The meaning of a “discount rate” is best understood by making a parallel with the interest rate you get from the bank on your savings account. While the interest rate is a % you use to calculate what 100 USD or EUR on your account will become after a number of years, the discount rate is a % to convert future cash into today’s money.
A start-up company with a product in development, for instance, will (hopefully) generate revenues in the future. The revenues in years x, x+1, x+2 etc. need to converted into today’s value with a discount rate. By first deducting future expenses from all future annual revenues, you get the Free Cash Flow in each year and when discounted those future free cash flows back to today, you will get what is called the company’s Discounted Cash Flow.
The discount rate will thus have a huge impact on the calculation of the value of a company. It is a % that will need to be determined in the valuation process, and it is not just the interest rate you get on a bank, but needs to also incorporate several risk factors. There are two kinds of risk factors that will need to be taken into consideration in the case of a biotech company with no products on the market:
- The general risk associated with the characteristics of the company, of which its management definitely the most important one.
- The product specific risk: obviously, a development project in phase 1 is much riskier than a phase 3 project. (this risk can be applied separately for a risk adjusted net present value calculation rNPV)
In other words, these are risk factors that determine whether the investor will ever see his/her money back, and collectively they will drive up the discount rate to a much higher % than the interest rate you get from the bank.
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