Question

How do your values as calculated in item 4 differ from the value that you calculated using the FCF method in item 1? Explain your responses. What are the main challenges and difficulties in finding a value using the FCF method of valuation for a startup that has little historical data? What do you do to value a startup using the FCF method of valuation? Explain in needed details. (As far as grading is concerned this question is very important as well so given it some thoughts.) S. 6.
Just #6 please

Answer 1

The free cash flow method is dependent upon the accuracy of assumptions made regarding the future cash flows and growth opportunities of a company. Usually these assumptions are made based on the company and its industry's past performance and riskiness of the business. For a start-up company with little or no historical data, and high chance of failing, the difficulty of making these assumptions increases.

To dampen the effects of these risks and uncertainities faced by a start-up, we can adjust its discount rate for failure rate and illiquidity:

Failure rate: A start-up is more prone to failure than an established company. Therefore, using the same discount rate for valuation is not reasonable. Adding a premium for expected failure rate will increase this discount rate and will be a better index of company's riskiness.

Illiquidity premium: For a private investment like seed capital in a start-up, the illiquidity of investment is very high. The investors would demand a higher return for blocking their money in such companies. Thus, adding an illiquity premium to the discount rate would incorporate this risk.