In this video, I want to briefly recap some of the issues that came up when we were determining discount rates, and I want to address certain questions that come up when people talk about valuation of startups. Where it is very common to hear investors talk about discount rates on the order of 30, 40, 50, sometimes 70 or 80 percent, where do those numbers come from? Now, before I discuss that, it is useful to be very clear about what it is that we included in the discount rates that we used for obtaining net present value of the projects we've been looking at. So remember that what goes into a discount rate is a combination of pure time value of money and some measure of risk. As we discussed in previous videos, pure time value of money is reflected by simply a risk-free rate, and that is, the interest rate paid usually by the US government for an equivalent period to the project that we are considering. A very common choice is the 10-year constant maturity rate or some yield on a 10-year government bond. Now, when it comes to risk, what we said is that the risk that we account for with our discount rates does not include idiosyncratic or diversifiable risk. So the assumption that we're making with regard to the component of risk that goes into the discount rate is that the investors in the firms we are considering, are holding well-diversified portfolios such that the risk of an individual company, anything that affects one individual company should wash away once I include many companies in my portfolio. So we are assuming that no investor chooses to put all their eggs in one basket, they hold a diversified portfolio of many companies. That will apply also when we're thinking about investments in early stage companies. So we are saying that what goes into the discount rate is just systematic risk. So just this component of risk that has to do with how my firm co-varies with the rest of the market, and we said that this is measured by beta. So the basic formula for the discount rate, if you'll recall, was given by the risk-free rate plus the market risk premium, so with compensation that investors require for holding risky assets. Notice that the risk-free rate is what you require just accounting for the time value of money, so the market risk premium will account for the fact that you are holding a risky asset, and then the beta adjusts this market risk premium up or down. The market has a beta of one by definition, so betas that are higher than one mean that firms co-vary more than one-for-one with the market, betas that are lower than one means that the firm co-varies less than one-for-one with the rest of the market. Now, this is a general point, a general theory of obtaining discount rates, and I now want to turn to specifically, how does one obtain the discount rates for very early stage firms, for firms that may be obtaining venture capital funds or angel funds, where it almost looks like this formula doesn't apply? In the next few videos, I will argue that it very much applies. The same logic is true for early-stage firms as it is for very mature firms, but we need to be very careful about what it is that we're accounting for when we're thinking about both cash flows and discount rates.
