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All of the theories of finance agree on this point: when managers spend money, they use capital, so they should think about how much that capital costs the company. There are many ways to get money, and the average of all of them is called the weighted average cost of capital, or WACC. Most of the time, it’s just a weighted average of debt and equity, but some companies might have weird preferred structures or other things, so it could be made up of more than just two parts.

To figure out WACC, multiply the cost of equity by the percentage of equity in the company’s capital structure. Then, multiply the cost of debt by the percentage of debt in the company’s capital structure. Interest on debt is a pre-tax expense, so the tax rate reduces the cost of debt (it’s tax-deductible).

The answer is

Ke equals the price of equity. The Capital Asset Pricing Model (CAPM), which is explained below, says this.

Debt has a cost of Kd.This is how much interest the company pays on its average debt. Since the value of company bonds changes, it’s technically the coupon divided by the market value of the debt. However, this is usually too complicated for the task at hand, and unless the company is in trouble, just looking at the book value is close enough.

T is the corporate tax rate. Since you want to make a decision on the edge, you should use the marginal tax rate, which in the US is usually 35%.

Equity value = company market cap minus cash and debt.For a private company, the best guess is probably based on the price of the last round.

Vd = debt valueAs we’ve already talked about, the proxy is the book value.

For most startups, equity is the main way to get money, so it may be helpful to say that WACC = Ke (the cost of equity), which means that the discount rate should also be equal to Ke.

The capital asset pricing model (CAPM) is used to figure out the cost of equity.

The CAPM gives us the cost of equity, Ke. how much money investors think they will make when they buy the stock. If they think they won’t get this return, they’ll sell the stock, which will cause the price to go down. If they think they’ll get more than this return, more investors will buy the stock, which will cause the price to go up and the return to be higher.

The standard CAPM equation for Ke is

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Rf = risk-free rate of return. A US government bond with a duration that matches the amount of time an investor would think about when buying the stock is a good substitute. The T-bill for five years is a good stand-in. At the moment, the 5-year T-bill yields 1.7%, and the 10-year yields 2.2%, so a risk-free rate of 2% is a good substitute.

B (Beta) = The sensitivity of the expected return of the stock to the market return. have to use the past to guess. Mathematically, it is the covariance of this stock’s historical return and the market’s variance divided by the market’s variance. So B = Cov (Rs, Rm)/Var (Rm). The best way to figure this out is to look at the beta of public stocks that are similar. Beta seems to be about 1.3 for public SaaS companies today. Rm is the market rate of return, or what investors anticipate the market will return. Over the last ten years, the stock market has returned about 8% per year, which seems like a fair rate for investors to expect. There might be different points of view (for example, the 5-year rate of return is a lot higher). One would expect a much higher rate of return from a private company.

If you put all of this data into a SaaS company, you’d get

Ke = 2% + 1.3 (8% – 2%) = 9.8% – 10% for a publicly traded SaaS company.

Ke will depend on the assumption of Rm for a private or high-risk company (the market rate of return). In reality, this is very unstable and depends on the situation. Sometimes you can get cheap money, and sometimes you can’t. Even though a lot of situational judgment is needed, Cambridge Associates, which keeps track of the better venture firms, says that the average return on investment over 30 years is 17.7%, which is probably the best proxy.

Ke = 2% + 1.3 (17.7% – 2%) = 22.4% 20% is a good guess to use.

As a point of reference, we figured out beta by taking the average of the Google Finance betas for a number of public SaaS companies:

Workday is better than Salesforce.com by 0.53 points.

ServiceNow got a 1.11, NetSuite got a 1.5, LogMeIn got a 0.96, LivePerson got a 1.35, and Demandware got a 1.31.

The newer public SaaS companies (ZEN, HUBS, and MKTO) haven’t been around long enough for a good beta to be calculated.

We recommend that SaaS companies use the following discount rates when using DCF to calculate a more accurate customer lifetime value (LTV):

- 10% for public companies
- 15% for private companies that are growing steadily (say, with more than $10 million in annual recurring revenue and growth of more than 40% year over year).
- 20% for private businesses that haven’t reached scale and steady growth yet.
- Is there a reason why startup SaaS companies shouldn’t use a different discount rate than public SaaS companies since their goal is to show that they have the unit economics to become public companies? Yes, it’s likely that there is. With this analysis, we are going into new territory, so it will be interesting to hear what people think about this question.

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