Valuing Equity in Start-Ups 3: Validating Your Valuation

Simulating the Free Cash to Equity is an excellent way of validating the equity valuation in a start up. The FCE distributions returned by the simulation can be used to estimate the annual FCEs at a certain probablity value (p-values in statistical jargon). The FCEs at low p-values (such as 1%)can be viewed as Certainity Equivalents of the projected most likely FCEs. Certainty Equivalent (CE) of a cashflow (say C1) is the smallest certain pay-off for which an investor would exchange the risky cashflow (C1). The value calculated by discounting the CE at risk free/discount rate adjusted for moderate risk, and the value calculated by discounting the projected most likely FCEs at a certain discount rate reflective of investor's return expectations are close enough, then that particular investors return is arguably justified for the riskiness built into the most likely FCE projections.