The so-called venture capital valuation method requires at least some ability to estimate cashflows over a period of several years and to determine what the exit value of the company might be. Making reliable forecasts in absence of historic performance and, as often is the case with new technology startups, with hardly any comparable companies around could 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 Dave Berkus, a US angel investor. 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 of them has a direct impact on its value because every area represents another set of potential risks the startup is facing.
According to Mr Berkus those five critical areas are:
– 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. As a result, the pre-money valuation of an early stage startup which has scored the maximum in all the key areas cannot exceed USD 2.5 million.
While being more intuitive and less numeric, a feature which may appeal to many, the Berkus method nevertheless has its drawbacks:
– it is calibrated using statistics and experience from the Silicon Valley area. Such data may not be readily available everywhere. And, of course, the valuation levels might be significantly different (meaning — lower) in other markets.
– assessing progress in each of the key areas and translating it into monetary value requires strong judgement and even some “feel”. That is hardly possible without a significant investment experience.
– Dave Berkus developed his method in 1990s and the maximum values in each category have not been adjusted for inflation and other changes in the business environment since then.
– this approach only partially addresses the financial risks which are inherent in any early stage startup.
The Dave Berkus method is an alternative way to estimate the value of a business which has not made its first sale yet. In absence of hard data it offers a useful framework to assess the potential investment target in a structured and systematic way.
This note was first published on Medium.com on 24 October 2023.
