The Blankenship Method
The Best Way To Calculate Your Startup Valuation
Let's talk about the best ways to calculate startup valuation. We've got our own calculator on our website. We've got the methodologies that go behind them, which impact both the entrepreneur who's trying to raise money and the investor who wants to make sure they're getting the best deal. In our book Kings Over Aces, which you can get a copy through this course, we mentioned some factors that should go into your decision-making process.
Whether you're raising money for a startup or whether you are investing in these same companies, there are five popular methods to measure startup valuation.
The Berkus Method
There's the Berkus Method, which was invented by this guy named David Berkus and it essentially involves a lot of estimation. Berkus says that investors should believe the company has potential if they have around $20 million in revenue by the fifth year. These are all estimates, right? I have to say, I've never looked at a startup valuation or business plan, looked at the financials and never taken them seriously, but that's what Berkus believes.
I'll get to Blankenship's method here, but it's a starting place and as I always said, my father is a physician, he gets asked all the time, "What's the best diet, Dr. Blankenship? What should I go on?" And he says, "Look. Just pick a diet. Okay? If it makes you more disciplined, makes you more focused and you're more likely to get to your goal of losing weight." In this case, I'll draw the analogy here, from my personal experience, that having these startups who constantly ask me, "Hey, Ross, what do you think our valuation should be or what it should be raising at?" I'd say, "Look, I'm going to give you mine and I want you to use the Blankenship method, but you can use whatever you want as long as you stick to it and you have rationale and objectivity to it."
The Comp Method
The second is the Comp Method and this is the comparable transactions method. It's a common method used to value companies that are for sale, but it can also be used when considering startups. The basic principle is similar to real estate. If you buy a house on one street, or if you're thinking about buying a house on one street, what does a realtor do? In order to determine the value of that company, they look at an appraisal of the house on the same street that you're looking at. So, if you've got a house side by side, if one sells for 1 million and it sold six months before and you're looking to buy the house next door to it and they're offering $2 million, well, what justifies that double valuation?
The comp method gives the opportunity to determine your value based on what other companies in the same industry, with similar revenue patterns, with similar growth strategies or growth to determine, and so the comparable method calculation involves the EV divided by the sales ratio. So, EV divided by the Sales Ratio and essentially that becomes the market cap plus debt. Market capitalization plus debt, plus preferred shares. That's one side of the coin. Market capitalization plus debt plus preferred shares, this is the equation, minus cash and cash equivalents and annual sales.
Let's take this all together. If you're a startup with current annual revenues of $2 million and you want to determine what you're worth right now, you could review a second company which just sold for $50 million with annual revenues of $15 million. Now, this gives you an EV to sales ratio about 3.3. Applying that ratio to your similar startup gives it a value of $2 million times 3.3 or $6.6 million in valuation. Let me just say that again. If you've got a startup with current annual revenue of $2 million, that's solid. Nice start. Then, you know about a company out there that just sold for $50 million and they got up to $15 million, you have to determine your EV to sales ratio, which in this case would be about 3.3. You have to apply that to your similar startup. You take $2 million, which is your revenue, times that new EV to sales ratio, 3.3 and then you get 6.6. That essentially gives you a valuation. I think it's a little bit better than the Berkus method, but I don't think it gives the absolute best sense of what your valuation is, so we'll keep going. We'll find the best for you.
Risk Factor Summation
The next is the risk factor summation. Now, it does resemble the back of the napkin calculations that Berkus does and has a bit of itemized categories to work with, but it combines both subject and objective. The risk factor summation method includes everything from management, stage the business, legislate political risk, all the way down to potential lucrative acts.
What this essentially does is a multi-factor estimation of valuation. So, they take 12 different factors from management stage of the business, legislative political risk, all the way down to potential lucrative acts and they add up these estimations into a potential valuation. I have to say this, of all the ones that we've ranked to calculate methods, don't bother with this one. I just need to get it out there that it's too many factors and it will drive you crazy as a startup investor or as a startup consumer. I applaud you for trying to figure it out, but the reality is that there are easier ones and I'll take you to the Blankenship method which is what you should be using. What any startup or investor should be using. Just know that it's out there and if people talk about it, you can come back and say hey, it's on Blankenship's course at AngelKings.com so check it out there.
Discounted Cash Flow
The fourth thing is discounted cash flow. I would say this, even though the previous one we just talked about, which was the risk factor summation method, provides all these estimations, DCF or discounted cash flow method is the most complex, but quite stronger as a potential valuation. The only challenge with the discounted cash flow is that it's usually used in publicly traded companies and you get a sense of, for example, if Nike and Under Armour, which are in the same consumer space, are growing at a certain rate per year or per quarter, then you can analyze their sales. They're publicly available vis-a-vis SEC and all the information that's out there. Why DCF works is it's essentially just saying that you should take into account cash flow during a certain period and a discount rate supplied based on the risk of that cash flow. That's all it is.
What is the advantage? Well, the disadvantage to DCF is that a lot of these are such fly by night miscues, right? Or they could be miscues on your projections and frankly, I would tell you if you're a publicly traded company where all this information is more accessible, the DCF makes sense because if you can compare them to historical averages, when you're doing a private startup valuation, you don't get that accuracy of projections and forecasts. You also have to understand that startup valuations are somewhat mitigated by the fact that you had these major outliers, which was the .com bust and boom during the 1990s and you've seen a lot of the private valuations change differently and the cash flow change more rapidly with certain startups versus publicly traded companies. I think the point is this, I think that you could use the DCF, but you have to understand that there's not a lot of public information out there about these startups and comparing them to others. Secondly, they don't factor in a lot of the historical cash flow data that publicly traded companies have, so it is a method to consider.
The fifth one on our list is the asset based valuation method. The asset-based valuation method is also known as the book value valuation. This sort of goes back to the intelligent investor, Benjamin Graham's idea of determining the book value of a company based on a number of facets, but asset-based valuation is all known as book value valuation. It's definitely the easiest way for investors to get a sense of what the real value is, but, so what an asset valuation is is it's the original cost of all assets is adjusted by impairment cost and depreciation. The total physical asset values are added to any balance sheet, values, cash on hand, accounts receivables, other positive balance sheet items and then long-standing outstanding debts, or liabilities rather, or expenses are subtracted from the total to get the asset based valuation. Now, clearly there's an estimate. There're some projections that you have to do. Frankly, the asset-based valuation fails to take into account the intrinsic values of ideas of future successors, right? But you can apply the asset based valuation's projected assets, liabilities and cash flow. However, you still run up a little bit of the headwinds with the asset-based valuation, that some of the inherent valuation metrics aren't there.
Of all these, what the heck should you use? What should you use? I'm doing a summary and review of these and you can find out more detail about each of them, but which should you use? Look, I'll give you this. This is, by far, takes all these five methods: Berkus, Comp, risk factor, Discounted Cash flow, Asset Based valuation, all of them and it puts it in the best of the best. What we've done is we've got the Blankenship method. This is my method that has worked tried and true and made me a smarter investor. I've found awesome companies and I've been ... Fortune favors the bold. I'm bold but I can tell you these are the best. These work.
You've got to put together a nice pentagonal shape here which is people, product, process, traction, financials. Build your own model. This is what our model is. You've got to use this. People, product, process, traction, financials. If the startup we're evaluating fits our 5 metrics, and it's got a phenomenal starting team, which holds triple the weight in our 100-point based score, then it goes into our total Angel Kings score. People always gets scored first. We rank them based on our due diligence. We do everything from credit and background checks on the startup founding team; we interview them; find out their histories and any previous companies they've started. We've got all these different questions that we ask them directly and it helps startup investors because we do all of that due diligence for them. We've assessed them, especially since they have 3 times the value.
The second is the product. Are they building a product that will be around 20 years from now? Is it something that people love? Whether the startup is using an MVP to build a simple product, but whatever they're building, is it a product that's going to catch real traction? Is it something people will pay for and pay for 20 years from now?
Process. There needs to be a process in place for your product or for your service, where you've got efficiencies built in to make your startup work. You know exactly know much you're going to make and how fast you're growing. Is there an essential process that makes sense and is your startup running efficiently? In the future, if someone were to buy your company, would they only be buying your client list? Do you actually have a process in which you deliver your service that can be more efficient? That's part of my process both for products and services.
The fourth thing is traction. At each level, you, as an investor, get more metrics about what a company might be worth. You can tell how fast a company's growing. If you're investing in a company and it's not growing 2-5% per month in a year, don't invest in that startup where there's inherently higher risk. Invest in a publicly traded company where you can measure these. There's a value added where there is high growth. Make sure to see if there is massive traction - somewhere between 5-10% per month growth in users, growth in revenue at a company. If you don' see that, don't invest in them.
The fifth thing is financials and I put this last because it is the last part. As I said, if you're looking at a business plan, financials are always ones you have to take with a grain of salt. That's part of the business plan where people are saying this year we're going to make 500 grand, but 3 years from now we're going to be making $50 million a year. There's a lot of means to the end. How the heck did you get there? Our financial analytical model that we built at AngelKings to help investors make better decisions is ingrained in this sort of ... Not just ... What are your numbers, but what are the assets? Why are these assets? Are they assets? What are your liabilities? Personally, from the people, what sort of stake do you have in it?
Essentially what it comes down to is this. The Blankenship method works the best because we take very objective information combine it in subjective quizzing and background checks, vis-a-vis people. We ask further questions about the product and once all of the questionings are said and done, we've got a calculation that adds up to about 90 points. If a company or a startup that we're looking at doesn't have at least 90 points or more out of 100, then it might be time to move on. If they do, then we'll actually invest up to a valuation of $20 million. That seems like a lot, but we believe in that company. If it's a seed round, we'll even invest in a company and give them a valuation of up to $20 million. Some people listening will be like, "You're crazy. What industries would that make sense?" Well, cyber security, which is one of AngelKing's strongest investments.
Cyber security has had a phenomenally fast growth, cloud-based, huge multiples and so we've invested in companies that were worth $20 million with these 5 factors. This is why we did it. Up to $20 million in valuation. As you continue on, they have to add up even more. By series A where we've invested, we've got to get 95 points. These 5 primary quadrants here have to add up to 95 points or more and we'll invest up to a $50 million valuation at that point. The way we calculate startup valuations is simple. It's this idea that to go from a 1-4 on an earthquake scale, on a Richter scale, is not as hard as to go from a 4-5. So, as you're going from C to A to B to C to D rounds in your fundraising, well, it's harder and harder, especially in our method, the Blankenship method, to get a higher score so we're more selective.
The point is this. If you want inside information about how to invest intelligently, the Blankenship method combines both the objective and subjective principles of calculating startup valuations. People, product, process, traction, financials all add up to a score out of 100. That's the Blankenship methodology and you should absolutely use that. It's better than any of the Berkus, comps, risk factor, discount cash flow, asset -based methods by far. Get inside access to this to learn about how to build the next billion dollar company or invest in those that we've found for you at AngelKings.com/course.