Last week as part of our 50 Questions series I wrote about how VCs value businesses by working back from expected exit values, using various industry rules of thumb and responding to market dynamics (hotness of deal and market). In the comments Senith asked why we don’t use discounted cash flow (DCF) analysis which as he says is “the most sound method [for valuing businesses] according to most textbooks”. I’m going to address that today.

DCF analysis estimates the value of an investment, project, or company by adding up the projected cash flows over time and then discounting them to account for the time value of money (£1 in ten years is worth less than £1 today) and also for the risk that the projected cash flows might not be achieved. Purists will correctly argue that the discounting should only reflect the time value of money and that the cash flows should be adjusted to reflect the risk, maybe using scenario analysis, but in practice most people conflate the risk and the time value of money into a single discount rate. The wikipedia article on DCF is pretty good.

A DCF analysis of the value of a VC investment in a startup needs four inputs:

- The amount of the investment (including any follow-ons)
- The projected return when the investment is sold
- The years in which each of these cash flows will occur
- The discount rate

The problem is that whilst the methodology might be theoretically more rigorous than the simpler working back from projected exit values using a target multiple return the input variables are sufficiently uncertain that the extra complexity doesn’t bring you any extra accuracy. Figuring out the right discount rate is particularly difficult and no better in practice than working with multiples.

One of the strengths of DCF analysis is that it takes account of time, which is very important with projects that are long and/or of variable length. That is less important for startup investing when the projected exit is nearly always 3-5 years away.

Ultimately VCs are measured on IRRs (Internal Rates of Return) and we do link our multiple analysis to a projected IRR for each deal, but that is typically done towards the end as a final check using simple lookup tables. I mention it now for completeness given the link between IRR analysis and DCF analysis, but I won’t go into detail because I think this post is long enough and technical enough already.