Including a terminal value in a 5-year startup financial model is crucial for several reasons, particularly when assessing the long-term viability and valuation of the company beyond the initial forecast period. Here’s why it’s important:
Check out these startup financial models to get a better understand of this concept.
Projection of Long-term Value: Most startups do not achieve profitability within the first few years of operation. The terminal value allows investors and the management team to estimate the startup's value at a point in the future when it is expected to have stabilized and is generating consistent cash flows. This is especially important for startups with long gestation periods before becoming profitable.
Investment Decision-making: For investors, the terminal value represents the bulk of the company's value in a discounted cash flow (DCF) analysis. Since many startups focus on growth over profitability in their early years, the terminal value can provide a better picture of the potential return on investment over the long term.
Simplifies the Model: Beyond the initial 5-year period, projecting detailed annual cash flows becomes increasingly speculative and unreliable due to the numerous variables and uncertainties involved. Calculating a terminal value simplifies the financial model by allowing for a summarization of all future cash flows into a single figure, making it easier to understand and communicate.
Accounting for Residual Value: The terminal value accounts for the assumption that a business will continue to generate cash flows beyond the explicit forecasting period at a stable growth rate, thus providing a more comprehensive valuation. It reflects the residual value of the business after the detailed projection period and acknowledges that a business doesn’t simply cease to create value after five years.
Enhances Valuation Accuracy: Including a terminal value in financial models helps in achieving a more accurate valuation of the startup. It does so by ensuring that the model captures both the value of expected cash flows during the explicit forecast period and the value of all subsequent cash flows into perpetuity, adjusted for risk and the time value of money.
Attracts and Reassures Investors: For startups seeking investment, showcasing a terminal value can demonstrate to potential investors that the business has a viable exit strategy or a sustainable business model in the long run. It reassures investors that the startup is not only focused on immediate growth but also has a vision for generating value in the future.
To calculate the terminal value, one can use various business valuation methods. There is the Gordon Growth Model (assuming perpetual growth at a constant rate) or the Exit Multiple Method (based on a future earnings multiple). The chosen method should reflect realistic expectations for the company's growth and industry standards. It's important that the assumptions underpinning the terminal value are well-justified and align with the company’s strategic planning and market potential. I use the Exit Multiple Method in the industry-specific models you find on this site. For real estate models, I use an exit cap rate.
Sometimes, a terminal value doesn't make sense...
Most business valuation models, particularly those based on discounted cash flows (DCF), incorporate a terminal value to capture the residual value of a business beyond the explicit forecast period. This approach is grounded in the assumption that a business will continue generating cash flows into perpetuity or until a defined horizon. However, there are specific scenarios or types of businesses where a terminal value might not be necessary or relevant. Here are a few examples:
Fixed Life Projects or Investments: Businesses or projects with a predetermined lifespan, where operations are expected to cease after a certain period, may not require a terminal value in their financial models. This can include certain real estate development projects, mining operations with a defined resource life, or specific infrastructure projects under a public-private partnership (PPP) agreement that reverts to public ownership after a certain time. Usually the debt schedule will last as long as the project is expected to last for so that when operations stop, the debt is repaid.
Businesses with Planned Liquidation: Companies that are established with a clear intent for liquidation within a certain timeframe, where the business model does not involve perpetuating operations beyond a specific date. In these cases, the financial model would focus on recouping the initial investment and realizing any potential profits up to the point of liquidation without needing to account for a terminal value.
Startups with a Defined Exit Strategy: Some startups are created with a specific exit strategy in mind, such as acquisition within a known timeframe, rather than long-term independent operation. While these businesses might still benefit from a terminal value in some valuation contexts, detailed exit plan models focusing on the expected acquisition price might not incorporate a terminal value in the traditional sense.
Ventures Dependent on Non-Renewable Resources: Businesses whose primary operations are tied to the extraction or consumption of non-renewable resources, and for which no plans to diversify or transition to renewable resources exist, may not use a terminal value in their models. Their financial viability is inherently limited by the quantity of the resource they have access to. I've got an oil and gas model that fits this spec.
Short-term Contracts or Ventures without Renewal Expectations: Some ventures are based on contracts or agreements with a clear end date and no expectation of renewal. For instance, a company might be formed to deliver a one-off event, such as a large festival or a construction project, where the business activities are expected to wind down completely post-delivery.
It's worth noting that while these scenarios might not necessitate a terminal value in a traditional DCF model, it doesn't mean they lack long-term value or potential. The approach to valuation or financial modeling will simply adjust to reflect the unique characteristics of the business or project, focusing more on the explicit forecast period and any residual value up to the point of cessation of operations, liquidation, or contract fulfillment.
In all the models I build, you will find an on/off switch for the terminal value, if there is a terminal value option in the first place.
Article found in Startups.
