The Berkus method provides entrepreneurs and early-stage investors with a simple framework to value a pre-revenue startup by focusing on risk factors instead of financial projections. This method is useful for founders and early-stage investors (angels, early-stage venture capital, and crowdfunding backers). However, the model’s simplicity does not replace the need to perform comprehensive due diligence of the startup.
A pre-revenue startup valuation method
The Berkus method is a method to value companies before their first revenues. The method was invented in the 1990s by Dave Berkus, a well-known US angel investor and venture capitalist.
Young startups often fail to live up to their expectations. In 2019, the startup failure rate amounted to 90% according to Investopedia. Recurring reasons for failure are a lack of funding, corporate governance issues, operating in the wrong market, a lack of research, ineffective marketing, and bad partnerships.
The model was developed as a reaction against the poor track record of start-up companies to meet their financial targets. Dave felt financial projections could not be relied upon for startup valuation purposes. Management forecasts often assume aggressive revenue growth and include unrealistic profit margins. That is why banks perform sensitivity analysis to assess a company’s repayment capacity, and why the Berkus method approaches startup valuation from a risk perspective. There is a belief that management forecasts are often too rosy.
The Berkus method of valuation assigns a value to the business idea and the company’s 4 principal success factors. Each category counts for a maximum of $500,000. In its original format, the Berkus Method allows for a maximum valuation of $2.5 Mio (including revenues) or $2 Mio (excluding revenues).
The key value drivers represent risk areas that can make or break the company. These principal risks need to be carefully managed if the company is to become successful. The value of the company increases when the company’s key risk areas are derisked. Hence, risk reduction and company valuation go hand in hand.
The method only applies to very young, pre-revenue startups. It is not appropriate to use the Berkus method to value a company with recurring revenue streams.
THE BERKUS METHOD CAN EASILY BE MODIFIED
Dave designed the Berkus method to fit his own needs. However, the Berkus method of valuation is universal. It is not restricted to a specific geography, sector, and/or currency. The model can easily be modified to fit your purpose. Some common adjustments are:
Change of the category valuation amounts
The values can be modified upward or downward to reflect prevailing market conditions in your country. The $500,000 value is merely an indicative value from which you can deviate. So, the valuation can exceed the $2.5 Mio threshold of the original Berkus method.
- An important aspect of startup valuations is the geographical location. In the US, startup valuations are the highest in the Pacific and Northeast regions. According to Kauffman Fellows, a venture capital investment of $1,000,000 buys 1.5x-2.5x more equity in non-coastal regions relative to the coast based on 2017 data. While the Bay Area continues to be the dominant player in the US venture capital landscape, VC capital finds its way easier to other parts of the country. In Q1 2021, Pitchbook published a read-worthy research note on the US Venture Capital landscape.
- The valuations in developed countries differ from the valuations in emerging countries and frontier markets. There are many potential explanations, such as higher country risk, smaller market opportunity, and differences in the cost of living.
- Since the Berkus method of valuation can easily be applied in other regions, the USD can also be swapped into your local currency.
- Today’s business environment differs from the business environment in the 1990s. A valuation of $2 Mio in the 1990s is higher relative to a valuation of $2 Mio today.
- The valuations of startup companies move in tandem with the market conditions. Startup valuations are higher during bull markets because investors are less risk-averse. In contrast, startup valuations usually decline as a result of economic downturns.
Replacement of the startup’s key risks
While the Berkus model was developed to value technology startups, the key risks can be replaced to match your requirements. For example, the key risks for an R&D-intensive company differ greatly from a retail company.
- In 2005, Alan McCann published a variation of the Berkus method where he swapped and relabeled some categories. Manufacturing risk was changed to development risk, and technology risk was replaced by investment risk.
- Development risk is much broader than manufacturing risk. It would also cover a situation where a pharmaceutical/biotech company needs to get marketing approval from the Food and Drug Administration (FDA) to commercialize an innovative, new medicine. The receipt of a government license or an essential quality/health inspection certificate would also fall under development risk.
- Alan introduced investment risk in his version of the Berkus method because he considered it as a principal risk. If investment risk is not a key risk for you, you can swap it.
- In short, this method invites you to consider your principal risks and assign a value to them depending on how well these risks are controlled.
THE STARTUP’S REVENUE HURDLE LOWERED
Dave Berkus used his method to value pre-revenue startup companies that had at least the potential to reach $20 Mio within 5 years. His investments need to yield at least 10x the original investment over their life to compensate for the extreme risks involved in startup investing. The hurdle rate of $20 Mio is equal to 10x $2 Mio. This number is inspired by the US market. If the valuations in your geography are lower, you can simply set a lower hurdle rate. However, it gives a good indication of the type of returns that professional investors are looking for.
THE ADVANTAGES AND DISADVANTAGES OF A BERKUS VALUATION
The key advantages are:
- The Berkus method is a very simple model that is based solely on qualitative aspects. This makes it a popular method to value pre-revenue startups. The method delivers a rough valuation estimate.
- The model can easily be modified (geography, sector, currency) to fit your circumstances.
- The method makes the user think about corporate governance and risk management topics, for example, what are the company’s strengths and weaknesses, does the management team possess the skills and competencies to deliver, how does the startup deal with conflicts between the founders, etc.
- It provides founders and early stage investors (business angels, venture capital funds, and crowdfunding backers) with a simple and quick valuation method. For example, I have seen several pre-revenue startups raise capital on crowdfunding platforms, such as Wefunder and Crowdcube. Their pre-money valuations were sometimes exorbitant for the risks that investors were taking!
The main limitations are:
- The model’s simplicity is its greatest strength, but also its greatest weakness. Founders and investors need to realize that startup valuations are the result of negotiations. Moreover, founders and investors have conflicting interests while discussing a potential investment deal. Founders benefit from high valuations while investors benefit from a low valuation. A Berkus valuation exercise can theoretically be completed within minutes. However, you better develop a solid understanding of the company’s business risk profile, key risks, and risk mitigants. The method’s simplicity does not replace the need for a comprehensive due diligence of the startup. Last, you would benefit from documenting your value drivers. These justifications might come in useful during the negotiation phase.
- The method ignores one of the most common pitfalls for startups: financial risk. While there are good arguments for this approach, a comprehensive financial plan is still required for any startup to assess its capital requirements, and to develop a better understanding of the company’s dynamics.
All in all, the Berkus valuation method is a simple, flexible, and user-friendly valuation method for pre-revenue startups. The valuation method disregards management’s financial projections completely. Instead, this method emphasizes that management of key risks generates value. This is an important insight because risk and risk management are often insufficiently considered by entrepreneurs and investors.
However, the simplicity of the method does not replace the need to conduct comprehensive due diligence. To arrive at a valid valuation, you need to have a solid understanding of the company’s business risk profile and key risks.