TGR: Understanding Terminal Growth Rate for startup valuation

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In the world of startups, countless factors shape a company's journey. Entrepreneurs face a mix of opportunities and challenges as they navigate their path. One concept that constantly throws a curveball is the Terminal Growth Rate (TGR). It might seem like a minor detail, but it has a huge impact on the value of a company. Imagine setting up a startup and pouring in all the time, energy, and passion. The traction is amazing; investors are lining up, and the anticipation is sky-high. But then comes the valuation process. Numbers are tossed around, and TGR becomes the invisible hand guiding the company's worth.

So, what does it mean for a startup? TGR is a crucial indicator of the company's total value. Is it going to be something big and significant, or will it lose steam? The key is finding that perfect balance between ambition and reality within TGR.

Understanding Terminal Growth Rate (TGR)

The direction of a startup's financial journey should be predicated on the Terminal Growth Rate. In financial modelling, TGR refers to an important number that tells us how much more money will come into our company in perpetuity after specific projected years i.e. typically 5-10 years. Broadly speaking, what can we expect after this initial frenzy of growth? It's like seeing through the looking glass to determine whether a startup will thrive or stagnate in the future.

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TGR is a game-changer as it helps identify a company's Long-Term Value (LTV), an essential factor in determining its overall worth. It isn't just a numerical symphony; it's about how companies engage their investors. TGR places the company in an advantageous position during funding negotiations and offers a window into its future growth prospects. A realistic TGR supported by diligent analysis can enhance investor confidence and ensure the company's valuation is commensurate with its future potential.

Mastering TGR: Seeking the Sweet Spot

If the startup aims too high, it can make the company look better than it is, leading to an inflated valuation. But if the company is too cautious, it might end up selling itself short. The key is to strike a balance that makes sense and attracts investors who believe in the company's vision.

However, it is important to look at this number alongside other factors like the discount rate and the company's forecast period. This helps keep everything in line and prevents unrealistic numbers from throwing off the valuation. It is also important to keep checking in on the TGR as things change—like shifts in the market, the company's performance, or updates to the financial plans. This way, the valuation stays true to where the startup is.

Achieving the Optimal TGR: Balancing Ambition with Reality

Determining the appropriate TGR involves various methodologies. For instance, one way to approach this is to consider either the industry's average growth rate or the country's economic growth rate, on which the company's market and location will depend. Another approach involves looking at historical growth patterns by examining a company's growth over time, such as 5-10 years, to estimate its Terminal Growth Rate. It is also important to account for factors like industry trends, macroeconomic conditions, and management forecasts. The aim is to determine a TGR that is both challenging and achievable. Thus, a viable and astute TGR can be arrived at through careful consideration of these internal and external factors.

For example, assuming XYZ Inc., a phone company, is worth using a Discounted Cash Flow (DCF) model. First, it should look at how much money it will make over the next five years, considering things like phone sales and service revenue growth. Then look at how the company will grow after those five years. This is where the terminal growth rate is used.

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This rate should be a steady, long-term growth rate that the company can keep up with. It's usually lower than the big growth they might have seen from launching new products because they can't expect those kinds of spikes forever. It should also line up with overall economic growth, like the long-term GDP, and at least keep pace with inflation so the company's cash flow doesn't lose value.

So, if the analyst picks 3 percent as the terminal growth rate, it means they believe XYZ's cash flow will grow steadily at 3 percent after the first five years. This rate reflects the company's ability to keep innovating, maintain its brand strength, and grow sustainably. This 3 percent growth rate will play a significant role in determining how much XYZ Inc. will be worth.

Conclusion

The Indian startup ecosystem survives on game-changing ideas that grow exponentially. That often means companies flaunt sky-high TGRs to grab attention. Young entrepreneurs see these impressive numbers and believe they must show the same explosive growth to get noticed. But investors have seen it all before—they know that high TGRs without a proper business plan or a clear path to making money can be a threat.

Think of the Terminal Growth Rate as more than just a figure on a spreadsheet—it's a key part of determining whether the growth plans are on track. By taking a closer look at the factors affecting TGR, one can spot areas that need improvement and boost the startup's future growth.

Eklavya Gupta is CEO and founder of Recur Club.

The thoughts and opinions shared here are of the author.