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What’s happening with valuations
Making sense of valuations in Startup Land
Startup valuations have gotten incredibly high in the past few years. Airbyte even raised at an ARR multiple exceeding 1200x, which has raised a few eyebrows. With $100m post money seed rounds, stalwarts like Fred Wilson have done calculations wondering whether seed funds could even make the economics work. So, people have been asking whether the current situation is sustainable. To assess that, we need to know what’s going on.
What’s in a valuation?
To best understand what’s going on with startup valuations, it’s important to have a framework for what valuations even are.
I think Alex Rampell at Andreessen Horowitz has the best description I’ve heard: startup valuations aren’t valuations at all but rather out-of-the-money call options. That is, they are bets that the startup’s valuation will at some point greatly exceed the “valuation” of the round, discounted because it is far away and uncertain. For that reason, I’ll refer to these as “valuations” in quotes for the rest of the piece.
The other side of startup financing is that it’s not just a call option, since derivatives don’t have scarcity (the only limit is the number of people willing to take the other side of the bet) and don’t provide primary capital that the business can use to grow. So unlike derivatives, which are purely zero-sum bets, startup financing has an impact on the future of the business.
Unlike with call options, there is a limited supply of shares that several firms are competing with. So of course, as in all things, the rules of supply and demand apply, and these “valuations” are also prices. Theoretically, there is a perfectly rational price because the terminal value and likelihood of success are objective facts — the variation around pricing come from differing opinions on those two factors.
There are therefore a few evergreen dynamics:
If you believe the terminal valuation is higher than before, the “valuation” should go up
If you believe the likelihood of achieving the terminal valuation is higher, the “valuation” should go up
If more firms are competing for limited supply, the price, or “valuation,” should go up
If you think you have better information than other people, or a leading signal, that should inform the price you are willing to accept, especially in a competitive market
In an uncertain situation, power-law distributions in terminal values should make you willing to accept a higher price than you normally would if you are thinking about a portfolio in a world with uncertainty
If more capital helps the company fuel growth and pull forward, a bigger early round should be rational because it improves the likelihood of attaining terminal value faster
If the cost of capital decreases, then implicitly the cost of pulling forward growth decreases, and you should be willing to accept a bigger round
What’s changed and how to react
So what about these huge valuations? While they are certainly not common, they are also no longer rare. This suggests something is different.
Looking at the above dynamics, it becomes clear what has changed. It comes out to massive TAMs, improved signals for established models, and competition.
The first, and obvious one, is massive TAMs that have exceeded everyone’s wildest expectations for decades. The original Uber seed deck imagined a TAM that is less than Uber Eat’s run rate alone. SaaS companies trade publicly for billions of dollars. The older, bigger tech companies are worth literally trillions of dollars. Best in class companies like Snowflake and Cloudflare post metrics that were thought to be impossible. The perceived terminal values of these companies has gone up dramatically, leading many investors to adopt Peter Thiel’s maxim that one cannot overpay for a generational company. And with the technical impact of zero interest rates, the discounted value of those cash flows are up too. Add in markets that are so large that they no longer seem to be winner-take-all and you have many reasons to increase the “valuation.”
The second change is in the quality of signals. It isn’t the wild west anymore in terms of many of the top tech business models. Many of the most popular models, like consumer internet, enterprise SaaS, and UGC marketplace, have spent the last two decades maturing and are now well understood. The metrics that matter are known, the customer bases are well-understood with repeatable rolodexes, and the number of experienced practitioners are large. This lowers risk, and certainly these businesses are easier to understand. For good investors who add value, more signals in a mature space means less reason to care about price since they can just pump money into their machine (at least, if you believe some VCs actually add value).
Let’s take the example of Airbyte (not to pick on them, of course). When it raised its now-famous Series B, Chetan Puttagunta, the Benchmark wunderkind who sits on its board, tweeted a number of non-revenue statistics regarding its open source product. Airbyte is an open core enterprise SaaS company. For someone like Chetan, who has been on the boards of several multi-billion dollar companies that used that same strategy, this seems like a strong signal. He probably believes, very rightly, that as long as the open source project is going in the right direction, he can help them achieve incredible revenue numbers at essentially any point of their trajectory. And if, like Chetan, you are a believer in the idea that software markets are “gigantic” you should be fine thinking that these companies can use cash like a crank and reach stunning valuations. Since primary capital goes towards growth and expansion, if your theory is that you understand how to crank that growth, providing more capital should lead to a higher “valuation” because the likelihood of reaching the terminal value goes up with the increased cash injection.
But there is a darker side to this dynamic too. Funds have more capital than ever, so there is simply more competition. What I am seeing in the market is a willingness to be speculative and allow for degraded signal quality. I have seen this the most with web3 and fintech. Companies with 100x+ revenue multiples have become not rare, as are companies worth $100 million that have not yet built a product. With crypto companies, fees and trading revenue are treated like user engagement numbers. Most notably, I have seen a number of companies with signed contracts that are not yet executedtreated as credible forecasts to justify high revenue multiples on the theory that they reflect low forward revenue multiples. It is important to note that these are real signals, but they are not as good as gold; there should be a discount on these signals that investors aren’t applying.
Competition is forcing investors to jump on these signals, partially because diligence timelines are compressed and partially because the next entry point may be even higher — or not exist at all. This leads investors to view the risk in whole categories as relatively low when with startups the risk is always high. Especially when prices are high, failures in execution can mean companies that are ultimately successful but relatively poor in outcomes for everyone on the cap table. Competition can also lead to ignoring signals too. As interest rates are rising, public markets are possibly going through a period of secular multiple compression, which would affect terminal values. Right now private market “valuations” have not adjusted because competition is too fierce, but if this appears to be non-transient, crossover “valuations” will change.
There is one last dynamic to note: venture capital is a product. What it sells to LPs is a way to deploy cash. So it is possible that investors are deploying cash to fulfill the LP’s side of their business and just foie gras-ing their startups in a way that will be negative for the whole ecosystem in the medium term in order to let themselves raise a new fund. This is not a good long-term strategy for the funds, either, though, since this may not even work for one cycle, let alone two.
The response to this is basically to not compromise on quality and move upmarket. Keith Rabois calls this shifting quality over fighting valuation. There are deals where companies have premium valuations but strong reasons to believe they have technical or market moats and are showing lots of signals. For those companies, the price will remain premium, but the long-run outcome will justify it. On top of that, I expect the rounds to be big, and therefore I expect playing the game to require significant funds, even more than before.