Startup valuations are tricky. This is due to the difficulty of assessing illiquid young companies with measly track records but exciting technologies and/or business models.

But you still have to pay attention to them. Why?

The valuations you begin with heavily influence the profits you end up with. Which is why I always ask founders what their company’s valuation is… and how they arrived at it.

The wrong answer – an inflated valuation – is a deal breaker.

Enter the Berkus Method

Last Friday, I was talking to a founder who was telling me why his social engagement company was such a great investment.

Its value? “Five million dollars,” he said. The startup was pre-revenue. And it was ramping up downloads at an impressive rate.

When I asked him how he arrived at a $5 million valuation, he said he used the “Berkus Method.”

I’ve heard of the DCF method, Risk Factor Method, Scorecard Valuation Method, Comparable Transaction Method, First Chicago Method and Venture Capital Method.

But the Berkus Method? That was a new one. When the founder explained it to me, it sounded pretty simple. Rather elegant, actually.

But I needed to know more. A company’s valuation is too important to depend on somebody’s two-minute explanation. So I did some digging.

And you know what? The Berkus Method is worth knowing.

It’s a four-factor valuation formula. These same factors also give you a nice framework to assess the investment opportunity in terms of current risk and chances of future success.

This is what I found out…

Version No. 1

Dave Berkus created the first version.

Dave is a startup investor and author. He came up with his method in the mid-1990s, he said, to “help with the imprecise problem of how to value early-stage companies.”

His method gained prominence when it was published in the book Winning Angels in 2001.

It identifies four major risks that startups face: technology, execution, market and production. A startup can be credited in each of these areas with a maximum of $500,000 for reducing risk.