Early Investing

How To Deal With Crazy-High Startup Valuations

How To Deal With Crazy-High Startup Valuations
By Adam Sharp
Date July 16, 2021

I saw a pretty interesting thing on Twitter this week. Founders Fund general partner Keith Rabois posted the following.

Keith is known for speaking his mind. And he has a very good track record. Founders Fund has a reputation for not overpaying on deals and somewhat going against the traditional Northern California venture capitalist (VC) culture. (In fact, Keith recently packed up and moved his operation to Miami.)

So what he said is pretty important. “There are no VC funds with pricing discipline. All of us have caved.

This is true from what I’ve seen. I’d estimate that California-based series A deal valuations — where VCs are involved — have at least doubled over the last year. In the case of a hot software-as-a-service deal, I’d say it’s risen 2.5 times or more.

This phenomenon happens primarily in series A deals where multiple VCs have “bid up” the price. Seed valuations are also rising, but they aren’t quite as crazy yet. Most institutional money is invested once companies have found “product market fit,” which often coincides with series A funding rounds. 

High Valuations = Blown Expectations

The worst part of all this is that these crazy high valuations are bad for everyone involved. The founders may think it’s good to raise at a higher valuation because there’s less dilution. But raising at a high valuation sets investor expectations even higher. Unless the company executes near-perfectly, things get difficult. It becomes a major challenge for the company to raise the next round and incentivize new hires with stock. 

The company may have to do a “down round” (where the price decreases in the subsequent round of funding), which lowers team morale. 

Raising at crazy high valuations is not good for either investors or founders.

How to Avoid Ridiculous Valuations

To avoid these ridiculous valuations when considering potential startup investments, try to invest at earlier stages. Go for companies that haven’t met with a ton of VCs. 

Prices are a bit more reasonable at the seed level — though even the seed deals in the San Francisco area are getting a little out of control.

So the next idea is to look for startup deals outside of California, as I discussed a few weeks back. And today, the easiest way to do that is to explore equity crowdfunding sites

You can find deals from all over the country on equity crowdfunding sites. And I promise you the valuations are lower in rural Idaho than they are in Silicon Valley.

Valuations on equity crowdfunding sites tend to be much lower than deals where multiple VCs are involved. However, the average deal quality is also lower. So you have to sort through more deals to find high-quality, high-potential deals.

But make no mistake, there are high-quality deals at reasonable prices that anyone can invest in. You just need to do some serious screening and searching to find them. 

Go for companies that have made a lot of progress and, if possible, are at the early stages of revenue generation. The competition for “proven” series A deals is absurd right now, so prices are much higher for companies that are generating significant revenue. If you invest in a pre-revenue company, make sure there’s real value there. Look for potentially valuable software and engineering talent, for example. 

You will occasionally find a more established startup with great potential and a fair valuation. Sometimes the founder realizes it’s not in their best interest to raise at a crazy valuation. Or maybe the founder doesn’t realize the value of what they’ve got, because they don’t know any California-based VCs. 

Either way, if you see a deal like this, jump on it.

And if you’re looking for some additional guidance on deal selection, check out First Stage Investor. Andy Gordon, Vin Narayanan and I provide regular research on individual deals we think are worth exploring.

Have a great weekend, everyone.

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