Assessing Survival Risk In Startups

Assessing Survival Risk In Startups

Startups often approach #venturecapitalist or #privateequity firms to raise capital. However, very few startups survive, whereas many cease to be a going concern. Therefore, if corporates/VCs decide to invest money in these startups, they should account for their survival risk in the discount rate.

For instance, a startup looking to raise capital from investors has the following.

Operating income = \$10 million
Tax rate = 25%

NOPAT = \$10*(1-25%)=\$7.5 million

Reinvestment rate = 40%

Free cash flow to Firm = \$7.5 *(1-40%) = \$4.5 million

Cost of equity = 15%

The probability that the startup will shutdown = 20%
Liquidation value at the exit = \$0.1 million

Valuation of startup as a going concern = \$4.5/15% = \$30 million

Valuation of startup accounting for survival risk = (1-20%)\$0.1 + 80%\$30 = \$24 million

The startup should get a \$6 million haircut from its intrinsic value of \$30 million as the probability of the startup shutting down is higher (~20%). This probability of failure declines as the earnings of the firm increase. The investors should incorporate the chance of loss into the #cashflows rather than at the discount rate.