How Angel Investors Value Pre-Revenue Startups (Part III)
Very few young startups meet or exceed their initial financial projections so that’s why angel investors give value to certain qualitative elements of the startup. No matter the region, product or industry, investors must reduce risk as much as possible. It’s important for you, the entrepreneur, to consider suggestions and methods to value your early-stage startup without existing revenue. Being aware of every method could only help you leverage and negotiate your own valuation with investors.
In a series of three posts, I’ve previously shared two pre-money valuation methodologies (Scorecard Valuation Method, Venture Capital Method) that are often used by angel investors. Below, in the third and final installment, we’ll review how investors apply the Berkus Method to value pre-revenue startups.
According to a super angel investor, Dave Berkus himself, the Berkus Method, “assigns a number, a financial valuation, to each major element of risk faced by all young companies — after crediting the entrepreneur some basic value for the quality and potential of the idea itself.”
The Berkus Method uses both qualitative and quantitative factors to calculate valuation based on five elements:
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
But the Berkus Method doesn’t stop with just qualitative drivers — you must assign a monetary value to each. In particular, up to $500K. $500K is the maximum value that can be earned in each category, giving the opportunity for a pre-money valuation of up to $2M-$2.5M. Berkus sets the hurdle number at $20M (in the fifth year in business) to “provide some opportunity for the investment to achieve a ten-times increase in value over its life.” Below is an assessment of a fictitious pre-revenue startup illustrating the general rules of the Berkus Method:
Above, with $500K as the maximum value per category, I assigned the greatest value to the quality of the management team ($350K) because the founders have deep domain expertise in their respective field. The quality team reduces execution risk. (After all, ideas are easy, but the execution is everything.) With so much risk undertaken by the investor, the startup’s management team must be fully capable of achieving long term success. The startup’s prototype ($300K) is sound, having minimal technology risk. Ultimately, I gave the startup a pre-money valuation of approximately $1.2M. To estimate your own startup’s value, download a copy of this Berkus Spreadsheet.
The Berkus Method was developed in the 1990s and Berkus has recently stated, “The original matrix is too restrictive, and should be a suggestion rather than a rigid form.” The method should allow for higher maximum value on elements not listed in the matrix. For instance, the pre-money valuations might be competitively higher in Silicon Valley than in New York City. According to AngelList Valuation Data, the average pre-money valuation in Silicon Valley is $5.1M compared to New York City’s $4.6M. The matrix should be able to be easily modified to respond to altered circumstances or conditions.
“Pre-revenue, I do not trust projections, even discounted projections.” — Dave Berkus
How to estimate the value of your startup before raising investment from angel investors is paramount. It’s also important to understand your investors interest such as the size of the exit they are striving for. There is no universal truth when it comes to valuations — Be flexible. The Berkus Method will not be relevant once your startup starts generating revenue, but it can certainly provide a simple approach to determining your value while in negotiations with investors.