NEW YORK (TheStreet) -- How should we value early stage start-up companies?
With some thinking that a new tech bubble is brewing, it's an important question these days.
And it's a tough one to answer. Valuing early stage companies is a combination of "going with your gut" and carefully examining both the current focus and future plans of the business. Many of these companies don't have the metrics to run a proper discounted cash flow analysis or any other type of qualitative evaluation.
Our formula for valuation is more of an art than a science, but it's rooted in logic. Here's what you need to know:
The first thing we look at is how much capital a start-up needs to accomplish their 12-to-18 month goals. Start-ups generally need a lot of funding throughout the course of their lives, but angel or early stage investor are mostly concerned with getting them to the next level, so it's important to define what the next level is.
If you're investing in a social app, then user growth is generally the metric to score. If the company provides software as a service, then revenue may be more relevant. However that next level is defined, that's the goal the company is going to need to hit in order to raise additional capital in the future -- hopefully from top tier venture capitalists. Once you've outlined what progress looks like, it's time to be honest about the capital requirements to get there.
Attractive Economics and Keeping the Team Incentivized
After you've calculated how much capital the company is going to require in order to reach its outlined milestones, you need to calculate how much of the company you want to obtain in order to make it worth your while for taking the risk. Just remember that you'll benefit more if you're not greedy -- the founders and team need to retain enough ownership to stay highly motivated to continue to build and grind through the hard times ahead. The last thing you want is to own 50% of a company with a team that isn't properly incentivized.
On average, an early stage financing will consist of a company offering (or selling) between 5% and 25% percent of the company. With additional financing almost always needed in the future, founders will continue to dilute their ownership. Thus, if they sell too much of their company to you out of the gate, they'll be left questioning why they're working so hard in later funding rounds when they only own 2% of the company.
The last thing to consider that can add a premium to the valuation is if the founder has a proven track record. Entrepreneurs with prior successes tend to get higher valuations because they pose less of a risk to investors. At early stages, the team usually matters more than the actual product, so founders' backgrounds play a major role in the valuation.
Prepare For The Unknown
As an investor you have to really love the team and concept, because things rarely go perfectly and start-ups often require more capital than initially projected. Before you write that first check, make sure you're committed to investing more if needed. You shouldn't be expected to throw your money at a failing company, but many incredibly successful companies (for example, Instagram (FB and Twitter (TWTR) had growing pains before they hit their stride -- the best investors are just as committed as the founders.