We'll cover five different methods for valuing startups, concentrating on valuing early startups and those that are in pre–revenue stages, starting with:
The Berkus Method
This method, which is used and defined by active angel investor David Berkus, involves a lot of estimation. The reason Berkus came up with the method is that he personally found that lengthy revenue forecasts rarely turned out to be accurate. According to Berkus, only 1 in 20 startups hit revenue forecasts, so he opted for an "eyeball" approach using a few key elements. The method applies best to technology companies, but can be applied to other products.
First, Berkus says that investors should believe the company has a potential to hit $20 million or more in revenues by the 5th year of operation. Then, he applies a scale to five components of a startup, rating each at up to $500,000. The components are:
- The startup has a sound idea–a product that provides a basic value with acceptable product risk
- There is a prototype, which reduces technology risks
- The startup has or plans for a quality management team to reduce risks in execution
- Strategic relationships are already in place, reducing risks for competition and market
- Product rollout and sales plans exist (not applicable to all pre–revenue startups)
Using the method, the highest valuation would be $2.5 million; a pre–revenue startup could only score $2 million. This is a very back–of–the–envelope method, but it can be a useful tool for angel investors evaluating startups in the earliest of stages.
Some disadvantages do exist with the Berkus Method, however, illustrating the point that no type of data should be considered in a vacuum. For example, this method doesn't consider market or competitive environment, which may be of importance in many situations.
Ross Blankenship is an expert on startup funding, angel investing and venture capital.
Ross Blankenship is also the Founder and CEO of AngelKings.com. Angel Kings is an investing platform that provides accredited angel investors the opportunity to invest in top startups and companies in sectors like cyber security, biotech, mobile, data and financial services. Angel Kings provides both venture capital funds for startup investing as well as private equity funding for early and middle-stage investments.