Do Valuations Matter When Investing in Startups?
In the fast-paced world of venture capital (VC), one of the most debated topics is the importance of valuations when investing in startups. This debate often polarizes fund managers, with solid arguments on both sides. In this article, we will explore the technical aspects of valuations, including the power law distribution, and present a balanced view using insights from various experts.
Understanding Valuations
Valuations provide significant information about a startup, including investor demand, the quality of the team, market opportunities, and the competitive landscape. They also reflect investors' willingness to pay, which is driven by competition among them and the overall market sentiment.
The drivers of valuations can succinctly be divided into investor willingness, competition, market demand, and company-specific factors such as team and technology.
The Power Law Distribution in Venture Capital
One technical aspect often discussed in the valuation debate is the power law distribution, which asserts that venture capital returns are not normally distributed but follow a skewed pattern where a few investments generate the majority of returns. This means that venture capital returns have "fat tails," indicating the potential for extremely high returns from a small number of investments.
In a power law distribution, small outcomes are most likely, but there is a significant possibility of huge outcomes.
In venture capital, this implies that a handful of successful startups can yield extraordinary returns, overshadowing the performance of the rest.
Basic Fund Dynamics
Understanding a fund's fundamental dynamics is crucial to grasping the importance of valuations. Here are three examples comparing an accelerator fund, a seed fund, and a large fund, with updated numbers based on different fund sizes and invested amounts.
For each example, 50% of the fund is reserved for follow-on investments, and the number of portfolio companies is set to 30 for the accelerator and seed funds.
Accelerator Fund:
Fund Size: $10M
Valuation Invested: $2M
Invested Amount: $166,667
Equity Owned: 8.33%
Required Exit to Return 3x on the Fund: $360M
Number of Portfolio Companies: 30
Seed Fund:
Fund Size: $10M
Valuation Invested: $10M
Invested Amount: $166,667
Equity Owned: 1.67%
Required Exit to Return 3x on the Fund: $1.8B
Number of Portfolio Companies: 30
Large Fund:
Fund Size: $1B
Valuation Invested: $10M
Invested Amount: $500,000
Equity Owned: 5%
Required Exit to Return 3x on the Fund: $60B
Number of Portfolio Companies: 1000
This analysis highlights that the scale of required exits varies significantly with fund size and investment strategy. For smaller funds, each investment needs to achieve substantial success to return the fund.
Investing at an earlier stage with traction-focused metrics can provide an advantage by de-risking the traditional accelerator model. This approach underscores the importance of careful valuation considerations concerning fund exit potential.
The large fund example, with its substantial number of portfolio companies, demonstrates the potential to spread risk and increase the likelihood of hitting multiple outliers. However, it also requires significantly larger exits to achieve target returns.
Importance of Portfolio Size for Power Law Returns
A venture fund typically needs to make at least 30 investments to effectively hit power law numbers (this number is widely debated and can range up to 250+). This is because the chances of finding a startup that will yield extreme returns, like Uber, are statistically low but increase with the number of investments.
For instance, in the examples provided:
Accelerator Fund: With 30 portfolio companies, the statistical chance of hitting an outlier like Uber improves. The fund must focus on identifying high-potential startups that can achieve outsized returns. The emphasis is on finding early-stage companies with solid traction and scalable business models, which can significantly boost the fund's overall returns if successful.
Seed Fund: Similarly, with 30 portfolio companies, the seed fund increases its chance of hitting outliers. However, the return needed to achieve 3x the fund is significantly higher, requiring exits of $1.8B. This necessitates a strategy that involves selecting startups with exceptionally high growth potential and the ability to achieve significant market penetration.
Large Fund: With 1000 portfolio companies, the large fund has a much better statistical chance of hitting multiple outliers, spreading risk, and increasing the likelihood of finding startups that can deliver extraordinary returns. However, the large fund also faces the significant challenge of requiring extraordinarily high returns to achieve its goals, with required exits totaling $60B to return 3x on the fund.
Moreover, the fund's sheer size and number of investments might lead to a ceiling in the availability of high-quality startups. There is a risk of diluting the fund's focus by investing in lower-quality startups, which could hinder overall returns. The challenge lies in finding enough promising startups to invest in.
Arguments for Valuations Matter
Valuations and Risk Management: Valuations help manage risk by setting clear expectations for returns. A triangulated approach, considering company factors, market conditions, and the fund model to determine acceptable valuations, ensures that investments align with the fund's strategy and return expectations.
Ownership and Fund Returns: Entry valuations are crucial for maximizing ownership, directly impacting fund returns. Higher ownership at lower valuations means better returns if the startup succeeds. Given the unpredictability of outcomes, controlling what is predictable, such as entry valuation and ownership, is essential.
Setting Up for Success: Valuations must make sense relative to the business stage and future fundraising potential. High valuations can hinder future funding rounds, increasing the risk of failure. A reasonable valuation sets a company up for sustainable growth and successive funding.
Arguments Against Overemphasis on Valuations
Focus on the Right Companies: Securing investment in the right companies is more important than the valuation. Getting into high-potential companies should be the primary focus in early-stage investments, even if it means accepting higher valuations. The power law distribution supports this, as being part of a successful startup can yield disproportionate returns.
Market Efficiency: The early-stage venture market is relatively efficient, with valuations capturing most of the positive signals about a company. Valuations may not significantly impact returns within a specific range because they reflect the market's collective assessment of a company's potential.
Flexibility and Opportunity: Being too rigid about valuations can lead to missed opportunities. While valuations serve as guardrails, flexibility is crucial, primarily when firm conviction in the team and product exists. Passing on promising startups solely based on valuation could mean losing out on potential outliers.
Balancing Act: A Strategic Approach
Venture capitalists need a balanced approach to valuations. Here are some strategies:
Clear Valuation Strategy: Having a well-defined valuation strategy helps maintain discipline. Exceptions should be rare and well-justified, ensuring that frequent overpayments do not undermine the fund's overall strategy.
Ownership Targets: Setting target ownership levels can help manage the impact of valuations on fund returns. Prioritizing ownership over valuation ensures that substantial ownership in successful startups is achieved.
Scenario Planning: Using scenario planning to back-solve valuations from desired exit outcomes helps determine if the current valuation aligns with the fund's return goals, considering factors like check size and ownership percentage.
Conclusion
Valuations matter in startup investing, especially for managing risk and maximizing returns through ownership.
While flexibility and market efficiency are important considerations, a well-defined valuation strategy ensures that investments align with a fund's overall objectives and risk tolerance.
By integrating these insights, venture capitalists can enhance their chances of backing successful startups and achieving significant returns.