What Informs an Investor's Valuation of a Startup?

The valuation process of a startup is similar to the price determination process of a product as it moves through a distribution channel. Sellers and resellers set the price of a product based on their desired profit margins. For a price-sensitive product like coffee beans, the higher the cost in the early phases of the channel, the lower the profit margins. For a price-inelastic product like concert tickets, an increase in price may not affect the seller’s margin, because they can pass that cost on to the end consumer. Valuations matter to founders and investors because they reflect the perceived earnings potential of the business over the lifetime of the company.

In 2020, the number of seed-stage deals with a post-money valuation of $100 million was greater than the previous five years combined. From 2014 to 2019, there were 12 such deals in the US. In 2020 alone there were 14, and that trend continued into 2021. The median and average post-money valuations of US-based seed-stage deals have consistently risen since 2013, the average rose from $6.5 million in 2013 to $14.2 million in 2020, and the median from $5.6 million to $10.0 million. This growth has been attributed to the abundance of capital in the seed market, especially as major later-stage firms enter it. In 2021, Sequoia, Index Ventures, Andreessen Horowitz, and Greylock Partners all announced seed-stage-focused funds with a combined value of $1.3 billion. (Source: PitchBook data.)

The Case Against Sky-High Seed Valuations

As later-stage rounds get more competitive, multistage firms aim to secure less expensive stakes in promising startups at earlier stages. In his writing, Fred Wilson, Partner at Union Square Ventures, warns against the trend of valuations this high at the seed stage, for two reasons: the high failure rate of seed-stage startups, and the dilution that occurs from seed to exit. From personal experience, Wilson has seen a seed-stage investor’s ownership stake get diluted by around 66.67% from seed to exit, and a report by Radicle found that 97% of startups fail between seed and exit.

Wilson backs his point with a model. The assumptions: a $100,000,000 fund; 100 investments; a $100,000,000 post-money value; a $1,000,000 investment amount; 1.00% ownership; 66.67% average dilution from seed to exit; a top-performing investment outcome of $10,000,000,000; and a power-law number of 0.75. The modeled fund’s outcome was a total value at exit of roughly $133 million, a 1.33x return. The point is that the probability of achieving positive fund returns when investing solely in $100M seed-stage deals is low. Since 2012, there have only been 14 VC-backed companies with exits over $10 billion.

That is why Wilson advocates for seed rounds with a post-money valuation in the lower eight-digit range. We reimagined his model for a fund that invested the same check size into seed rounds with a $20M post-money valuation. The ownership stake would be 5% as opposed to 1%. Keeping all other assumptions the same, that model achieved a fund return of 6.67x, with a total value at exit of roughly $667 million.

Call the $100M post-money fund “Fund A” and the $20M post-money fund “Fund B.” Keeping the top-performing outcome the same, Fund B would outperform Fund A five times over. Fund B would only need a top-performing investment outcome of $2 billion to achieve returns similar to what Fund A produced with a $10 billion outcome. Since 2012, over 130 VC-backed companies have exited at valuations of at least $2 billion, so there is a higher likelihood of Fund B achieving positive returns.

What Founders Can Take From This

The message is that lower-valuation seed-stage rounds are more likely to lead to positive fund returns for investors. But there’s a deeper insight: the inductive reasoning process investors use when considering an investment. Investors think about the potential value of an investment in relation to the overall desired performance of the fund. Founders can leverage this framework to better prepare for diligence and negotiation.

For instance, if a founder is asked, “What is the size and growth stage of the target market?” they can prepare by thinking about how the share of the market they hope to acquire could translate into returns for the fund. A good answer might be: “The size of our market is X and is expected to grow at Y% each year over the next 10 years, at which point we hope to have acquired Z% of the market. Using the average enterprise-value-to-revenue multiple of recent exits in our industry, our company could be worth $K billion.” If an investor asks about exit activity in the industry over the past few years, they are really asking, “What is the likelihood of a liquidation event?” Investors see that as an opportunity to earn returns for the fund.

Founders can also use this framework in negotiation. Economic terms (participation rights, liquidation preference, pro-rata rights) are put in place based on the perceived risk to investors. Founders should think about how an investment into their company could lead to the desired returns for the investor’s fund. The more a founder knows about a fund and its recent performance, the better prepared they will be for diligence and negotiation. This principle is valuable in the fundraising process regardless of the valuations involved.