There are many different approaches taken to both vetting and valuing a startup company.

VETTING:

Typically, an investor (or investment firm) will have some thesis or lens through which they view the world of investments available to them.

This is often a function of their own experience in certain industries, people they have worked with before, past investment data, etc.

A few examples might be:

  1. “We invest in B2B companies in XYZ industries with a revenue run rate over $ABC”
  2. “We only invest in consumer software and place a high emphasis on customer validation”
  3. “We are most focused on the founding team and look for a total addressable market over $ABC”
  4. “We are social impact investors and care about social good”

Each investor may have their own answer to the question above and usually they are happy to share this information. There are definitely people who invest more opportunistically and don’t stick as dogmatically to such specific criteria.

The second piece of the puzzle which works in conjunction with the criteria listed above is the risk-reward profile the investor is interested in. This can vary greatly from angel investors to VCs at different stages of the company life cycle.

Many early-stage investors are most interested in “home runs” (ie a Facebook, Uber, Snapchat, Dropbox, etc) and are willing to place bets that are to some degree binary.

These companies need to have the potential to grow VERY fast and have access to a large addressable market. To quantify this, they are not looking for companies that are likely to give them a 5x return (over a few years), but more interested in ones that provide a 100x+ return even if that means a greater risk of company failure.

Of course, this is not universally true.

There are other investors who are more interested in higher probability “doubles” or “triples” and may not be willing to take huge risks on consumer applications that are much less predictable than the types of companies they invest in. They may be more focused on current revenues or sales process, etc.

I would say there are two universal areas of interest for most investors:

  1. The Team. If they don’t trust the people, it ain’t happening.
  2. The Customer. If they can’t see very clear value to a customer, then its unlikely the company will receive investment. Some investors even insist on interviewing a large set of customers as part of their diligence process (which makes a lot of sense to me).

The nuts and bolts of “vetting a company” once investor interest has been expressed would mostly be verifying that all the information that has been shared is true (financial, user analytics, etc) and that the technology is real.

NOTE: This answer is very generalized and the investment parameters can vary greatly from investor to investors, so my best advice is to ask them directly.

VALUING:

This is definitely more art than science. There are a few key considerations, but beyond that, it’s very hard to place a value on something that is more “potential” than “realization” (if we are talking early stage companies).

The main considerations tend to be:

  1. Market comps — In cities with a lot of ventures investing, there tend to be widely accepted ranges. This simplifies the process because it brings some level of uniformity to a highly uncertain question and narrows the discussion.
  2. Investment vehicle — It’s very common for early-stage investors to use a SAFE or convertible note because that allows them to punt the valuation question down the road to some degree (rather than a priced equity round where a valuation is explicitly stated).
  3. Competition for access — If a company has a lot of prospective investors who are interested, not all of them will get to participate. This will cause the investors who most badly want to be included to improve their terms.
  4. Investor goals — If an investor is looking for companies that can one day be worth a billion dollars, they may not be as concerned about whether the valuation at a very early stage is 3MM or 5MM. They will be more concerned about keeping the founders motivated. If its a different type of investor with different goals, they may be more sticklers on the valuation.
  5. Founder motivation — I mentioned this before, but I’ll say it again because it’s important. If you are investing in a business, you need the people in charge of it to be motivated. If an investor cranks the valuation down too much (and still manages to get a deal), there is a very real concern that the founders will be much more comfortable walking away if things get tough.

More explicitly, from founders I have spoken to the early stage SAFE/convertible note cap range tend to be in the neighborhood of $2MM-8MM.

Even though there aren’t really great methods for determining these numbers, you should still be prepared to defend whatever you decide.

The most common methods I have seen are:

  • Accept what is the market in your area (as noted above).
  • Use an expected value or DCF approach; to do this you would probably make a financial model going a few years out and then assign odds of reaching various performance levels in your model. Do research and make assumptions on how companies in your space are valued (ie what business metric drives their value) and then calculate a valuation for your company at each performance level in your model. Multiply each valuation by your estimated odds of reaching that level. Sum the results, and you have an expected value approximation that is at least somewhat rooted in logic (hopefully).
  • Start out at $6–8MM and then adjust based on how aggressively you are rejected (this is a pretty half-assed way to do it, but we live in a crazy world).