Valuations 101: The Risk Factor Summation Method
The Risk Factor Summation Method is the fifth methodology for estimating the pre-money valuation of pre-revenue companies we have described in recent posts. Readers may have noted that both the Scorecard Method and the Dave Berkus Method considered a narrow set of important criteria for investment in arriving at a pre-money valuation.
The Risk Factor Summation Method, described by the Ohio TechAngels, considers a much broader set of factors in determining the pre-money valuation of pre-revenue companies. This method may be less useful as a stand-alone valuation method for investors, but it is my opinion that this method should be one of several methods used by early-stage investors to establish pre-money valuation because it forces investors to consider important exogenous factors.The Ohio TechAngels describe the method as follows: “Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit. Of course, the largest is always ‘Management Risk’ which demands the most consideration and investors feel is the most overarching risk in any venture. While this method certainly considers the level of management risk it also prompts the user to assess other risk types,” including:
- 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 (above) is assessed, as follows:
- +2 very positive for growing the company and executing a wonderful exit
- +1 positive
- 0 neutral
- -1 negative for growing the company and executing a wonderful exit
- -2 very negative
The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2). For more information on determining the average valuations in your area, see the Scorecard Method.
As an example, assume the average pre-money valuation of pre-revenue companies in your area is $2.0 million. If your judgment of the twelve factors above has five neutral assessments (five zeros), five +1’s, one -1 and one -2 (a net of two +1’s), then add $500,000 to the average valuation of $2.0 million, arriving at a $2.5 million pre-money valuation.
Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for seed/startup companies. The Risk Factor Summation Method is useful as one such method. We will wrap up this series with a post summarizing the multiple valuation methods for establishing the pre-money valuation of seed and startup companies in an upcoming post.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.