How much is an early-stage company, or some stake in it, actually worth? Traditionally, practitioners have been encouraged to employ either comparables analysis (relative valuation) and/or discounted cash flow (DCF) analysis (absolute valuation) in their attempts to arrive at reasonable estimates; however, the outputs generated by these models tend towards uselessness as less than one percent of early-stage firms will actually manage to meet or exceed projections. This post explores two alternatives, the Berkus Method and the Risk Factor Summation Method, which have been developed specifically for early-stage settings. Though both are inherently imperfect, each is quite useful for assisting practitioners in the construction of logical (and believable) valuation narratives.
THE BERKUS METHOD
David Berkus developed his eponymous approach more than two decades ago. Since then, it has received only limited academic attention (it was first addressed in Winning Angels—a practical review of early-stage angel performance written by a couple of Harvard faculty members); however, it is both recognized and frequently employed in early-stage settings. Unlike traditional approaches which involve looking forwards a number of years, attempting to project financial performance, and working backwards to an appropriate valuation, the Berkus Method focuses on the subjective analysis of five key factors:
- Soundness of the idea (basic value)
- Prototype existence (reducing technology risk)
- Quality of the management team (reducing execution risk)
- Strategic relationships (reducing market risk)
- Existing sales (reducing production risk)
Once analyzed, individual factors are each assigned up to $500,000 of “earned” value. All five partial valuations are then aggregated to arrive at a definitive firm-level valuation.
Consider, for instance, a hypothetical startup scenario: a moderately interesting idea, a workable but rudimentary prototype, a completely unproven team, no strategic relationships, and little to no market testing. These facts could, perhaps, support the following valuation:
- Soundness of the idea (basic value) – $250,000
- Prototype existence (reducing technology risk) – $100,000
- Quality of the management team (reducing execution risk) – $0
- Strategic relationships (reducing market risk) – $0
- Existing sales (reducing production risk) – $0
Aggregated estimate of startup value: $350,000.
Is this a reasonable figure? Arguably, yes – it positively accounts for the two areas where the startup does seem to have some traction (the basic idea and the existence of an early-stage prototype) while simultaneously keeping the valuation down due to the risks inherent to the latter three factors. That being said, Berkus is, of course, wholly dependent on subjective estimates, so arguments could be made for either lower or higher partial valuations in all five areas.
Due to the fact that national startup valuation averages frequently exceed the maximum of $2,500,000, Berkus updated his approach a few years ago by encouraging the use of higher factor caps, when appropriate. So, a high-tech startup raising money in Silicon Valley, for instance, might attach a maximum of $1,000,000 or more to each factor while a low-tech startup raising money in Wilmington, DE might choose to stay within the original guidelines.
RISK FACTOR SUMMATION METHOD
The Risk Factor Summation Method is similar to the Berkus Method, but starts with a median valuation and proceeds to make set adjustments—up and down—based off of an analysis of twelve risk factors. Each risk factor is assessed as follows:
+2 Very positive for growing the company and executing a successful exit
-2 Very negative for growing the company and executing a successful exit
Every point is worth either plus or minus $250,000 when it comes to the final valuation (which starts at an appropriate geographic median).
The risk factors:
- Stage of the Business
- Legislation and Political Risk
- Manufacturing Risk
- Sales and Marketing Risk
- Funding and Capital Raising Risk
- Competition Risk
- Technology Risk
- Litigation Risk
- International Risk
- Reputation Risk
- Potential for a Lucrative Exit
Like Berkus, the Risk Factor Summation Method is also inherently subjective, so reasonable people can and likely will disagree on the conclusions drawn regarding different variables.
Neither the Berkus Method nor the Risk-Factor Summation Method provides us with either greater accuracy and/or precision relative to traditional valuation techniques; however, both help early-stage practitioners in the construction of logical (and believable) valuation narratives.