Valuation of Start-ups – The Risk Factor Summation Method
Prateek Mittal
Welcome back people to our series of articles on Valuation of Start-ups. So far we have discussed a couple of methods for valuation of pre-revenue start-ups. The first was the Venture Capital Method and the second one was the Scorecard Valuation Method.
Here we discuss the third method for valuation of start-ups, the Risk Factor Summation Method. While this method is somewhat similar to the Scorecard Valuation Method, there are some differences in application.
The first step of the Risk Factor Summation Method is the same as the Scorecard Valuation Method which is determining the average pre-money valuation of pre-revenue start-ups in the region.
The second step is to evaluate the following risk factors and assign a score to them ranging from +2 to -2 depending on the effect of the risk factor on the business and valuation of the start-up. The risk factors are as follows:
- Management
- Stage of 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
For each 1 point $250,000 is added or deducted from the average pre-money valuation of the pre-revenue start-ups in the region to arrive at the pre-money valuation of the start-up in question.
Suppose, the pre-money valuation of pre-revenue start-ups in the region comes out to be $1.25 million.
Out of the above Risk Factors, 5 are rated to be neutral i.e. 0 rating, 2 are rated +2, 2 are rated +1 and 3 are rated -1 then the total comes to +3.
The pre-money valuation will be = 1.25 + 3*0.25
Hence, the pre-money valuation of the start-up in question will be $2.0 million.
With this, we end our three part series on valuation of start-ups. We have discussed three methods for valuation which are used more frequently by the angel funds and venture capitalists to value a pre-revenue start up. The traditional methods of DCF, Relative Valuation, Book Value, Liquidation Value, Fair Market Value are mostly irrelevant for a start-up which is not yet started generating revenue.
However, even in these methods, we are not saying that any one method is a fool proof way of arriving at a valuation. Usually in a practical scenario, an investor will apply a combination of these methods to arrive at a valuation.
Remember one thing that the valuation is a range while price is the amount paid by the investor. One can determine the range of values for a start-up using the above methods but then it depends on the negotiations between the founders and the investor on what price the final investment is made.