The grass is rarely greener, but it's always different

What is the Risk Factor Summation Startup Valuation Method?

What is it?

Still, amongst the pre-money, pre-revenue startup valuation methods such as the Scorecard or Berkus methods, falls the Risk Factor Summation valuation method.

It is a valuation method that emphasizes the risk associated with creating a startup in a given industry and location. Much like Scorecard, the Risk Factor Summation method uses a base value extracted from averaging out comparable startups in the same niche & geographical location and adjusts accordingly comparing the reference value against 12 common risk factors.

If the startup to evaluate scores higher (meaning there is less risk for that startup to fail) in a given area, more points are added to the final valuation. Conversely, if it scores lower (more chance to underperform or due to factors that are outside its control) then fewer points are added to the final valuation.

The total points are then added and the final score is multiplied by a flat money amount agreed upon (although it generally is €250.000) and finally added to the average value to get to the valuation.

How it Works

Same as for the Scorecard valuation method, the first step is to find similar previously funded startups and extract their average valuation.

Once we have it, we must consider the previously mentioned 12 common risk factors and see how our startup position itself against each one of them. These risk factors are:

Risk Factor
πŸ§‘πŸ½ Risk of the Management
🏎 Stage of the business
βš™οΈ Supply chain or manufacturing risk
🧯 Political risk
πŸͺ† Sales and marketing risk
πŸ’° Capital raising risk
πŸ€Όβ€β™‚οΈ Competition risk
πŸ“Ÿ Risk of Technology
βš–οΈ Risk of Litigation
🌎 International risk
β˜”οΈ Risk of Reputation
πŸ₯― Exit value risk

Pear each one of these risks, we must assign either a positive, neutral, or negative score within the [-2, +2] range, depending on the seriousness the risk poses against the startup to take off. The scoring table is as follows:

Rating Risk Rationale € Adjustment to Pre-Money Valuation
+2 πŸ‘ŒπŸΌ Extremely Positive Mitigation Add €500,000
+1 🀌🏼 Positive Mitigation Add €250,000
0 πŸ–πŸΌ Neutral Add/Minus Nothing
-1 πŸ‘ŽπŸΌ Negative Mitigation Minus €250,000
-2 🦢🏼 Extremely Negative Mitigation Minus €500,000

Once we've assigned a risk score to each one of the factors, we add them up and multiply the final number by the money factor to have the average valuation adjusted to the risk scenario. Then the amount is added to the average valuation and we achieve the final valuation we give to the startup.

Example

(As a side note, all the names & projects I mention are a product of my own imagination, I look for them online beforehand to be sure I don't come up with existing companies or brands, but I might slip.)

We work at a Venture Capital firm called FantasyVC and we are tasked with providing a sensible valuation to a new promising startup that has crossed our path and is thinking of adding it to our portfolio.

This startup is a travel startup focusing on providing hyper-customized travel experiences for tourists in Galicia, Spain (incidentally where I'm from). The project is a joint effort with the regional government in order to foster international tourism. The name of the company is Agarimo, which is a term for endearment in Galician, the regional language.

It is decided to use the Risk Factor Summation method to evaluate this startup.

Step 1: find similar funded startups in the sector to extract a benchmark value

Same as for the Scorecard valuation method, the first step is to gather similar startups in the same industry and location in order to get a sense of the typical valuations of these other companies to receive. Since Galicia is a region within Spain that garners less tourism overall than other better-known places like AndalucΓ­a or Costa Brava, we have to complete the table with travel startups that operate at a national level as well:

πŸ•Ά Name πŸ‘• Valuation
Breogan Travel (Galicia) €1.3M
Viaje Artabro (Galicia) €3M
SpanishTrek (whole Spain) €5M
O Fogar Travel (Galicia) €1.6M
SunAndFun (whole Spain) €4.5M

We realize unfortunately that the valuations in this area go all over the place so eventually, we will use other types of valuation methods that don't rely heavily on an initial comparison with other startups, such as the Berkus method, in order to average it out with this one.

Calculating the mean of all the startups throws an average valuation of (1.3 + 3 + 5 + 1.6 + 4.5) / 5 = €3.08M. This number will be the ballpark figure to adjust.

Step 2: evaluate the risk factors and adjust the scoring

Now it's time to put our knowledge of the business and industry to work. The company has a strong management team but they are newcomers to the startup world. There is little competition due to the relative niche they operate in.

Sales & marketing could be tricky due to the region & touristic attractiveness being unknown close to other places in Spain that are better known, but that can also be an asset and there is no political risk involved rather the local government tries to draw more tourism to the area so they'll provide with facilities when dealing with bureaucracy and certificates.

The final table of evaluated risk factors ends up as follows:

Risk Factor Rating
πŸ§‘πŸ½ Risk of the Management -1
🏎 Stage of the business -1
βš™οΈ Supply chain or manufacturing risk 0
🧯 Political risk +2
πŸͺ† Sales and marketing risk +1
πŸ’° Capital raising risk 0
πŸ€Όβ€β™‚οΈ Competition risk +2
πŸ“Ÿ Risk of Technology 0
βš–οΈ Risk of Litigation 0
🌎 International risk 0
β˜”οΈ Risk of Reputation -1
πŸ₯― Exit value risk 0

Adding up the ratings we get the total rating of -1-1+0+2+1+0+2+0+0+0-1+0 = 2, then we multiply it by €250.000 to arrive at €500.000.

After that what is left is to add the amount reflecting the risks evaluated to the average startup valuation gathered in the first step and we have our valuation: €3.08M + €500.000 = €4.3M.

Pros

  • Simpler than the Berkus or Scorecard to calculate and easier to find blind spots.
  • Desperation from the business owner will score the startup downwards.

Cons

  • The method is mainly pessimistic and assumes all the risk factors weigh equally.
  • As opposed to the Pros list, the startup belonging to a less popular industry will automatically be penalized.

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References

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