The Berkus Method: Valuing an Early Stage Investment.

Posted on March 25, 2012 by Dave Berkus

The Berkus Method was updated in November, 2016, and is available here…

For those of us who’ve invested in early stage companies, especially technology startups, we have confronted a universal problem.  There are many ways to project the value of a company for purposes of pricing an investment, but all rely upon the revenue and profit projections of the entrepreneur as a starting point.  Many formulas then discount those projections according to some set percentage or by assigning weight to elements of the enterprise.

And in my opinion, all fail to take into account the universal truth – that fewer than one in a thousand startups meet or exceed their projected revenues in the periods planned.

Years ago, confronted with the same conundrum, in the middle 1990’s I came up with a method of assessing the value of critical elements of a startup without having to analyze the projected financials, except to the extent that the investor believes in the potential of a company to reach over $20 million in revenues by the fifth year of business.

[Email readers, continue here…] First published widely in the book, Winning Angels by Harvard’s Amis and Stevenson with my permission in 2001, the method has undergone a number of refinements over the years, particularly in the maximum assigned to each element of enterprise value, reducing those amounts as the investment market adjusted from the craziness of the bubble to more logical values in the years that followed.  Because the Internet has such a long memory and documents from the distant past can be found with ease, a search the “The Berkus Method” today will yield a number of conflicting valuations culled from the many subsequent publications of the method over the ensuing years.

Here is the latest fine-tuning of the method. You should be able to adopt it to most any kind of business enterprise, if your aim is to establish an early, most often pre-revenue valuation to a start-up that has potential of reaching over $20 million in revenues within five years:

If Exists:                                                 Add to Company Value up to:

1. Sound Idea (basic value, product risk)            $1/2 million

2. Prototype (reducing  technology risk)             $1/2 million

3. Quality Management Team (reducing execution risk)    $1/2 million

4. Strategic relationships (reducing market risk and competitive risk)   $1/2 million

5. Product Rollout or Sales (reducing financial or production risk)         $1/2 million

Note that these numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million), but certainly also allowing the investor to put much lower values into each test, resulting in valuations well below that amount.

There is no question that startup valuations must be kept at a low enough amount to allow for the extreme risk taken by the investor and to provide some opportunity for the investment to achieve a ten times increase in value over its life.

Once a company is making revenues for any period of time, this method is no longer applicable, as most everyone will use actual revenues to project value over time.

Posted in Ignition! Starting up, Raising money | 17 Comments

Address the five risks to increase your valuation.

Posted on March 15, 2012 by Dave Berkus

In the creation of a new enterprise, there are five principal risks to be addressed by the entrepreneur.  Professional investors will probe these five risk areas and make the decision to invest based upon comfort with each.  So it is important for the entrepreneur to identify, address and mitigate each of these in order to increase valuation and decrease the risk of ultimate loss of the business.

First:  Product risk.  Is the product or service possible to produce at all, let alone economically enough to compete in the marketplace?  One way to mitigate this is by using early money to create a prototype, to perform market research, to complete the first generation of the product, or to deliver the service to a satisfied customer.

Second: Market risk.  Are you ahead or behind the market with your product or service?  Will the public respond in numbers to buy, license or rent your offering?  This risk can be mitigated by finding a customer willing to purchase as soon as a proven model is completed, and willing to state this in writing.  Another is to gain the support of a core vendor who is willing to offer special extended terms to the company as its investment in creating the product in a finished state.  A third demonstration of overcoming market risk is by holding controlled focus groups and gathering information from unbiased potential customers supporting the acceptance of the product or service.

[Email readers, continue here…]   Third: Management risk.  A great idea often fails from the inexperience or inability of management to bring the idea to market.  Similarly, great management often can manipulate an original idea or business plan into one much more attuned to the market, adding tremendous value that might have been lost sticking to the original plan.  This is sometimes labeled “execution risk” addressing whether management can create and run the company producing the product acceptable to the marketplace.

Fourth: Financial risk.   Any new enterprise is at risk if there are not enough resources to get the company to breakeven, which is a proxy for stability.  If a company truly needs five million dollars to get to breakeven, investors that provide the first million are greatly at risk of the company failing to raise the remaining capital or of subsequent investors valuing the company at a lower price than the first investors, causing a “down round” in which the early investors are punished for taking the first risk.

And fifth: Competitive risk.  If there are high barriers to entry with such protections as patents, long development time already spent or contracts with the major potential customers, then the risk of a competitor with more resources jumping into the frothy pool and taking advantage of the demand created by the company is minimized.

Reduction or elimination of one or more of these risks increases the valuation of the company and certainly improves its chances of survival and growth.

Posted in Finding your ideal niche, Ignition! Starting up, Positioning | 4 Comments

Beware the “dirty cap table.”

Posted on March 8, 2012 by Dave Berkus

When you seek professional investors, whether organized angels or venture capitalists, one of the early questions you are asked is “How have you financed the business so far?”  Investors love to see entrepreneurs who have used their own money to ignite their businesses.  But often, entrepreneurs turn to others for initial capital. Describing that capital using the phrase “friends, family and fools,” or “FFF,”   has become as common as to be trite.  And even more recently, “crowd sourcing” has been enabled by the Internet – seeking many investors at a small amount per investment.

The problem in taking such money rests in the legality of taking money from non-accredited investors, people who do not meet the SEC standard for making non-public company investments.  Currently that standard requires a minimum of $200,000 in annual income or over one million in net assets, including the value of the investor’s principal residence.  Since many small investors in a young business do not meet that standard, there is a chance that the company has taken money that it should not have taken, according to SEC rules.  There is an exemption for members of the entrepreneur’s family and in some cases for close friends with intimate knowledge of the entrepreneur and of the plan and, of course, for employees of the company.  It is worth checking with an attorney to see if such investors are truly exempt.

[Email readers, continue here…] Some small companies work to create “private placement memorandums,” attempting to protect themselves against this problem, couching the proposed investment in legal language stating the risks involved in making the investment.  The PPM does nothing to mitigate that problem when the investor is not accredited.

To compound the problem, often stock is issued by the entrepreneur without filing any report of such issuance with the state of issue.

The sum of these problems is that a disaffected investor can sue the entrepreneur or the entrepreneur’s company for a rescission of the investment and return of the money invested if the money was taken improperly, especially when the business has failed and the investment lost, putting the entrepreneur at risk for the loss of additional personal assets.

The cure for this, when professional investors enter the picture, is for the company to craft a “rescission offering” to those shareholders who invested illegally, offering to repurchase their shares at full value invested.  This is sometimes difficult since it often happens just at the time a company needs new money most and is in the process of seeking that money for growth.  If a previous investor does not accept a rescission offer, there is some insulation provided to the company against a future lawsuit by that investor.

So, plan to take money only from qualified investors. Check with your attorney if there is any doubt.  The risks of a problem rise with unmet investor expectations, and fade with success.  But sometimes, such behavior will cause a subsequent angel or venture capitalist to pass on an otherwise good opportunity, and that would be a shame, one that could have been avoided by diligent process in the early investment cycle.

Posted in Growth!, Raising money | 6 Comments

Personal Guarantees are a fact of life for many entrepreneurs.

Posted on March 1, 2012 by Dave Berkus

Starting and running a small or growing business can be a challenge to the most confident and optimistic entrepreneur.  And the process of borrowing money or financing asset purchases can be an eye-opener for those who are not used to today’s lender and seller aversion to granting easy credit.

Most any entrepreneur with a clean credit record can obtain a bank card with a $50,000 limit, if s/he is willing to give a personal guarantee and has enough assets to back the promise it contains.  As the amounts get higher or as banks get into the picture, the negotiation around a personal guarantee becomes more of an issue with the lender and the entrepreneur.  As a rule of thumb, a company with a majority owner in control will be required to provide such a guarantee for most any borrowing of significant size in relation to assets.

But what happens when the entrepreneur has taken investments from one or more outside investors and may not even own a simple majority of the company’s stock?  [Email readers, continue here…]  To most lenders, the guarantee is still a requirement, putting the entrepreneur in a position of additional risk that is not spread among the shareholders.

At least one company has entered the market providing personal guarantee insurance to bridge this important and uncomfortable gap between risk and comfort.  For a fee, insurance can be purchased that will back up most or all of the guarantee in the event of a default, allowing the risk to be mitigated with cash. Since this is a new area for insurance coverage, there is much interest but little experience to create actuarial tables for the insurer or stories to tell for candidate customers.  But the very idea is one worth investigating if the problem is one you face.

All entrepreneurs assume risk when starting and growing a business.  It is only smart to consider ways to mitigate risks when opportunities to do so arise.

Posted in Growth!, Protecting the business | 4 Comments

Consider all resources before seeking investment.

Posted on February 24, 2012 by Dave Berkus

I cannot tell you how many times I have seen executive summaries of business plans in which the entrepreneur seeks $5,000,000 to build the business.

First, few startups can use that much money today with all of the virtual services available and increasingly inexpensive methods of development, prototyping and marketing. Second, almost no professional investor will consider putting that much into a startup until there is proof of market demand, product viability or some other mitigation of failure.

Third (if you’re keeping score), it is not wise to dilute the founder’s ownership greatly in the first round of financing.  The investors want a motivated entrepreneur, and it is certainly more difficult to motivate a twenty percent owner than a sixty percent owner.

Fourth, there is the matter of control.  Entrepreneurs have a vision for what and how to create and build a great business.  Giving control over that vision to others early on often dilutes the vision and is a disincentive to the entrepreneur.

[Email readers, continue here…] Professional investors love to see companies where the first round of financing came from the entrepreneur, showing “skin in the game” and more motivation to succeed because of money invested as well as time and creativity.

There are so many resources for early money to validate an idea, turn it into a product and increase the value of the company before professional investors come into the picture.

Starting with credit card debt or a personal loan and working through money from friends or family, or simply consulting to earn money for investment, entrepreneurs should consider early resources for capital to produce a prototype, do market research or start to build a team.  Once there is progress in any of these critical areas, raising professional investment is easier and the likelihood of a higher valuation makes for retention of more equity during the first important professional round.

Posted in Ignition! Starting up, Raising money | 3 Comments

Be approximately right rather than exactly wrong.

Posted on February 17, 2012 by Dave Berkus

I love this statement from John Tukey, coiner of the word ‘bit’ to describe a single switch of digital micro-data.  Tukey was a statistician, one you would expect to describe events in terms reeking with precision.

Instead, Tukey implored us to think in terms of relevancy, cause and comparisons to known events.  And all this ethereal talk makes me think of how we investors and entrepreneurs are often led to search for instances in which our plan can be wrong, based upon a past measure.  Or how one fact in an argument can be disproved, making the entire argument in error in the minds of some.

Yet, if we do bet upon the jockey with more weight in our decisions to invest than upon the horse (or business plan), then our goal is to be approximately right and not to discount the plan for failure of one element which can be proved precisely wrong.

I made an investment in 2000 in a company that a decade later returned 110 times our investment at its IPO on the NYSE.  I invested in the jockey even though I liked the plan.  And that plan changed several times during the early years, molded into one that worked unbelievably well, enough to create an entire debit card industry which the company dominates today.  It would have been easy for early investors to find reasons not to invest based upon any number of facts upon which the original plan was based, many of which could be proved exactly wrong in the minds of fellow would-be investors.

Early stage investing is more risky than later stage when we can look back, know and measure prior successes.  But the bet is more often upon the jockey and that s/he will be approximately right by maneuvering the plan with the management team, rather than executing a plan that was flawed as originally written, and in retrospect exactly wrong.

Posted in Finding your ideal niche, Growth!, Positioning | 1 Comment

Is it the jockey or the horse?

Posted on February 10, 2012 by Dave Berkus

                Early stage investors have been arguing over this for years.  Do they bet on the entrepreneur (jockey) or the business idea and plan (the horse)?   This is serious stuff.  If you are looking for money, this question will certainly come up in one form or another when you approach professional or organized angel or VC investors.

                My answer always varies as I examine each deal, sometimes deferring and passing on an investment because of an uneasy feeling about the entrepreneur, even if the business plan seems able to capture the market.  Speaking for others, I see VC investors jumping into deals knowing that soon they will push to replace the entrepreneur with a professional, experienced manager that the VC has vetted and trusts.

                I have bet on the entrepreneurial jockey a number of times and been blind-sided by after-investment behavior that completely reversed my opinion about an entrepreneur’s ability to manage growth to breakeven.  Other times, the entrepreneur went on to assemble a great team and execute the plan as it inevitably changed again and again.

[Email readers, continue here…] Although this debate will continue for ages, I tend to fall on the side of betting on the jockey, simply because it has been a rare business plan that did not change again and again seeking a successful model in the marketplace.  And great management is able to morph a company to adopt without destroying the culture of the company in the process.

                What if you were the investor and someone walked into your office handing you a business plan executive summary that floored you with its brilliance?  And what if that person admitted immediately that he or she had no team and was not the person to take this plan to market?  Would you, as an investor, plow money into the plan and help to incubate the idea into a real enterprise?  I would not, nor would most all of those I co-invest with.  There are millions of great plans that failed over the years for want of a great management team.  And I am sure there are many, many average plans that developed into great companies with the help of a great team.

                So if you are one of the entrepreneurs without experience or ability to take your great plan to market, admit this early and form a team that investors can trust to do this, personally stepping into a position that fits your core skills, be it marketing, sales, development, or other areas required by a young company.  

                It would be refreshing as an investor to meet an entrepreneur with a great plan and a pre-formed management team fronted by the strongest possible leader, even if the entrepreneur offers to take a back seat in order to make the vision a grand reality.

Posted in Raising money | 3 Comments

Learn the science – practice the art of negotiation.

Posted on February 3, 2012 by Dave Berkus

From the time we learn to manipulate our parents from the crib to the present day, we learn to negotiate to obtain our wants and needs.  As we grow, we negotiate constantly with our parents, then with our peers.  As we enter the business world, we negotiate with our bosses and our subordinates.  We negotiate with our suppliers, customers, investors, and even our auditors. At home, we certainly negotiate with our spouses or significant others.

If we are constantly negotiating to obtain an advantage or just a win-win attempt at parity, we should make an effort to learn and then practice the art of negotiation (although I prefer to think of it as a science then delivered in its final form as art.)

Because I believe that negotiation is so important to our success in the business and in the social world, I re-read my favorite book on the subject again every couple of years, just to keep myself aware and sharp using the tools and techniques so important to a successful negotiation.  The book, You Can Negotiate Anything, by Herb Cohn was first published in 1980 and is available today as the best and easiest to read of all the books on the subject.  I implore you to read this book and internalize the three crucial variables, the many styles of negotiation, and the fourteen powers you can call upon or recognize when used by others in a negotiation.

[Email readers, continue here…]  Over the years, I have been delegated by a number of entrepreneurs and boards to negotiate critical agreements, sometimes to sell the company or merge it with another.  I was selected because I did not have an emotional stake in the outcome as did the entrepreneur, or the continuing relationship with a buyer as would others in management who might remain after the sale.  With that freedom, I was able to use the tools of negotiation to achieve a result better than if I worried each moment about disrupting the deal when making each move and countermove.  There is a lesson there, one the same Herb Cohn quoted in a later book, in which he entreated his readers to negotiate with care, but “not that much care” as to lose perspective.

I recall one such instance, when delegated to be the lead in negotiating a sale of a company on whose board I sat, I asked the entrepreneur to name his expected price in an ideal sale, which he did immediately as if he’d been thinking of this for some time.  Surprising him and the rest of the board, I asked him to go home and not to attend the negotiation session set for that evening at a local hotel, promising to call him immediately with the outcome.  I am sure he worried over losing control of his most important business negotiation ever, but he did cede the task to me (and another board member). 

Doing my homework ahead of time, using one of Herb Cohn’s principles (please read the book), at the start of the negotiation I placed a paper in front of the negotiator representing the intended buyer, showing how our company would be accretive to their public company valuation, properly valuing our purchase at three times the ideal amount as stated by our entrepreneur-CEO.  The buyer looked over the numbers for a few minutes, recognizing the accuracy of my statement from his due diligence and knowledge of his own financials.  In a sincere response so transparent as to be an obvious truth, he stated, “Oh, but I only have authority from the Board to offer two-thirds of that” which of course was twice our entrepreneur’s the asking price.

After forty-five minutes of further negotiation, we walked from the room with an agreement to sell the company for cash at twice the asking price.  And as the entrepreneur still tells the story, we two board members walk on water for having delivered such great results.  In fact, we had done our homework, presented a logical case, and created a win-win by leaving enough value for the buyer to add to its market capitalization as well as doubling our sales price.

Since we negotiate daily for things large and small, wouldn’t it be high on your list to learn to use the tools and be aware of the elements of a great negotiation?

Posted in Depending upon others, Positioning, Surrounding yourself with talent | 8 Comments

Watch out for the gray areas in non-competes.

Posted on January 27, 2012 by Dave Berkus

   What if you are the seller of a previous business or shares amounting to more than an insignificant percentage of a previous business?  Certainly the buyer’s asset purchase documents included a non-compete clause, usually valid for two years from the date of the closing.  And because there was consideration paid to you in the sale, that clause is binding upon you and is effective almost everywhere.

                  Well, what if the buyer is now bankrupt?  That does nothing to regain your right to its purchased information.  The estate of the bankrupt company retains and can resell those rights into the infinite future.  (Patents expire after 14 or 20 years – depending upon type – and publicly disclosed patent information is no longer subject to the agreements after that expiration, as long as you use only the publicly disclosed information as filed within the patents themselves.)

 [Email readers, continue here…] What if the buyer abandons your previous product?  That does not change their purchased rights to it.  What if you invent a substantial enhancement or change to the product?  As long as you did not use patented processes or trade secret material from you previous company, you should be protected, but you might be prepared for a fight.

                How about after the two year limitation in your agreement?  Separate confidentiality from non-compete, and obey the confidentiality clauses.  The non-compete agreement does expire when stated.  But watch it. Some clever buyers try to slip in an unlimited non-compete, and some courts have upheld this.  And there are gray areas for former key employees who signed a non-compete with a limited life as part of the sale, but remained on for some time thereafter employed by the buyer.  Does the non-compete start anew upon the employee’s departure?  Courts tend to apply only the reasonableness standard to these gray area cases, looking to see how much the person now competing gained from the original sale.

                The safest advice is to avoid using any materials from the previous company, and compete only after the expiration of any written agreements or clauses signed with the buyer.

Posted in Depending upon others, Ignition! Starting up, Protecting the business | 1 Comment

What about previous company non-competes?

Posted on January 20, 2012 by Dave Berkus

Entrepreneurs tend to remain in the business arena they came from.  Some are alumni from companies that would be a competitor to the enterprise being created or joined.  And some are former selling shareholders of just those businesses.  What is the rule about those pesky non-compete agreements signed upon discharge or sale of the previous company?

The good news is that if you were not a significant (usually 5% or more) selling shareholder of a previous company, many states specifically exempt non-compete agreements signed between companies and their employees or minority shareholders.  In that case, you must worry only about information and trade secrets taken from the previous company which are both certainly subject to protection by almost all laws and courts.

So, to everyone: do not take customer lists, design documents or any document considered a trade secret from any previous employer or previous consulting customer.  Yes, some companies were sloppy and did not have you sign a confidentiality agreement, but that procedural slip does not protect you from their legal wrath.  Further, there is no expiration on these documents. You cannot complain that the document or information in question is more than five years or two employers old.

Posted in Depending upon others, Protecting the business, Surrounding yourself with talent | 3 Comments