I came across the Risk Factor Summation model recently while looking at VC Valuation methods, but have struggled to pin down a really good explanation of the approach and "Good" and "Bad" examples for each of the included factors. While I hope that my post below is helpful and you maybe learn something, I'd love to get your feedback and ideas of how you think about each factor so we can create a more robust framework with which to use this approach. This post was getting quite long so I’ll post it in a few parts over the next few days.
What is the Risk Factor Summation Method?
Originally developed by Ohia TechAngels, the RFS is a method used by venture capitalists and angel investors to value pre-revenue companies, typically in the pre-seed or pre-Series A stage of funding. It builds on approaches such as the Venture Capital Valuation method or the Dave Berkus Valuation Method by considering a broader range of risk factors that can affect start-ups as they grow into mature businesses.
Ohio TechAngels reportedly described 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: management, 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.
"Reportedly described" as this is quoted all over the internet but I cannot find an original source.
How does the RFS Method Work?
Step one, an initial pre-money value for the company is determined through looking for 'market comparables', typically competitors in the same or similar industries. This shouldn't take into account specifics of the company per se but look for the average valuation for the industry and at the growth stage the company is operating in.
Step two, the method considers 12 risk factors, which we will cover in a moment. Each risk is assessed with regards to how it may impact the ability of the company to grow and execute a lucrative exit, and is assigned a score as follows:
- +2 = Very Positive / Very Low Risk
- +1 = Positive / Low Risk
- 0 = Neutral / Medium Risk
- -1 = Negative / High Risk
- -2 = Very Negative / Very High Risk
Step three, The average industry valuation derived in step one is adjusted up or down depending on the score for each risk factor. The adjustment amount can vary depending on what source you ask but typically shifts around $250k for each point move either way (e.g. +2 would add +$500k to the valuation; -1 would subtract $250k).
Thought 1: is a flat adjustment of $250k per point a suitable number? Should we consider otherwise for certain industries, or adjust this up or down based on the stage of the company (angel, seed, early) or the position of the market cycle?
So What Are the Factors?
I'm glad you asked. As mentioned, there are 12 and are presented in roughly the same order wherever you look. Retiba* has offered some great summary sentences to get you started on what each risk means, which are included behind spoiler blocks in case you want to try and guess first - if you get 100% as a newcomer I will be suitably impressed.
* don't expect to use the tool through that link without first surrendering your email address :-(
- Management Risk - Is it possible that the current business management team will impose a high risk on the business in the future?
- Stage of the Business - Is the business at the initial stage of the maturity cycle that is inherently risky and likely to fail to a great extent?
- Legislation / Political Risk - Can unfavourable regulation, legislation, and political conditions lead to business failure?
- Manufacturing Risk, or Service Delivery Risk - Is it possible for the business to have trouble producing and failing altogether due to limited raw materials or an inability for counterparties to make good on agreements?
- Sales & Marketing Risk, or "Go to Market" Risk - How much your business may be affected by sales and marketing problems?
- Funding / Capital Raising Risk - Given your awareness of the ecosystem, how likely is it that the business will have trouble raising capital in subsequent rounds?
- Competition Risk - Given your awareness of the market, how intense do you assess the competitive environment the business will face?
- Technology Risk - To what extent can the emergence of new technologies in the future jeopardize the existence of the business?
- Litigation Risk - How likely is it that the business under evaluation goes through litigation crises and fails?
- International Risk - To what extent can unfavourable international conditions and interactions with other countries put the business at risk?
- Reputation Risk - To what extent can the business under evaluation be exposed to the crisis caused by brand reputation?
- Potential Lucrative Exit - How likely it is for the potential lucrative of the business under evaluation to be in trouble in the future, and the company will not be able to make a good profit margin for its products and services?
Several of these factors may be quite familiar (e.g. Management Risk, Stage of the Business), while others (e.g. Litigation Risk, International Risk) may be harder to fathom. Seraf provide a simple example of how positive and negatives for each factor can result in a valuation adjustment. While a helpful indicator, the examples here are limited. I've taken a stab at expanding on each factor and will share these in the next post.
Edit: As mentioned, feedback welcome, and do let me know if you have read any good sources on this method that I may have overlooked.
Submitted June 06, 2021 at 09:08AM by AnInvestmentsDude https://ift.tt/3ghixoL
