Learn about this company valuation methodology aimed at early-stage startups.
“Those of us who have invested in early-stage companies, especially startups, have faced a universal problem: there are many ways to predict the value of a company with the goal of pricing the investment. But the starting point of many of these methodologies are the estimates made by the entrepreneur in terms of income and profits. And, in my opinion, all of these forget the universal truth: fewer than every thousand startups meet or exceed their estimates within the planned deadlines.” The Berkus Method helps you calculate how much your early-stage startups are worth.
These are the words of David Berkus, a renowned American investor and father of one of the company valuation methodologies aimed at early-stage startups: the Berkus Method. It was the nineties when Berkus came across a system that, in his opinion, managed to solve the question of how to make a valuation of those companies (especially technology) that were in the early stages and whose revenue predictions, therefore, were not reliable.
More than twenty years have passed since Berkus defined the bases of its methodology, which, in two decades, has been mutating to adapt to the market. If we look at the latest version, updated in 2016 by Berkus himself, these are the elements to take into account when valuing a startup:
The starting point is this: the candidate startup has to be sure that, by the end of the fifth year of operations, it will be able to reach a gross revenue of twenty million dollars.
If yes, let’s move on to the second phase: the risk factors that any startup faces. Initially, Berkus had summarized these factors as: product risk, technology risk, execution risk, and financial risk. And in the face of these, the investor had identified five elements of risk reduction: the idea, the founding team, the functional prototype, the strategic relationships, and the traction. To each of these elements, the investor can assign a value of up to half a million dollars, up to a maximum of 2.5 million dollars.
Today, Berkus recognizes that this $2.5 million maximum valuation loses steam when considering how the market for startup valuations has evolved. The sector and market in which each company’s product is developed completely determines this figure, explains the expert in his blog. “The method must be flexible enough for its users to negotiate or determine the maximum valuation they would be willing to accept in a perfect condition (if each factor obtained the maximum score),” he says.
Berkus also transfers this flexibility to risk factors. As an example, a startup developing a medical device could replace technological risk with the risk of FDA approval of its device.
“The risk is that these options will make a very simple process more complex […] but the relaxation of the listed restrictions will allow the Berkus Method to live in another generation, survive the effects of inflation, and better cater to the specific needs of niche market valuations,” concludes the expert.
The application of the Berkus Method ceases to make sense when the company begins to generate recurring revenue, since these become one of the bases of the startup’s valuation.
