Investors and investment bankers may like to give the impression that there is a method to it, but the truth is that valuating an early-stage company is an imprecise science that depends on a number of factors, some having little to do with the intrinsic value of the company and more to do with the environment.

So, what do venture capitalists, or VCs, look at while valuing a company? Most investors give similar answers: Size of the potential market: Generally, the larger the better.

Quality of the management team: Passionate, broad-based management teams with complementary skills and domain expertise preferred.

Business model: Who pays and for what? How much will they pay? How scalable is the model? Does headcount need to scale proportionately with revenue?

Competitive landscape: It is good to be the first mover or at least an early mover. However, if it involves the creation of a new category or market, or a radically new consumer habit, it can be risky. It’s nice if customers are used to currently spending money for the same purpose and your offering solves the problem better and you propose to earn revenue from (their) existing budgets. It’s also good if this is a proven business elsewhere in the world.

Stage of company: The earlier the company is in its life cycle the more risky it is. However, an investment in an early-stage company can yield massive upsides to investors if it succeeds.

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In spite of the fact that we were probably overpriced in our first round of fund-raising, our investors earned returns of slightly under 30 times in seven years.

Quality of offering: How good is the offering? Will it get traction among customers?

Cost structures and potential margins: How large are the margins likely to be when the business scales up? Will margins increase with scale? Does the business have operating leverage?

Market structures and power: Is there likely to be excessive dependence on a few customers? Can the business build up massive dependency for its services among its customers? Will there be switching costs for customers? Does the business build defensible intellectual property? Will there be barriers to entry for competition in the future?

Basically, all these are surrogates by which investors can get some sense of potential return and risk—a peek into the future.

Yet, there are external factors which will finally influence whether or not a VC will invest in a particular company and at what valuation.

At Naukri, in April 2000, we raised our first round of venture funding at a valuation of around Rs44 crore—we had achieved sales revenue of Rs36 lakh in the year gone by. Sounds insane—but, well, it happened.

It was a bubble investment—dotcoms were the flavour of the month, investors were competing to give us money (we had two offers on the table and we had spoken to only four investors), the Internet was expected to change the world and everyone was going to get very rich very fast.

Six months later, as it became apparent that the bottom had dropped out of the dotcom market, the company would probably have been valued at around Rs2 crore even though the revenue was going to more than double over the previous year.

Most investors will deny it, but there is some kind of herd mentality among many investors. They compete with each other and they talk to each other. So, if one investor makes a certain kind of investment that looks like a smart thing to have done, it spurs others to make investments in similar companies.

When dotcoms were in fashion in late 1990s, everyone wanted to invest in the Internet sector. The ensuing competition resulted in a de facto auction and pushed valuations sky-high. And when investors decided that they wouldn’t touch dotcoms with a barge pole, valuations were in the basement for a long, long time.

Bubble investments were followed by a situation where companies were left with no hope of a second round; subsequent tranches were held back, companies were merged, promoters were sacked and replaced by professionals. Many simply shut shop. All in all, there was a lot of pain for everyone.

Yet, the intrinsic worth of the companies had not changed much from the time they received their first round of investment till the time they were forced to shut shop.

Irrational exuberance followed by irrational pessimism.

Just as beauty is in the eye of the beholder, valuation is in the eye of the investor.

The author is co-founder and chief executive officer, Info Edge (India) Ltd, which runs the Web portal He writes a monthly column on careers and enterprise.

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