The Berkus method is a procedure for the valuation of companies created particularly to evaluate startups in their initial phase. This, resorting to a subjective methodology taking into account that the analyzed company does not have a history of income.
In other words, the Berkus method is a model to estimate the value of recently created startups. For this, subjective criteria are used, since there is no historical data of the firm.
To understand why a model like this exists, we must remember that, to value any company, a projection of its income flows is usually made, based on the financial structure and the benefits that the business has already generated. These cash flows are then used to calculate the net present value (NPV).
However, the case of a startup in its initial phase is very particular, since it is a company with the potential to present exponential growth, but has not yet generated income.
In that sense, surely the firm is looking for financing to promote and consolidate its business. What exists is probably a product or service idea, a committed team of professionals, and some capital, but not much else.
Therefore, a valuation method is required that can serve to project the expected expansion of the startup.
This method was created by Dave Berkus in the 1990s, from his point of view as an angel investor.
Aspects evaluated in the Berkus method
The Berkus method evaluates the following aspects of a company:
- Quality of the business idea: In this item, the need that the startup is seeking to cover will be evaluated. In addition, it will be questioned if the idea is innovative, or if there are similar businesses in the market.
- Quality of the founding team: The founders will be evaluated, what their skills are, if they complement each other by dedicating themselves to different areas of the business (perhaps one specializes in management and another in marketing). It is also important to know if the team has previous experience in the sector and what their history is.
- Technological barriers: In this item, also called a prototype, it is evaluated if the product works correctly and if it is capable of meeting the buyer’s need.
- Business traction: It refers to analyzing how the consumer responds to the product.
- Strategic relationships: It will be studied if the company has strategic partners to be able to enter the market or if, on the contrary, it will face entry barriers in that aspect. In the same way, the investors of the company will have to be known and if the firm has any recognition in the market.
Each of these items will be assigned a value of up to half a million dollars, which would reach a maximum of 2.5 million dollars, if the maximum valuation is awarded.
Now, it must be taken into account that this method is subject to flexibility, with the valuation varying according to the sector in which the company is engaged.
Another point that we will emphasize is that this method is aimed at startups that do not yet generate income.
Let’s see an example of how the Berkus method would be applied, assuming that we are dealing with a business idea for a new mobile application for executives.
So, in general terms and in a very summarized way, the idea seems to be solid, as well as the product. Also, the founding team is highly skilled, although new to the industry. And, finally, there are no potential strategic partners. Therefore, we arrive at a value like the following:
|Quality of the business idea||$460,000|
|Quality of the founding team||$300,000|
|Technological barriers or prototype||$400,000|
As we see in the example, the Berkus method can seem very arbitrary. However, its use is limited to startups that do not yet receive revenue.