I recently gave a brief talk at Boston Angel Boot Camp regarding valuation and this blog post is adapted from those comments.
It’s sort of heretical for a VC investor to suggest that valuation doesn’t matter. So let me be perfectly clear… I certainly believe valuation matters to some extent in all circumstances and to a great extent in certain circumstances. And I work diligently to try to negotiate an attractive, reasonable valuation to maximize the potential return on all deals whether I’m investing my own capital or other people’s money. But the world of early stage venture investing is clearly not one of perfect market efficiency as others have pointed out.
Let me get my caveats out of the way first:
- Valuation matters a lot in mid-late stage VC investing, where the difference between a 2x return and a 3x return is significant
- Wanton indiscipline about valuation is bad for any investor, regardless of stage
- Early stage companies that raise capital at very high valuations run the risk of creating an “overhang” which makes future fundraising difficult (if your Series A is at $40M pre, it makes raising a Series B vastly harder than if your A was $10M pre). Reid Hoffman makes this point in this video (about midway thru), in terms of planning for capital raises over the life of a company not just maximizing valuation of the first round.
But overall valuation matters substantially less than one might initially think, at least for early-stage investors. There are three underlying dynamics at work:
1) Startup investment outcomes, at the earliest stage (i.e. seed or Series A), do not map to a normal distribution. A lot go to zero. Some result in small returns which for this purpose I’ll define as >1x – 5x. A handful are 10x outcomes and a tiny fraction are monster 30-100x+ returns.
2) The market for early-stage VC investments is intensely competitive, but one that is inherently inefficient. Any mutual fund or hedge fund investing in public markets can freely trade in the equity and debt securities of every public company in the world. Every VC sees different startup investment opportunities, and even the largest and most well known firms don’t see 100% of the most promising early-stage startups. Later-stage VC and growth equity investments are arguably somewhat more efficient markets, since the companies are larger and typically more broadly known. Also intermediaries like investment bankers and brokers play a greater role in this end of the market.
3) Similarly, early-stage investing is one of imperfect information. Imperfect in that different potential investors may have more or less information about an opportunity, perhaps due to a prior relationship with the entrepreneurs or differential knowledge of a market’s prospects based on sector focus. And certainly imperfect in that all early-stage startups have a limited body of historical performance on virtually every dimension (financial, product, etc) which an investor can assess.
Combine all three factors and you end up in an environment where early-stage valuations matter comparatively little. Instead an investor’s ability to source, select, and win investments which ultimately have good outcomes matters immensely. Let me highlight a hypothetical example with numbers to illustrate.
Scenario: A seed stage investor is considering investing $1M in a very raw startup, but one being built by an exciting team in an interesting market. The “bid” on pre-money valuation is $2M, the “ask” is $3M. The ask is obviously 50% higher, which is a heck of a lot. Compare this to a hedge fund evaluating an investment in Google… the difference between buying at $475/share and $715/share will probably make a huge difference on ultimate return.
This seed stage company goes on to get acquired for $50M without taking additional capital. If the seed investor paid $2M pre they’d make over 16x on their investment. If they paid $3M pre they’d make over 12x their investment. Heck, even if they paid $4M pre they’d still have a 10x return.
A $50M exit may not be meaningful for a large VC but it can be a great outcome for the founders or seed investors. But you can play out this exact same scenario for a “venture scale” company, with larger investment over multiple rounds and exit amounts in the 9 and 10 figure range. The result for the earliest investors remains basically the same.
In other words, even if the seed investors paid 50-100% higher valuation then they initially contemplated they’d still have a great investment outcome. What matters isn’t the exact valuation… but rather the fact that they invested in that company and other successful ones like it. Getting rock bottom valuations in a portfolio of mediocre startups tends to produce a bad fund level outcome for a VC. As a former colleague used to say, there is no subprime strategy for venture capital.
We obviously can’t invest with the benefit of hindsight. But if valuation matters far less in early-stage investing, how can VC’s build competitive advantage to ensure they’re investing in the startups that ultimately become the most successful? I have specific thoughts about this which I’ll save for a follow-up post.