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Discounted cash flow (DCF) analysis, first discussed by Irving Fisher in 1930 and later on formalized by John Burr Williams [1938], is currently the most common valuation method for stocks and cash-generating companies. The DCF method adjusts the value of future cash flow to the time value of money and is basically an equivalent form of net present value analysis (including real options analysis).
DCF is fundamentally based on cash flow projections. However, projections for high-risk, high-technology (Hi-Tech) ventures, for example, which are very often private and non-tradable, might be considered highly speculative, especially for ventures with a long time to maturity. In the absence of cash flow forecast and in view of the high uncertainty about the successful completion of the venture's R&D effort, it is not possible to apply the DCF method, and the valuation of such ventures becomes more of an art than a science. In fact, valuation of risky cash-flowless ventures requires a mindset that is different from what we are accustomed to. We cannot rely on historical figures since, at best, we have only short-term statistics-on the scale of several years; moreover, quite often we have to suffice with incomplete information about the venture or company. In the absence of a structured and methodical way for valuating such projects, CEOs, CFOs, investment managers, venture capital (VC) and other investors resort to a variety of methods, including gut feeling. Unfortunately, a misperceived value of the venture can make or break the deal and may result in either a bad investment or a good opportunity lost.
Cardinal to the investment process is the estimation of the exit value of the venture. It is important to emphasize that high-risk, highgain investors such as venture capitalists are mostly interested in the exit value-i.e., the terminal value-of the venture rather than its present value that they can negotiate at the time of investment. Given the exit value, investors can calculate backwards, using relatively simple algebra, the present pre-money value of the venture. A good illustration for such back-valuation algebra, adopted from a presentation of Versant ventures (Atwood [2002]), is presented in Exhibit 1. Taking into account the low success rate of emerging technology ventures and the required expected return-on-investment (ROI, IRR, etc.), VC investors...