Are Startups Over-Valued?

The market has had a strong run, far outpacing GDP growth

To Answer This Question, Start With the Public Markets

Like many VCs, we are preparing our 2020 year-end results and letter to our investors (limited partners, or LPs). As has been the case for many VCs, our results have been good; in the wake of the pandemic and all the carnage that is happening in other parts of the economy, embarrassingly good. If history is a guide, the question I expect to hear most from my investors (limited partners or LPs) is: these results look great today, but are startups over-valued? Can this bull market for tech, in general, and tech startups, in particular, continue? It is a question a lot of investors are asking themselves.

  • Amazon generated $386 billion in revenue, $21 billion in operating income, and generated $66 billion in cash flow through their operating activities.
Interest rates are sharply down in recent years — and dramatically down since the pandemic began

Public Valuations Drive Startup Valuations

So now that we have deconstructed and gotten to the bottom of the soaring public market valuations in tech, we can turn our attention to exploring why private startup valuations are rising so dramatically. Only a year ago, the rule of thumb was that fast-growing, industry-leading SaaS software companies were valued at roughly 10x revenue in the public markets. Even though they didn’t have any earnings, private startups were valued at a comparable level because VC investors used the public comps as a rule of thumb — if the core business model and growth potential were the same, it was natural to assume that the revenue multiple would be a good barometer since earnings would come with scale, as evidenced by the more mature companies described above.

Early Stage Valuations Not Affected by Increase in Public Market Valuations

If public market multiples are up 2x, affecting later stage private market multiples, how about early-stage market multiples? Here is where it gets really interesting. My subjective read of the market is that pre-seed and seed valuations — the end of the market where we invest in as a typical entry point into a startup — have not dramatically changed. At Flybridge, the prices we are paying for equity in pre-seed and seed companies just have not changed all that much. Yes, the occasional hot company at the Series A stage will command a valuation that looks more like a later stage one if they get credit for forward execution. In other words, an investor says, “I believe you’ll do exactly what you say over the next year, so I’ll give you full credit for this year’s plan and pay for future growth just so I can get into this opportunity.” But by and large, pre-seed stage valuations remain in the $5–7 million post-money valuation and seed-stage valuations remain in the $10–15 million post-money valuation range.

Early Stage Valuations: Cap Table Math vs. Comparables Math

Why haven’t these valuations changed while the later stage valuations and public valuations have? I can speculate two reasons. First, the earlier part of the market is the more inefficient part and the supply of capital has not grown as rapidly in the later stage. Thus, prices remain stubborn. Second, the price of a seed-stage company is arbitrary. At that pre-revenue stage, they are all worth zero — nothing substantial has been built and not real value has been created yet. Therefore, valuations are more about cap table math, driven by rules of thumb regarding how much investors want to own (typically 15–20% in aggregate at that initial stage) as compared to the amount of initial capital that a founder wants to raise to run the set of initial startup experiments for 18–24 months (typically $2–3 million)? Because the cost of experiments continues to be low (and arguably has dropped even further recently thanks to the cloud, open-source, and no code/low code), the amount of capital raised in seed rounds tends to be similar year over year. Founders are quite good at focusing on executing the experiments that matter the most during that initial 18–24 months to hit their key valuation inflection points. And if the prevailing math is cap table math (i.e., ownership) versus comparables math (particularly when there is no revenue off of which to calculate any comparables), it is unlikely that this valuation trend will change.

Conclusion

All of these trends bode very well for early-stage investors. We get to invest at a relatively low (and only modestly rising) valuation in promising startups who can rapidly gain valuation momentum with traction and achieving product-market fit. At least until interest rates rise, and predicting that is way outside my wheelhouse. That’s the message we will be sharing with our LPs.

Former entrepreneur turned VC @Flybridge, teach @HBS, author of Entering StartUpLand and Mastering the VC Game

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