Limited Math Valuation

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The so-called venture capital valuation method (more on that here) requires the ability to estimate cashflows over a period of several years and to determine what the exit value is going to be. Making reliable forecasts if there is no historic performance to base your future projections on and, as often is the case with new technology startups, when there are hardly any comparable companies available to use as a proxy may be tricky. The Dave Berkus method, a much less mathematically rigorous approach, offers a possible alternative.

As the name suggests, this method has been developed by Mr Dave Berkus, a US angel investor (more information about him is available here) in the 1990s. It is based on a fairly straightforward approach assuming that there are five key areas that are critical for any startup’s success. The progress the company has made in each and every one of them has a direct impact on its value as it allows to mitigate potential risks.

According to Mr Berkus those five critical areas are as follows:

  • Sound idea, the presence of which addresses the product risk
  • Prototype, the existence of which reduces the technology risk
  • Management team, the quality of which reduces the execution risk
  • Strategic relationships with key suppliers or customers that reduce the market risks and erect barriers to entry for potential competitors
  • Product rollout or sales, where the closer the company is to the point, the lower the possible production and financial risks

Each area is assessed and evaluated separately and gets assigned a monetary value ranging from USD 0 to USD 500 thousand. Thus, the maximum pre-money valuation of an early stage startup, which has demonstrated excellent performance in all the key areas, can not exceed USD 2.5 million.

While being more intuitive and less numeric, which may appeal to many, the Berkus method nevertheless has its drawbacks. First of all, it is calibrated using the statistics about company values and is based on the experience from the Silicon Valley area. In other markets such detailed data may not be available. And, of course, the valuation levels might be significantly different (meaning – lower) in other geographies.

Also, assessing progress in each of the key areas and translating that assessment into monetary value requires strong judgement and even some “feel”. That is hardly possible without a significant investment experience developed over time.

The Dave Berkus method is an alternative and straightforward way to estimate the value of a business which has not made its first sale yet. While there are obvious difficulties in applying it in the markets outside the Silicon Valley as the sole valuation instrument, it might serve as a useful tool to approach a startup valuation in a structured way. 

To conclude, there is no single foolproof method to estimate the pre-investment value so early in the company development cycle. My personal favourite from what I have seen so far is the formula suggested by another entrepreneur and business angel, Mr Paul G. Silva:

“a pre-money valuation of an early stage startup is whatever amount which is needed to give investors a 10x return assuming that the company does half as well as it projects in twice as long and having raised twice as much money as the founders today think they do”.

The return expectations can be lowered, of course, but the other assumptions are probably even on the conservative side.

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