How the DCF Equation Applies to High-Growth Company Valuations 

Companies seeking to raise money in private capital markets need an understanding of how to create value based on cash flow. This report reviews an aspect of valuing such companies through the discounted cash flow (DCF) method, the primary method used for cash flow analysis across all asset classes.

When evaluating loss-making companies for extended periods, it is difficult to utilize the DCF for anything other than discounting forward looking profitability. In this article, J&A introduces an alternative approach—a modified DCF model—that analyzes a company’s investment worthiness by understanding its risk profile and the investor’s expected returns. 

The DCF model is used as a way to approximate the value of an investment. A DCF valuation starts by forecasting the future cash flows that an investment is expected to generate and considers the expected future growth of the asset’s cash flows. The equation incorporates risk factors by adjusting the discount or interest rate. In practice, the cash flows (CF1) include cash inflows and outflows such as revenue, expenses (excluding non-cash items such as depreciation and amortization), taxes, and other financial metrics related to the investment being evaluated. The discount rate (r) is determined based on factors like the cost of capital, the required rate of return, or a suitable benchmark rate.

Discount Rate Substituted for Interest Rate

For high-growth companies, one uses the cost of capital as a substitute for the discount rate. This number is simply the factor by which future cash flows are reduced to account for the time value of money and the risk profile of a project. Typically, riskier projects require a higher cost of capital to compensate investors for taking on more risks.

The cost of capital includes multiple components, such as the cost of debt (interest rate on borrowed money) and the cost of equity (required rate of return expected by equity investors).

The weighted average cost of capital (WACC) is a weighted average of a company’s cost of equity and cost of debt based on the money the company has already raised or the cost of raising capital at the moment in time. 

Required Return of Equity or Cost of Equity

The required return on equity, also referred to as the cost of equity, is the minimum rate of return that shareholders (equity investors) expect to earn on their investment. 

For high-growth companies that prioritize reinvesting their earnings to fund expansion and growth, the following formula is used:

In this formula, r_f represents the risk-free rate of return on a risk-free investment, the beta is the measure of the stock’s risk, and r_m is the expected return above the risk-free rate for investing in the overall market.

Abbreviated DCF Equation for High-Growth Companies

By using algebra, the DCF is actually:

The equation above is the correct proper, mathematically detailed equation to calculate a business’s discounted cash flow at a future period. Some of these variables matter more for high-growth companies than others. Variables that are less important can be removed to create a more concise picture of how the DCF behaves.

Focusing on the Variables that Matter

Small, high-growth companies receive investments because investors are betting they will become large companies, so the possible outcomes of these companies should be measured in extremes.

The purpose of a DCF equation for a high-growth company is to evaluate the extremes of potential value based on realistic cash flow scenarios in the future. Said differently, “If the company generates $100 million of cash flow but has to lose $200 million per year for three years, what is the asset’s value?” The DCF equation allows a financial modeler to create cash flow scenarios based on a projected income statement and calculate a likely business value. The DCF model also allows decision-makers to determine how much cash needs to be generated to meet valuation targets. A company that wants to be worth $1 billion will have mathematical cumulative cash generation requirements, taking into account losses based on a determined interest rate, cost of equity, and cost of debt. 

For high-growth companies, one can ignore many variables that a traditional DCF model requires, such as the tax rate. A variable like the tax rate is important when an investor considers deploying large sums of money for low percentage returns, such as investing $100 billion cash into a treasury bond. But the tax rate is meaningless when considering investing $10 million into a company worth $0, $10 million, $100 million, or $1 billion in the future. 

In other cases, companies might:

Based on all this, the appropriate DCF equation for a high-growth, early stage company is:

The variables considered by investors and decision-makers for companies of this profile are beta, the market’s return, and the asset’s cash flow. We will now investigate beta and r_m in more detail. 

This more thorough view of the DCF equation allows us to analyze the relationships between its variables more rigorously. Investors in high-growth companies know they take on a lot of risk with their investments. Investors in high-growth companies expect to be compensated through this risk-taking by getting an outsized return. For the DCF model, this return can only come in cash flow that warrants a greater valuation than what the investor is paying for the asset. Based on these assumptions, many parts of the DCF equation become irrelevant because they do not impact the final valuation number the investor seeks to compensate for this risk.

Selecting Beta and r_m for High-Growth Companies

There is no perfect answer to determining the right beta for a small, high-growth company. Beta is a statistical measurement derived from the volatility of the S&P Index. The S&P has a beta of 1. If a stock also has a beta of 1, then the stock will move the same amount as the S&P 500 Index. If the S&P goes up by 1%, a stock with a beta of 1 will also go up by 1%. If the S&P goes up by 200%, the stock with a beta of 1 will also go up by 200%. 

Beta plays a role in assessing a stock’s risk and how it moves in the overall market. Beta creates the slope, and it grows (or destroys) the underlying asset’s value based on performance. A beta of 15 is extremely high and would suggest the stock is volatile and risky since it moves 15 times more than the overall market. 

As beta grows, so does the volatility of the stock in relation to the S&P. If a stock has a beta of 7, then it will go up or down seven times as much as the S&P. Suppose the S&P goes up by 10%, the stock with a beta of 7 will go up by 70%. And if the S&P goes up by 15%, the stock with a beta of 7 will go up by 105%. Small changes in the beta lead to large changes, positive or negative, in the underlying stock price as it moves. A larger beta leads to a lower valuation. If an investment is extremely risky, an investor is likely to pay less for it because there is a greater probability that their investment will decline in value.

A perceived beta of 2 is different from 5 and is different from 100. Various qualitative factors, including pending litigation against a company, management changes, negative publicity, and industry sentiment can influence beta. These events introduce uncertainty and risk, which cause a stock’s beta to deviate from 1. Generally, a beta of 5 for NYSE listed equities is considered very high. 

The market return (r_m) is easier to estimate and requires less data for statistical analysis. The r_m can be calculated by multiplying possible investment outcomes by their probabilities and summing the results to reach a weighted expected return of the market. Venture capital (VC) funds have historical data on the return of different investments, which helps them estimate the expected return on their portfolio of investments. 

Nevertheless, historical performance does not guarantee future results, as investment outcomes vary significantly. Ideally, it will provide a conservative estimate of r_m when compared with the asset managers’ future performance. 

Assume an investment in a Series A company has a 25% chance to either go to 0, increase by 50%, double, or quadruple equally. Note that we will not assume negative returns in this scenario since negative returns are most relevant for derivative trading. 25%*0+25%*50%+25%*1+25%*4 = 1.375%, so the r_m of this scenario is 1.375%. 

These numbers can be altered to create a different r_m based on the investor’s model. One important thing to note is that the r_m will remain relatively static. It would be uncommon for any investment opportunity to have an r_m of 4, 10, or 100; this suggests the returns are too good to be true. Some high-frequency trading algorithms can reach results of this magnitude, but they are not consistent. 

The selections for beta and r_m simply reduce the expected value of the cash flow in a period. Both these variables appear in the denominator of the traditional DCF and the modified one in this report. As the denominator of a fraction grows larger, the ultimate value of that fraction becomes smaller, leading to a decline in the expected value of the asset. 

A larger beta leading to a lower valuation is intuitive. When an investment carries high risk, investors tend to offer a lower price due to the likelihood of potential losses. However, a greater r_m also contributes to a lower asset value. How can this happen? Remember, the cost of equity in this equation refers to the return investors require for the risk they are assuming. So, while a higher r_m seems like it should increase the asset’s value, this r_m is used to calculate the required return of equity to the investor, consequently increasing the company’s cost of equity. This subtle psychological indication of this simple equation holds powerful implications for the issuer raising money. Founders and CEOs often assume that belonging to a high-growth industry increases their value. However, this equation clarifies that the asset’s value only increases based on its ability to generate future cash flow. Mathematically, according to the DCF, the higher the expected market return of the investor, the lower the asset’s valuation—a point of utmost importance.

Since different returns and their likelihoods derive r_m, the positive and negative scenarios should be considered together. And counter-intuitively to many business owners, when a market is driving a return of 4, 10, or 40 times, it only puts the pressure on the company to provide higher returns, therefore reducing the valuation in the mind of the investor. 

Key Takeaways for Business Owners

Most of this is very theoretical. The equations used by cash flow and public equity investors were not developed for early stage, high-growth companies. However, there are vital lessons for business owners to grasp regarding investors’ thought processes. Private equity investors have expertise from public markets and were trained on financial fundamentals that include these equations. These equations provide a framework for an alternative investment to any subject seeking one. Investors possess the gift to choose where to allocate their capital. When an investment opportunity presents itself in a promising space, but its offering details are so outside the range of what is reasonable regarding these basic equations, investors will find it very difficult to commit to such an investment. This is particularly the case when these investors manage funds on behalf of their limited partners and are bound by a fiduciary duty to those whose capital they manage. 

Qualitatively, business owners need to consider how they compete with investment assets for investor funds and how the beta or expected market return (r_m) of those other assets aligns with opportunities presented in a specific investment offering. 

Quantitatively, there are outbound limits for beta and expected market return (r_m) that business owners can consider when determining what set of scenarios makes their investment offering enter the realm of mathematical reasonableness. 

For example, a beta cannot be 100. Generally, public-traded equities can have betas of up to 20. A small, high-growth business that doesn’t trade frequently, will decrease beta since the stock is less volatile. The r_m of an offering shouldn’t be greater than 1 because it will lead investors to demand a greater return and therefore increase the cost of equity and lower the valuation of the business. Mathematically, an r_m of less than 1 will reduce beta and its subsequent exponential change in the denominator of the DCF equation. 

The most important takeaway from this entire exercise for business owners is that companies must have sound valuations based on their planned profitability. This is now exemplified in the global high interest rate environment and companies like Uber are becoming profitable. Eventually, in a company’s life cycle, all investors will evaluate offerings based on these free cash flow models. Therefore, even if the equation may not be entirely applicable to a Series A company, it will apply to that company as it grows. Cash is king (or queen)—always.

Transaction Structure and Its Impact on Seller Liquidity in M&A

Transaction Structure Impacts M&A Valuations 

Mergers and acquisitions (M&A) occur when one company purchases or combines with another, usually resulting in a change of ownership and control. M&A goals include creating shareholder value by growing profit, gaining market share, expanding into new markets or product lines, and accessing technologies.

A transaction’s structure refers to the combination of assets used to compensate the seller for the fair market value of the business being sold. In a complete sale, the seller is often compensated through a combination of cash, equity instruments, debt instruments, intangible assets, and tangible assets.

Liquidity refers to the ease and speed with which an asset or investment can be converted into cash. 

It measures how quickly an individual or organization can access their funds by selling an asset.

Types of Transaction Structures

Transaction structures are categorized into three types: unstructured, typically structured, and highly structured. These classifications shape the composition of the payout a seller receives based on the mix of assets involved.

An unstructured transaction is where the buyer acquires the target company by offering an all-cash payment in exchange for ownership. In an all-cash transaction, investors and sellers employ different methods to assess a company’s valuation and negotiate a price.

Financial performance, historical cash flows, tangible and intangible assets, and market multiples are common factors in this process. Public companies also have their share price, but negotiating this price is possible, especially in deals that involve significant stakes. In this structure, the buyer is assuming they can generate a return on investment. This return will likely come from revenue synergies, growth, or cost synergies to increase profitability.

In a typically structured M&A transaction, assets are diversified among cash, equity, debt, tangible, and intangible assets. The valuation is a blend of these components allowing both the buyer and seller to negotiate the final price based on the expected return of non-cash transaction components.

For example, a business with a total value of $100 million would be considered typically structured if the sellers received $60 million in cash at close, $20 million of equity in the acquiring entity, $10 million worth of a promissory note paid to the sellers (note holders) over two years, $7 million worth of employment agreements and bonus potential, and the $3 million company yacht at the time of sale.

This approach allows buyers to reduce risk and optimize capital allocation, as well as incentivizes the sellers to support the company’s long-term growth.

A transaction is highly structured when the majority of the fair market value is placed in non-cash assets such as intangibles, equity, and debt. The valuation is more complex, and valuation methods involve assessing the future cash flows of intangible assets, such as intellectual property (IP), contracts and agreements, research and development (R&D), licenses and permits, and customer relationships. For example, a large tech company would acquire a startup with cutting-edge software and IP to enhance the buyer’s product offering, just like a large consumer goods company would acquire a niche brand to increase sales of the niche brand across the large brand’s sales channels.

In a highly structured transaction, the buyer assumes they will achieve a desired return on investment (ROI) within a specified timeline primarily from the acquired intangible assets based on factors like the ability to license the intellectual property (IP) and the market demand on the products associated with the intangible assets.

Equity, Debt, and Intangibles Drive Transaction Structures

Equity-Driven Structures

An equity-driven structure emphasizes the exchange of ownership stakes in the acquiring and target company. Equity instruments are financial securities that represent ownership in a company and give the equity holder a claim to the company’s assets and earnings. Equity instruments include:

1. Options: Financial derivatives that give the holder the right but not the obligation to buy or sell a specific amount of a company’s stock at a predetermined price within a specified timeline.
2. Preferred or common equity: Carries preferences or rights over common stock, which include priority in receiving dividends, liquidation preferences, and other rights that may be outlined in the company’s bylaws.
3. Equity: Public companies’ equity is traded on stock exchanges and subject to market fluctuations, while private companies’ equity is not publicly traded and involves negotiated agreements among investors.
4. Restricted or controlled stock: Shares that are subject to certain restrictions or conditions on their transferability or sale.

Equity-driven M&A structures attract strategic investors who are typically corporations or businesses looking to expand their market presence, product portfolio, or geographical reach. Strategic investors acquire companies that align with long-term strategic goals.

Consider an example of a large professional services firm acquiring a mid-sized professional services firm. The larger firm would offer profit-sharing units or equity to the mid-sized firm. The mid-sized firm would consider this deal because it creates access to more potential clients and can smooth out the volatility of dividend payments for more niche service lines. 

Intangible Asset-Driven Structures

Intangible asset–driven structures usually create the lowest near-term fair market value but the greatest long-term upside. Intangible assets also possess a slightly riskier profile. Several types of intangible assets and payouts exist, each with distinct characteristics.

1. Bonus payouts: Additional financial rewards given to key employees or executives as a form of extra compensation, which is based on their performance, achievements, or contributions.
2. Employment agreements: Legal contracts that outline the terms and conditions of employment for the target company’s key employees after the acquisition.
3. Earnouts: Arrangements where a portion of the purchase price is contingent upon the future performance of the acquired company and is paid to the seller based on achieving specific financial or operational milestones after the completion of the acquisition.
4. Reselling agreement: Allows the acquiring company to continue selling the target company’s products or services.
5. Revenue sharing agreement: Outlines how the revenues generated from products or services will be shared between the acquiring and target companies.
6. Royalty agreement: Payment of royalties to the target company for the use of its intellectual property.

Large corporations seeking strategic acquisitions focus on intangible assets that complement their existing businesses. A tech giant aiming to strengthen its position in the smartphone industry would acquire a startup known for its innovative smartphone display technology and a portfolio of patents related to this technology. Out of an intangible asset–driven structure, the tech giant would gain a competitive advantage in the smartphone industry and increase returns through sales related to reselling, revenue share, and royalty agreements.

Debt-Driven Structures

In a debt-driven M&A structure, the seller becomes the financier or lender to the company and the buyer. This differs from a leveraged buyout when the note holder is a private lender, not the original seller. In this scenario, the seller transfers control of the business and receives a note entitling that seller to a debt repayment secured by the business just sold, the assets of the buyer, or a combination of the two. A majority debt structure is only common for distressed or semi-distressed assets. Debt instruments include: 

1. Senior secured debt: Takes precedence in repayment over other debt instruments, often backed by collateral like real estate, and it usually offers lower interest rates due to its lower risk for lenders.
2. Debentures: Unsecured debts backed by the buyer’s general creditworthiness rather than specific collateral.
3. Convertible note: Allows the seller to convert the debt into equity (typically common stock) of the acquiring company at a later stage.
4. Promissory note: A written promise to pay a specific sum of money by a certain date. It outlines the terms of repayment, the principal amount, and the interest rate.

Debt-driven transaction structures are less common in private equity markets. Debt is often a component of the structure but rarely the majority of the fair market value. This is because sellers and buyers generally have access to the same set of debt when they own the same or largely comparable assets.

Transaction Structure Components Effect on Seller Liquidity 

M&A sellers want to know the likelihood they will receive a non-cash asset’s perceived fair market value. For this reason, each part of a transaction structure should be analyzed based on the likelihood that the asset can be liquidated for cash near or equal to the fair market value determined at the time of a transaction. Extremes of non-cash liquidity examples include common stock in Alphabet, the parent company of Google, and shares in a private equity business with $1 million in revenue. Google shares can be sold on a public exchange with relative ease and may only be limited by the SEC Rule 144 volume and timing restrictions. Whereas shares of a $1 million private equity company will likely not be liquid until the company grows significantly. A red-green-yellow ranking of general transaction structure elements and the likelihood that these can be converted to their associated cash value is presented below. Green suggests the highest likelihood, such as in the Alphabet example, and red indicates a lower likelihood, such as with the small privately owned company. 

Business owners need to understand that transaction structures have a significant impact on the fair market value of an asset and the ultimate return a seller can receive from the sale of their business. This can be in either the buyer’s or the seller’s favor. Both parties need to consider what ultimate payout they seek and their risk appetite to achieve it. Cash, equity, debt, and intangible assets can all be structured together to create a wide variety of possible outcomes and payouts for sellers. These require careful consideration by the seller.

One of the best examples of how an M&A transaction can be structured and still benefit the buyer and seller more than an all-cash transaction is when Alphabet bought Double Click. At the time of the transaction, digital advertising was still the minority of spending for most brands. But as this budget item grew, Google was able to accelerate its market share more quickly. The transaction structure of the Double Click acquisition is not public, but a more structured transaction would certainly have benefited both parties.