Every startup needs to consider valuation because it allows the owner to decide how much stake in the company they can afford to give an investor when raising funds. High valuation means they will give fewer shares for more investment, and low valuation will mean more shares for less investment. Valuation is also very important from an investor’s perspective because it will allow them to gauge the returns based on how much they invest. However, the valuation of a startup is challenging, given that they have negligible revenue to make a forecast, and they’re highly susceptible to failure. Valuation experts often use different methods to present a valuation as accurately as possible. Berkus method is one of the best and most widely used methods.
The simple Berkus valuation approach may be used to estimate a company’s pre-revenue. By concentrating on risk considerations rather than financial expectations, the Berkus method provides founders and early-stage investors with a straightforward way to assess a firm before it generates income.
Background on Berkus Method
In the 1990s, a reputed Angel Investor from California named Dave Berkus developed the Berkus method. He developed the Berkus Method to introduce fluidity in valuation, including quantitative and qualitative factors, as stated in his article After 20 Years: Updating the Berkus
Method of Valuation
the best way to value a startup is to give value to those elements of progress by the entrepreneur or team that reduce risk of success.
Berkus created this method solely on the fact that less than one in a thousand new businesses succeed in generating revenues that are as expected. So he questioned how one could utilize financial predictions as value criteria when you know how unlikely they will be reliable future indicators.
Advantages and Limitations of Using the Berkus Method
To understand how Berkus Method can be useful, it’s important to understand its benefits and shortcomings. Here are the main benefits of employing the Berkus Valuation technique for startups:
- It offers entrepreneurs and investors an easy valuation approach for startups.
- A traditional valuation method for a pre-revenue startup as it bases itself on qualitative aspects delivering a rough estimate of the startup’s worth.
- The method can accommodate modification to fit any business model and its circumstances.
- The technique enables users to consider corporate governance and risk management issues such as the business’s merits and shortcomings, the management team’s capabilities, how the firm handles founder disagreements, etc.
Here are the main limitations of using the Berkus method of valuation:
- Berkus method gives a quick valuation estimate, but it may not provide a complete picture of the business risk profile, some evident risks, and solutions to it.
- The method does not include the financial risk and other pitfalls to estimate valuation.
Now you know that the Berkus method is a simple and easy way to value a business by including the qualitative strengths that may help it flourish. However, one must consider its limitations and use supplementary methods and understanding of the subject.
Criteria and Factors in Berkus Method
The Berkus Method uses qualitative and quantitative considerations to determine value utilizing five elements:
- Sound idea (base value) — An concept is evaluated if it can address a problem. It may also enhance the industry’s business model.
- Prototype (combatting technology risks) — Replicates the idea or product to assess feasibility. Prototyping addresses flaws before investing time, money, and energy.
- Management (combatting implementation risks) — Depending on the founder’s reputation and the management’s efficiency, it offers security and contributes to valuation.
- Strategic Relationships (combatting market risks) — Startups often partner with large companies to use their knowledge and resources. These linkages show how a startup can improve deployment.
- Product rollout (combatting production risks) — Development concludes with the product launch, and it determines a startup’s success.
With this method, valuation is determined by giving each of the above criteria a monetary value, originally ranging from $0 to $500K, which leads to the max pre-revenue valuation of up to $2.5 million. Let’s see how it works below.
How Berkus Method Works
Five $500k zones gave the Primary Berkus approach a potential limit pre-money value of $2.5 million. For example, a business with:
- A potent business idea will get a valuation between $0 to $500,000.
- When the management team is great, they get an additional valuation between $500,000 to $1,000,000.
- A working prototype that customers are interested in adds more value, ranging from $1,000,000 to $1,500,000.
- With strong partners and alliances, they’ll get a valuation between $1,500,000 to $2,000,000.
- If the company has had the product rollout and shows signs of growing revenue and profitability, it will increase the valuation from $2,000,000 to $2,500,000.
With changing times, different areas businesses are located in, and different average valuations, the Berkus Method must modify the theoretical maximum. This change makes areas and amounts more versatile, represented in the typical startup value.
For example, If a startup’s average valuation is $5 million, all five regions would get 20% of $5M, meaning $1 million instead of $500k.
Let’s pretend a startup founder is interested in a standalone value. While there are no quantifiable considerations, having a solid understanding of pre-money valuations of company peers by sector is recommended.
This is because the Venture Capital Approach gives less weight to qualitative considerations like those listed above and instead emphasizes quantitative data from the industry.
The Berkus approach to valuing pre-revenue firms is simple, adaptable, and easy to utilize. It provides a helpful framework for early-stage venture capitalists and business owners to assess new ventures. To acquire an exact assessment of a startup’s demands utilizing various valuation techniques, though, it’s best to bring in an expert.
Consult experts at Eqvista, who can assist you in valuing your company, either as a startup or according to the requirements of Section 409a of the Internal Revenue Code. When you sign up with us, you may use Eqvista’s helpful features like cap table and shareholder management. Have more questions? Contact us today to learn more and get your startup valuation.