at least a 50% return on the other 3 (on average). Even then the VC will have a net return of about 12.5%. It is estimated, however, that the top quartile of VC funds make about 30%. They are making, obviously, superior returns. As a rule of thumb, therefore, VC funding likely has a discount rate of somewhere in the vicinity of 35% - 45% IRR. VC funds that make north of 25% for their investors probably experiencing fail rates of about 20%.

From an entrepreneurs perspective ; don’t worry about discount rates. Number crunchers (me included ) will find a way to justify your demand / ask / valuation if they think you will create cash flow. It’s all about cash flow and customer numbers / value. Stick to that.

It depends on many factors- one main of which is whether you have to sell it or buy it. So assessment and its justification depends on which side you have to make it.