Startup Valuation: How Venture Capitalists Value Early-Stage Companies

Startup valuation, often perceived as an art more than a science—and occasionally even as black magic—is a complex process characterized by high levels of ambiguity. Unlike mature businesses with years of historical data and steady cash flows, early-stage startups often lack substantial track records and have uncertain future prospects. This makes valuation more of an informed speculation rather than a precise calculation, as traditional valuation methodologies often fall short. Venture Capitalists have to rely on a mix of metrics, market trends, intuition, and experience. Consequently, the craft of startup valuation becomes a delicate balance between analytical rigor and speculative judgment.

In this post and the companion webinar, I delve into the mechanics of how Venture Capitalists evaluate early-stage startups. I discuss the key dynamics in VC valuation, two primary methods VCs use, and the internal, external, and human-related factors that impact startup valuation. I also provide a long-term perspective on the state of the market. Whether you're an Investor or an Aspiring VC preparing job interviews or an entrepreneur raising funds, this post will offer valuable insights to help you navigate the complex terrain of startup valuation.

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Key Dynamics in Venture Capital Valuation

Venture Capital valuation is a complex, often subjective process that relies on a multitude of factors. Let's explore some of the crucial dynamics that define this process, from the dualistic approaches of VC investing to the unique rules that govern startup valuation.

Two Approaches: Fundamental-Driven vs. Land Grabbers

Two distinct approaches have prevailed in the last two decades:

  • Fundamental-driven VCs focus on performance and market fundamentals, taking into account a startup's potential for profitability, market size, and growth rates. They are meticulous, preferring to invest when they can clearly see a path to substantial returns.
  • Land Grabbers, on the other hand, recognize that there will be a limited number of unicorns every year and focus on getting "unicorn real estate", regardless of valuation.

The influence of each group over startup Founders fluctuates with market cycles, especially during periods of market bubbles and bursts. Haystack Founder Semil Shah suggested in March 2021, in a frothy VC market, that this dichotomy explained a dislocation.

Fundamental-Driven Investors represent a more traditional view of valuation. These Investors' philosophy is deeply rooted in evaluating businesses based on revenue growth potential. They're willing to pay a premium, but only within the framework of this approach, which is often based on public comparables and exit comparables. Their aim is to back startups whose unit economics show promising growth.

FOMO around limited real estate for VC ownership in those earliest rounds is very real and warranted. 

Semil Shah - Haystack (Source: website)

On the other hand, Land Grabbers represent a newer breed of Investors or established players who have quickly adapted to the rapidly evolving startup landscape. Tiger Global and other crossover funds exemplified this trend. They view early-stage investments as finite, highly coveted pieces of real estate. The stakes here are high, as they often only get limited chances to secure an ownership stake in a startup. Their approach is less about valuation metrics and more about securing a stake in potentially game-changing companies at the earliest stages. For them, the fear of missing out on the next Snowflake, Zoom, or Airbnb can be a powerful motivator, overriding traditional valuation metrics. This approach is especially prevalent among billion-dollar funds that require high-value outcomes to significantly impact their portfolio. They need to "move the needle".

The Only Rule That Matters in Startup Valuation

In traditional investment theory, as popularized by Investors like Oaktree Capital's Howard Marks, the age-old mantra is to "Buy Low, Sell High." This refers to the practice of purchasing stocks or other securities at a low price and selling them when their price appreciates. This strategy is a tried-and-true method for generating profit in the public markets. (Marks recently encouraged public Investors to hold on to their stocks when it made more sense, and not sell due to "the fear of making mistakes, experiencing regret and looking bad."

However, in Venture Capital, this adage loses some of its relevance, primarily due to the power law dynamics and the potential for extraordinary returns. Instead of seeking to buy cheap, Venture Capitalists invest in startups with the hope of massive growth, which could result in exponential returns. This approach is different from traditional investing because the primary focus is not on buying at a low price, but on identifying potential 'unicorns' that could provide outsized returns.

Valuation is a mental trap.

Peter Fenton - Benchmark (Source: 20VC)

Peter Fenton, a general partner at Benchmark, and an early Investor in huge successes such as Twitter, Yelp, and Elasticsearch, stresses his belief that valuation is just one factor to consider when investing in a company. The team, the market, and the product are all more important. If a VC firm identified a startup as a potential winner in its market due to its fundamentals, it should be willing to pay a premium even if the valuation seems high.

The high risk, high return rule is a fundamental principle in finance and investing. Simply put, it means that the potential for higher returns is typically accompanied by higher risk. This is largely due to the inherent uncertainty in predicting future outcomes: the greater the uncertainty, the greater the potential variability in returns, which translates into higher risk.

Venture Capital is a quintessential example of this principle in action. Startups, particularly in their early stages, are highly risky ventures. They operate in uncertain markets, often with unproven business models, untested products, and inexperienced teams. They may face stiff competition, regulatory challenges, or technical hurdles. Many of them fail. According to various studies, the failure rate for startups can be as high as 90%.

However, the potential returns on successful startups can be extraordinary. When a startup succeeds, it can generate returns many multiples higher than the initial investment. These 'home run' investments can more than compensate for the many losses in a VC's portfolio. For instance, a single successful investment in a company like Facebook, Uber, or Airbnb can cover the losses from numerous failed investments and still provide a substantial overall return to the VC's fund.

I’m often wrong. But when I’m right, I’m f*cking right.

CHRIS SACCA – LOWERCARBON CAPITAL (read more here)

This potential for outsized returns in the face of high risk is what makes the Venture Capital asset class appealing to certain types of investors. These investors, typically institutional ones like endowments and pension funds, or high net worth individuals, are willing to accept the high risk associated with Venture Capital investing because of the chance of achieving high returns.

State of The Market (Update: July 2023)

Venture Capital investments have been on a downward trend in recent months, as Investors have become more cautious about the economic outlook. In the first quarter of 2023, VC investment in the United States fell by 31% from the previous year. This trend is expected to continue in the second quarter, as investors wait to see how the economy develops.

The decline in investment volume has triggered a softening of valuations compared to the astronomic levels in 2021. It is having a ripple effect on the startup ecosystem. As Investors become more selective, startups are finding it more difficult to raise capital. This is leading to layoffs and other cost-cutting measures at many startups.

These factors are making Investors more risk-averse and less likely to invest in early-stage startups. As a result, the Venture Capital market is likely to remain volatile in the near future.

Now, let's delve into the methods VCs use for startup valuation.

Two Methods VCs Use for Startup Valuation


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