Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
Valuation is the process by which a startup’s potential worth is determined, as well as the ownership stake an investor will have in the business. For angel investors looking at early-stage startups, it can be difficult to assign a meaningful value to a company, especially when it has yet to generate any revenue. That said, it’s important to make an effort at the valuation process, as it bears directly on the profits you stand to earn during a successful exit. Doing so will indicate whether – and to what degree – an investment is worthwhile and will provide insight into comparable companies and the market in general.
Valuation may be conducted by the investor, by an angel group, or both. While an initial valuation must occur before any investment is finalized, it may be repeated at a later date during future rounds of funding.
Once due diligence has been completed, an angel investor may be ready to move forward. At this time, they’ll need to determine how much they’re willing to invest and the ownership stake they’ll require in return. These details will be specified in the term sheet and must be agreed upon by both parties. Because investors are seeking the best possible deal and startups want to be regarded as having worth in the market, valuation can be a touchy subject. Angel investors must make an effort to handle the process tactfully while also ensuring that all aspects of the company are being thoroughly considered.
Pre-Money Valuation Methods for Startups
There are multiple methods of valuing a business and no particular one is necessarily the right fit for any given investor. Many angel investors utilize multiple methods as a cross-check, while others rely on specific methodologies they’ve already tested and found to be reliable. The methods we’ll be discussing here are: the Scorecard Method, the Berkus Method, the Risk Factor Method, and the Venture Capital Method.
Scorecard (The Bill Payne Method)
The Scorecard method was derived by Bill Payne and is one of the most popular valuation methods for angels.
“This method compares the target company to typical angel-funded startup ventures and adjusts the average valuation of recently funded companies in the region to establish a pre-money valuation of the target” (Payne 2011)
The Scorecard method weights different criteria and then evaluates how the startup fares with regard to comparable businesses. It then takes the adjusted weight (or factor) and multiplies it by the average pre-money valuation of comparable startups to arrive at the target company’s valuation.
In order to utilize this method, angels must first research comparable startups in the region and determine their average pre-money valuation.
The first – and most heavily weighted – criteria is the team, with a weight of up to 30%. For example, suppose that you’re comparing the entrepreneur, the team, and the board against a similar startup from the previous year which had a stellar team. Perhaps you decide that, by comparison, the current company has 90% of that previous team’s strength. You’d multiply .30 by .90 to get .27. That number goes in the last box and is later summed with the other factors. Once all factors have been summed, that result is multiplied by the average pre-money valuation of the comparable startups. That final figure is the target company’s valuation.
The following table illustrates the different criteria that this method takes into account and their respective weights. The “Target Company” is the one which an angel is currently attempting to value. The factors are the adjusted weight, which will be summed together and multiplied by the average valuation of similar companies to yield the final result.
Bill Payne provides a worksheet to help angels better understand the impact of various issues on different criteria (see the link in the Resources section at the end of this article). While this method appears quantitative thanks to its range of weights and measures, it remains qualitative and will result in a subjective valuation. This will almost always be the case for early-stage startups.
The Berkus Method
The Berkus Method was derived by Dave Berkus and focuses on four risk factors. By reducing those risk factors, a company can earn a higher valuation. Essentially, the Berkus Method equates a certain amount of value with the reduction of a particular risk, normally $500,000. If a startup adequately reduces all four risks and also provides a sound idea (also valued at $500,000), it would then be valued at $2,500,000. The four risks taken into account by the original method are: technology, execution, market, and production.
While revisiting the method last year, Berkus noted that it’s important for angels to modify the method to suit their own needs. Not every startup has the same risks and the method should be altered as appropriate to each situation.
The Risk Factor Summation Method
While the Berkus method examines a small number of important risk factors to help judge valuation, the Risk Factor Summation Method, though similar in methodology, considers a greater number of risk factors and utilizes small sums to provide a more comprehensive valuation. This method’s goal is to force investors to consider the different types of risks in detail and to evaluate whether each is being sufficiently mitigated.
The twelve risks include:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/Capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each risk is considered in turn and the investor must assess whether the target company is positively, adequately, or negatively controlling and mitigating the risk. Each assessment carries a number, which then correlates to a value.
- +2: Very positive for growing the company and executing a successful exit
- +1: Positive
- 0: Neutral
- -1: Negative for growing the company and executing a successful exit
- -2: Very negative
With an average valuation for a pre-money, pre-revenue startup in hand, you’ll need to assess how the target company is meeting each risk. For every one point added, $250,000 is added to the average valuation. For every one point subtracted, $250,000 is subtracted from the average valuation. If, for example, you’ve completed your assessment and have added one very positive (+2), two positives (+1, +1), six neutrals, and three negatives (-1, -1, -1), that equals +1, which means that you’d add $250,000 to the average valuation. That new number would then be the target company’s final valuation under this method.
The Venture Capital Method
Introduced by Professor Bill Sahlman in 1987, the Venture Capital Method takes into account the amount that an investor wants to profit on their investment and requires that you have your calculator at the ready.
Most angel investors are hoping for a return on investment (ROI) of around 30x. In other words, once the company has been sold or the exit strategy implemented, the angel investor hopes to net thirty times their initial investment. For this to occur, the post-money valuation (the value of the company after an investment has been made) will equal the terminal value (the sale price of the company) divided by the anticipated ROI (30). In order to best estimate the post-money valuation, you’ll need to find industry-specific terminal value numbers for comparable companies. Once you have a good estimate for your terminal value number based on expected company sales and industry data ($60,000,000, for example), then you’ll divide that number by the ROI (30, in our case) to yield a post-money valuation of $2,000,000.
The post-money valuation is equal to the pre-money valuation plus your investment. Therefore, if the post-money valuation is two million and you are investing $1,500,000, then the pre-money valuation (the valuation before investment is made) is $500,000.
This method does not take into account risk factors. It simply considers the company’s anticipated sales price and the profit an investor desires on his investment. It should, therefore, be combined with other methods to provide a more balanced valuation picture.
There is no single, ideal startup valuation method. Some angels even apply multiple methods and then utilize the result that seems most fair or accurate. This practice also helps angels to become more familiar with the various valuation methods so that they can adjust each according to their own preferences. Similarly, they may find that an average represents the best valuation figure. Additionally, you’ll want to consider the possibility/likelihood of ownership dilution in the future (should a company require more investment) and take that into account during the initial valuation process. Generally, this means further discounting the valuation in proportion to the amount of expected dilution.
As you learn more about valuation, you’ll likely come across a particular phrase with some frequency: “It’s an art, not a science.” Experienced angel investors caution that valuing a company isn’t a discrete science, but more of an intuitive understanding of a business and an industry. Completing additional valuations over time will not only serve to familiarize you with the different methods and applicable terminology, but will help you to create your own valuation systems as the process becomes ever more intuitive.
The valuation process can be challenging for an investor, especially when faced with an entrepreneur who believes that his company is worth more than you’ve assessed. It’s necessary to develop strategies for effectively communicating your findings and for negotiating with entrepreneurs in order to ensure that suitable investment terms are reached. Once a valuation is agreed upon, you can then determine the amount of your ownership stake and whether you should proceed with the deal.
The Scorecard Valuation Method: http://billpayne.com/wp-content/uploads/2011/01/Scorecard-Valuation-Methodology-Jan111.pdf
The Berkus Method: http://berkonomics.com/?p=2752
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.