Valuation of Early-Stage Technology Ventures: An Approach to Derive the Discount Rate

Abstract

Valuation of firms in general and early-stage technology ventures is sometimes referred to as an art rather than a science. Yet, an objective and practical valuation is critical for venture capitalists to make sound investment decisions. The authors develop an approach to derive the discount rate for a present value approach to valuation, broadly used by practitioners, that accounts for a missing data history and subjectivity in the early stage. This approach is based on thorough previous research analyzing the impact of subjective valuation determinants on a venture’s value and thereby expands the results’ academic and practical context. This impact is transformed into a valuation score and matched to a suitable discount rate structure. An initial validation within the valuation of three early-stage technology ventures provides promising results, with modeled discount rates showing a deviation of less than 2% from the real target return applied. The resulting discount rates can then be used for valuation.

TOPICS: Private equity, factor-based models, accounting and ratio analysis

Key Findings

• ▪ The missing financial track record of early-stage technology ventures requires an accurate reflection of relevant non-financial determinants. The authors develop a quantitative valuation approach for early-stage technology ventures based on conventional valuation methods that accounts for these non-financial determinants.

• ▪ With this approach, a suitable discount rate is derived based on the observable non-financial determinants. The resulting discount rates can then be used for valuation within a present value valuation framework, such as the venture capital method.

• ▪ An initial validation within the valuation of three early-stage technology ventures provided promising results with modeled discount rates showing a deviation of less than 2% from the real target return applied.