2022 Risk Factor Summation Valuation: What, Why, How, Advantages and Disadvantages
Updated: Nov 8, 2022
Startup valuation is a tricky field. There are several different ways to value a startup company, which makes things a bit complicated. In general, there is no single approach that works for all startups. The first step to determining a reasonable startup valuation is understanding how much money venture capitalists are willing to invest in startups. It's important to understand the different types of startup valuations that can exist.
The risk factor summation valuation method is a systematic approach that enables an investor or a business to analyze the value of securities in terms of the risks they are exposed to. It is used to calculate the value of a company by writing down all its known factors and their potential impact on the company's financial statements. Within this method, the risk factors exposed to a firm are weighed and summed up with each other depending on their overall importance. The result can be used as the basis for comparing different investments or portfolios of investments.
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What is the Risk Factor Summation Valuation Method?
The Risk Factor Summation Valuation Method is a method used to calculate the value of a company by summing up the estimated value of each risk factor. This method is used by investors, analysts, and managers to determine the overall value of a company.
The process involves identifying the factors that contribute to overall risk and then determining an appropriate amount for each factor. This method is useful when many factors contribute to the overall risk of a company, or when multiple factors could affect a single factor.
The Risk Factor Summation Valuation Method (RFSVM) is a pre-money valuation method. It assumes that all factors are independent variables, which means that their sum can be used to determine the value of a startup irrespective of the order in which they appear on the balance sheet.
What are the 12 factors of the Risk Factor Summation Valuation Method?
The 12 factors are as follows:
1. Management Risk
2. Stage of Business Risk
3. Manufacturing Risk
4. Sales and Marketing Risk
5. Funding/Capital Risk
6. Technology Risk
7. Competition Risk
8. Litigation Risk
9. International Risk
10. Reputation Risk
11. Political, Regulatory, and Legal Risks (PRL)
11a.- Government Regulations - Laws and Regulations that may affect the operations of a company or industry; Example: Health and Safety Legislation, Taxation Laws, etc.;
11b.- Political, Regulatory, and Legal Risks - risks that are outside of the control of management, but which nevertheless have a significant impact on a company's ability to perform its business activities; Examples include foreign exchange fluctuations, changes in government policies, industrial disputes, etc.
12. Potential lucrative exit Risk
Formula Used for Risk Factor Summation Method
Each risk factor’s level of risk = calculated average of comparable companies in the similar industry
Total Valuation = Sum of all risk factors.
Why Risk Factor Summation Method is Important?
The risk Summation Valuation Method is a system that helps to evaluate the risk of a business or project. This method is used by companies and individuals to determine the current and future risks of an investment. It can be used in situations where there are uncertainties involved in calculating the value. It helps investors to determine the average losses that they are likely to experience over time if they invest in a certain investment opportunity.
How to Perform Risk Factor Summation Method?
The risk factor summation method consists of classifying and summarizing the risks that contribute to your project. The following is a list of steps that you will take to perform this process:
Step 1: The historic data from previous years or other sources, such as industry experts or government agencies from similar industries is collected to come at the average value of each risk.
Step 2: Now you consider your startup company and assign value for each risk depending upon the probability it will occur. The value could be very low, low, neutral, positive, or very positive.
For low risk (+1) the amount considered is +$2,50,000, very low risk (+2) +$5,00,000, Neutral (0) $0, High risk (-1) -$2,50,000 and very high (-2) risk -$5,00,000.
Step 3: Risks are quantified and added up using simple mathematics to arrive at a total. The higher the potential future loss is, the higher that company’s risk will be.
Example of Risk Factor Summation Valuation Method
Let’s say we want to do a Risk Factor Summation Valuation for a startup company Cressa which is into healthy cereals for breakfast.
We first collect the data of comparable companies in a similar industry. Calculate the average amount of money for each risk factor.
Now, we consider our startup company and assign levels of risk- very low, low, neutral, high, or very high.
We then put the calculated average value assigned to each risk. In the end, add all the values to come to the total valuation.
As you can see in the above table the total valuation after adding up all the risk factors is 2,50,000 Euros.
Advantages of Risk Factor Summation Method
The advantages of the risk factor summation method are:
1. The method is easier to use.
2. It can be used for pre-money valuation for startup companies.
3. It allows businesses to easily assess their risks and control them accordingly without having to do any complicated calculations.
4. It doesn't require too much time or effort.
5. It also doesn't require any specialized software or technical knowledge on your part, which makes it ideal for new investors or people who have limited experience in finance or investing.
6. It does not require a lot of resources.
Disadvantages of Risk Factor Summation Method
1. This method cannot be used as a standalone method for valuation.
2. The base year is used as a benchmark for calculating the expected loss from each risk factor. This could result in a bias if the assumptions made about future changes in the base year are not valid.
3. The sum of losses from all risks is not necessarily equal to zero. In some cases, one or more factors may hurt the overall profitability of an insurer, but this will be masked by other positive impacts of other factors (e.g., increased loss experience).
4. An inherent problem with using historical data is that it can be misleading as it does not consider any future developments (such as new regulations).
Conclusion
The Risk Factor Summation Method (RFSM) is a risk assessment method that helps to identify and quantify the risks associated with a project. To do this, it takes all the different risks that may occur during a project and adds them together to create an overall risk score. In other words, rather than looking at individual risks, this method looks at all the risks in one big lump sum. This method can be very useful in a variety of settings especially when the traditional discounted cash flow method cannot be used because there is uncertainty involved with the cash flows. While calculating the valuation of a startup other valuation methods should be taken into consideration along with this method.