Valuation Inflation

Fred Wilson recently wrote about valuation obsession where companies are trying to raise money at nosebleed valuations in order to obtain the credibility & visibility they they want (or that the press wants to cover). He also talks about concern that valuation has become about checking a box or the number itself vs validation around building a great product and business. I felt compelled to chime in here because the short-term markups can be a great look but doors (options) close fast for a company with a valuation it cannot justify for reasons beyond deal economics, and this is worth unpacking.

I’ll echo Fred’s sentiment that the goal ought to be maintaining conversation and focus around building a great product the market loves, with a healthy and positive company culture. The valuation will follow and will be earned accordingly without the risk of the big down round or re-cap when the trajectory isn’t vertical.

For a counterpoint Dustin Moskovitz had this to say about Fred’s post;

Fred’s claim that he isn’t acting out of self-interest is nonsense. High valuations = low dilution = smaller returns for investors. They benefit companies because candidates value equity compensation more. You can’t just claim it’s a vanity metric w/o addressing those realities

I understand the forces that are driving the inflation and where these big rounds are strategic. I also think it needs to be kept in check by both sides of the table. A little more deference to long term viability in a more challenging market is prudent and gives the company a much greater chance at survival when that day comes. Would you rather be returning capital and selling furniture, or closing a flat or slightly down round and trimming the team 20%? Hard to win when you are dead.

You are free to accuse me of more VC self-interest, but I get both sides and think its a good conversation to have out in the open. I’d like to see the inflation noted and kept in check where possible.

For me, both POVs resonate and yet have me concerned. As long as the music is playing, the game will continue…but when it stops the damage done to companies (and early stage VC) could be 10x worse than it needs to be. When the doors close and options become limited the likelihood that everyone loses goes up. A company with 5M in ARR and a 250M post is a lot harder to sell or fund than the one with 5M in ARR and a 60M post in a tough market.

Yes, I’m an early stage VC and I do care about valuations and ownership. I see too many companies raising money at inflated valuations given progress right now. Investors need to keep deploying capital and companies need to keep raising, but its driving the inflation up the chain.

For some additional color on the dual lens I see this through… I’ve been out there with my hat-in-hand fundraising in tough economic cycles (most recently 2008–9 with Filtrbox) so my thinking on this topic is influenced accordingly. As a founder, I was far more concerned about who I got to work with and learn from than 5 points one way or another. I was also raising in a really tough market dynamic and valuation wasn’t the priority. When we sold the business, the modest post money we were carrying and limited capital raised created a lot of optionality and the ability to achieve better multiples for our investors. We were not over our skis, but to be fair I couldn’t have chased a huge valuation if I tried back then.

Things I’m seeing now:

1. 2nd and 3rd seed rounds to “buy more time for the A” because the company either doesn’t have the momentum to get an A round done or the founders want to achieve a high valuation / big raise. Companies can end up 3 rounds in, early investors tapped out, with a post in the high teens or 20s before going out for the A round. This can be the beginning of the lean over the skis…and create a super high hurdle for the next round. When that round takes too long or the terms aren’t to the company’s liking…it puts the entire business at risk and the options become limited, fast.
2. Competitive ratcheting — Company A, raises 20M on 60 pre because they are in SF and a 1B fund backed them. They still sold 25% of the business, and they are going to burn the 20M in 2 years. The investors and CEO want to “king-make” this company by building a financial moat around it that deters the rest of the market. If I’m being cynical, the product at this company is probably the 3rd priority. Quickly, Company B in the same space feels intense pressure to raise as much or more in order to be seen as equal in the market. They go pitch every big firm they can for their 20M round, but no one bites, because they are in Chicago not SF and now seen as #2 at best given the obsession the tech press has with valuations. Had they gone out for 5 and raised 7, they’d be back at the shop building product. Now they are 4 months from cash-out and morale is tanking.
3. The cost of winning — Dustin’s point above is actually an important one as part of what I think he’s alluding to is the “the cost of winning” the press / mindshare game in a place like the bay area right now. Its all just math and relative percentages so when you get $1B funds doing early stage investing the intersection of the fund needing to write a large enough check for it to be worthwhile x the valuation itself providing leverage for the business x the 20M still only lasting 18 months in SF…I can understand how the system enables an early stage business to have an 80M-100M post, and how you get to the place of a 1B valuation pretty quickly if the starting point is grossly inflated.

Building a great company is hard enough and valuation inflation dynamics tend to close more doors than they open. While it might be easier for a company to recruit (expensive) talent with the billboard raise, the future financing options can become limited fast. Time to exit extends, and M&A options shrink as there are fewer buyers in the thin air. When we end up with a material change in trajectory in this macro cycle…look out below.