A startup I know well posed an interesting question this week. The company is raising seed funding. The founder has taken a cautious path so they have good traction and a revenue model. Nonetheless this is their first formal round. One of the potential investors is unsure of the valuation. Said investor is proposing a discounted cash flow (DCF) valuation.
DCF is a well known and respected technique. Analysts use it to value companies and long term projects every day. What is it? Wikipedia has this definition:
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
This is crazy
The investor who thinks this works for any startup is crazy. The basis of DCF is a forecast of future cash flows. Startups operate in a world of complete uncertainty. Forecasting revenues is near impossible. When I review startup business plans, I am interested in the financial forecast. But I am looking for messages about ambition, traction and product/ market fit. I don’t place any reliance on the actual numbers.
If you look closer you will see the little word “All”. Proper DCF uses all future cash flows. Most startup business plans only include 3 year forecasts. I have seen DCF valuations of capital projects that cover 20, 30 or even 50 years. At seed stage most startups do not even survive the 3 year horizon.
Small Business Consulting Gets Technical
If you get this, it is easy to dismiss DCF. Irrelevant in the startup world. I agree that it makes no sense as a basis of valuation. But I think it does hold some lessons for a SaaS business. The reason? Consider the parallels with lifetime value (LTV).
LTV is one of the core SaaS measures. In concept it is just like DCF. You calculate the revenue or gross profit for each customer. Over the life of that customer. Your LTV is the sum of the future expected revenues from each customer. Then calculate an average to give an individual customer LTV.
This is a newer and less developed way of measuring value compared to DCF. What lessons can we learn from LTV’s older, more grown up cousin?
“Discounted by using the cost of capital” covers several things. Including some reasons not to use DCF for a startup valuation. The words are bit of financial jargon. So the best way to illustrate this is by unbundling the terms.
On the surface LTV is better than DCF at estimating lifetime. In many calculations there is no fixed lifetime for DCF. Churn puts a time horizon into every LTV number. The maths of using churn this way makes sense. But it hides an important truth. Churn happens to the customers that leave. In every cohort there are customers that stay around. These accounts are gold mines.
Mobile network operators discovered this early. Your average customer is an expensive habit for an MNO. He or She changes the handset every 2 years. This means an extra customer acquisition cost. Often linked to a drop in monthly revenue. Some people don’t do this. They keep that old Nokia forever. Many love those things. The monthly line rental and the call package just keep rolling in.
You can make an simple calculation of the impact of this. Take a typical SaaS SME customer paying £50 subscription every month. The company has nice ow churn of 1% per month. The average LTV formula is:
LTV = MRR X 1/CR where MRR is monthly recurring revenue and CR is the churn rate.
For our example customer this gives LTV of £2,500.
The technical term for revenue which keeps going forever is perpetuity (P). The formula for calculating the value of a stream of payments in perpetuity is:
P = MRR/IR where IR is the monthly interest rate or cost of capital if you have that number.
Imagine an interest rate of 10% per annum. High by today’s standards. Above the range of 4-8% quoted in this article from Forbes last year.
Using this rate P is £6,000. The customer you keep is worth almost 2 and a half times the average. Before you factor in the extra customer acquisition costs involved. Remember you have to replace every user who cancels a subscription.
Cost of Capital
Applying calculated values for cost of capital makes no sense in the startup world. The uncertainty overwhelms the logic. Thinking about how to approach this provides a great frame of reference for some big decisions.
Time value of money is real. A dollar today is worth more than a dollar in a year’s time. But the difference is not infinite. Discounts to encourage people to pay for a year or more upfront make sense. The cash upfront can be a lifeline for a startup. Dry interest rates don’t capture the value that represents. You do need to think about what works when pricing up your product.
Capital structure is not a relevant factor. The startup parallel is opportunity cost. Or cost of choice if you prefer. Again not something to wrap up in a percentage rate. But think about adding features, tackling new markets and so on. Early doors the question is which option brings the best return. As you become established this changes. Now you need to ask a different question. Will investing in something new earn a good return? Is it better to put more resources into your proven business model?
Weighing up risk is one for the future. Every step on the startup journey is high risk. A founder cannot be reckless but risk analysis can lead to paralysis. Be aware but don’t lose the bias to action.
Building a scalable SaaS recurring revenue model is neither art nor science. Skill and judgement play a part in every decision. A rigid set of rules and boundaries has little meaning. A framework that helps your team recognise the context of your choice can be a big help.
Professional finance managers have developed some great techniques. DCF has an important place in this arsenal. The basis of these models is valid theory and sound maths. The variables involved kill the benefit for a startup. Understanding how established methods work can still provide valuable lessons. The core SaaS concept of LTV is a cousin of DCF. Looking at both is illuminating.
No two SaaS businesses will be the same. Within any business, the context of each decision will also be different. No advisor can lift the load of making tough decisions from an entrepreneur. Great small business consulting for a startup means helping founders make those choices better. Helping new leaders learn their craft. Subscribe for more insights direct to your inbox.
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Kenny Fraser is the Director of Sunstone Communication and a personal investor in startups.