Currently, there’s a lot of froth in the early stage investing scene. A lot of people are applying “rules of thumb” to various early stage investments without any regard for where the rules of thumb came from.

As long as the unbridled liquidity continues this likely won’t be much of an issue for the investors that are able to successfully exit. However, it’s going to make the exit multiples look more depressed and considering that business mortality rates are increasing, on average, early stage investor returns are going to be worse.

I’ve heard stories of people applying revenue multiples to businesses that don’t scale, locally oriented retail businesses that have limited potential to expand outside of their home geography and other capital intensive enterprises. I’ve also heard of “knowledgeable” people applying multiples to the pre-raise valuations (investors are effectively investing at the post-raise valuation) and also excepting other elements of the capital structure (having other funding mechanics in an early stage company is by itself is pretty unusual).

While it can be difficult to know what a reasonable valuation is for early stage investments it’s probably better to follow an established framework as opposed to applying a rule of thumb for a majority of the investors that are entering the space.

To understand why applying revenue multiples and other rules of thumb to every type of business might not be the best solution, we need to understand where the rules of thumb came from. The rules of thumb are generally established by more experienced investors who have seen similar cases play out over multiple time frames and the results generally get to a similar level. It’s important to understand the logic that was used to create a rule of thumb if you’re looking to apply one yourself.

When looking at investing in a business, there are two ways to play it:

· Understand the value of discounted future cash flows (invest): This is the traditional way to establish what a business is worth. Work out how much cash a business can generate out to a certain attainable timeframe and then create a terminal value to work out what those cash flows are worth into perpetuity. After you’ve worked out how much cash the investment can make, you discount the cash flows back to the present with some predetermined discount rate. This works well for businesses where you’re able to model their underlying economics and becomes harder when you’re dealing with businesses that are able to grow at an exponential rate.

· Take a greater fool perspective (speculate): Don’t be too concerned about what level you invest in a business, just hope that someone will be willing to pay a higher price than you are paying. Hope has never been a sold investment strategy. However, it feels like that’s how some investors are applying rules of thumb today.

Experienced investors typically note that over time, when they apply their valuation models (future value of discounted cash flows as referred to above) to a given business, they get to a similar financial metric when applying a range of valuation techniques. A rule of thumb could be developed for the multiple of revenue that should be applied based on the current growth rate, level of revenues, and future capital that will be required to capture a meaningful amount of market share.

The multiple that could be applied to a Software as a Service business which could have global reach will be significantly different from that of a locally oriented food delivery business that has questionable unit economics.

The rules of thumb that apply to one industry, rarely apply to another.

Why are investors using questionable valuation metrics?

This is a result of more investors entering the space and more investors chasing ever loftier return expectations. When applied to Asia, there are more early stage investors that are entering the eco-system. I hope and expect that this will continue to increase as the focus on nurturing entrepreneurship is being given a gentle nudge by local governments and prior entrepreneurs exit and look to give back.

Arguably, there are a number of reasons why these investors are pegging valuations to nonsensical comparison sets when approaching early stage valuations; including increased liquidity in capital markets generally, more investors being drawn up the risk curve in search of higher returns, more investors joining the fray after reading about exceptional exits in the media and believing that they will don’t want to miss out on the next rocket ship to Mars.

Further, the proliferation of crowd funding platforms has made early stage investing more accessible to more people. ICOs are another matter entirely. The issues that are evident in any funding round are amplified with crowd funding platforms. There is a lot of “dumb money,” retail investors that are being told what the valuation should be by the entrepreneur. An entrepreneur is going to set the valuation as high as possible on one of these platforms to avoid dilution.

There’s no “smart money” determining where the valuation should sit (although I’ve seen similar tactics from “smart money” in later rounds so the term “smart money” is applied loosely). Layer on top of that the scarcity tactics that are able to be flashed at retail investors on crowd funding platforms “Only $XX capacity left.” Investors should be asking themselves, “If this investment is so good, why haven’t the professional investors jumped on it?” I mean, finding investments is their day job.

What’s the solution?

It would be better for the less experienced early stage investors to find a framework that suits them and apply that to each of the potential investments. Whether that’s the Berkus method, the Risk Factor Summation method, the Scorecard Valuation method or one of the other methods that’s available.

Don’t get trapped into thinking about a valuation in the terms dictated by the pitch deck. Using these rules of thumb not only impacts the investors but it could also impact the founders later in the game. If they’re talking a bit game and raising on a rule of thumb at the early stages, they might find that there are no professional investors that are willing to participate in a higher round later because no-one likes a down round.

If you’re getting involved in early stage investing, take your time, talk to people with more experience. Think about using a framework that you can apply opposed to a rule of thumb and use documents that allow you to have some flexibility (SAFEs > equity at the early stages).