Last week I posed a question on twitter that I have been asked many times before looking for a rationale on why pre-seed and seed investors should not care about valuation. I didn’t get any responses, because half of my twitter followers are due to Justin Bieber randomly following me, so I did some research to try to understand some of the stances on this often-discussed topic.
To me, valuation is important and should 100% be considered when investing at all stages.While you can make an argument that seed investing is more competitive than ever, and that the importance of getting into a deal should be weighed against the valuation because you believe the company will be a huge success, in VC there’s a greater than 50% chance that you’re wrong. And regardless, as an investor it intuitively doesn’t make sense to disregard valuations.
But I kept digging anyways.
Ron Conway, one of the best angel investors of all time, has invested in convertible debt rounds with no caps. He also has stated that when you are investing in the next big thing, investing at a $3M valuation vs. a $5M valuation doesn’t mean much.
I built a simple model (based off of Fred Wilson’s dilution post’s doc) that looks at ownership for a seed investor who joins a $500k seed round with $100k at both a $3M or a $5M post-money valuation. You can play around with it as you see fit, but what it shows is that an investor in a company that goes on to exit for $1B after raising seed – Series E, returns 66% more money (or ~$5M more) at exit, on a $100k investment invested at the $3M valuation. To be fair, both returns are great, but when returns cover a portfolio where 50-70% of initial investments lose money, or when you’re a fund competing to raise money against an increasing number of early-stage VCs, a 77x return versus a 121x return in your portfolio could be meaningful.
What this model doesn’t take into account is the potential difficulty a company can face when they attempt to raise follow-on funding if their seed round was priced too high. Nor does it take into account how the type of investor in the seed deal can affect future fundraising prospects.
We have seen an increase in larger institutional VCs who use seed rounds to buy optionality to invest at a later round. Those who are merely writing a $250k check out of their $250M+ fund won’t care about their seed investment’s valuation, as their plan is to build meaningful ownership in follow-on rounds instead. However, if they choose to not follow-on this can harm the company in a big way because of negative signaling. Chris Dixon ironically wrote about this in 2012 before he joined A16Z.
As I dug deeper into the subject, the take I agreed with most was from Jerry Neumann who said this in his post from 2011:
The idea that was briefly tossed around that valuation doesn’t matter because a startup either goes big or dies is wrong. Ludicrous, in fact. There’s a range of outcomes for every fund. The cliche that out of each ten investments, two are winners, three are failures and five go sideways shows this. The two winners determine whether the fund is an overall winner or loser, but how sideways the five go determines whether it’s a good return or a great return. What happens to the second tier of investments matters. And, for the math challenged, even if startup returns were binary, when you invest in many of them you get a binomial distribution, so expected value matters.
Leo Polovets of Susa Ventures found himself a little less sensitive to valuations as Neumann:
Valuations do matter, but exact valuations do not. The average return of an angel investment is 2.6x over 3.5 years, and it’s okay if your valuation estimates are off by 5-10% once in a while…For a professional fund, the goal is to have better than average returns (e.g. 4x or 8x), and in that case the quality of companies that you invest in becomes more important than your ability to calculate their valuations to the nearest dollar.
Jordan Cooper and Rob Go each had interesting points for and against valuations mattering as well. With Cooper saying that he views a bad valuation as a potential indicator of bad judgment, and Go conceding to overpaying at the seed stage regardless, thus he doesn’t get too hung up on valuations.
To wrap this up, I’ll leave you with, Roger Ehrenberg of IA Ventures, who may have summed it up perfectly:
Who cares. If deal pricing gets out of whack relative to what you believe is fair, simply walk away. Nobody is holding a gun to your head to invest in a particular company. Might you feel badly if you pass due to valuation and the company becomes super successful? Of course; but this kind of disappointment is part and parcel of being an early stage investor. Remorse around deals done and lost is part of an investors’ DNA. It would be far worse to stray from your mission and discipline and to start doing deals that feel uncomfortable, because more likely than not it will be a mistake for you to have invested in deals outside your zone.