![Why Valuations Are Getting Too High for Seed Stage Investors [OPINION]](https://helios-i.mashable.com/imagery/archives/01tD1CHgP0ZFwFzc1oRixQ2/hero-image.fill.size_1248x702.v1647020094.jpg)
One of the surest signs of a bubble is when you start to hear the phrase, "This time it's different." That's my cue to clap my hand over my wallet and head for the nearest exit. That same mentality is starting to bubble up around seed stage valuations. Investors are justifying those higher valuations with comments like "social media and viral loops make marketing more effective" or "If things don't work out, we can sell to Google as a talent acquisition."
It all comes down to the fact that all the previous norms of seed stage investing have gone out the window. The problem is that this shift partially ignores two important factors: History and economics. Here's why valuations still matter.
History
Uncapped convertibles used to be the standard financial instrument of seed stage investments. Investors didn't face the same kind of valuation risks they do now. Angels didn't care about valuations because the idea of a $30 million pre-money for a Series A round of fundraising was laughable. Back then, $10 million was a respectable Series B valuation.
Today, the same conditions no longer apply. Pre-product startups with novice founders are getting $8 million pre-money valuations. The angel who leaves it up to venture capitalists to set the valuation of his or her investment is likely to end up paying a $20 million premoney.
Economics
So what? Do you think Sequoia feels bad about the premoney on their Google investment? The Google argument is a pernicious one, because it relies on two fallacies. First, availability bias means that we remember Google far more than the legion of failed investments from that same time period.
Second, the Google argument assumes that you even get the opportunity to invest. You're not Sequoia. You might not get into that hot deal you heard about. If you still invest at a high valuation, you're like a car shopper who passes on the Ferrari dealer to then pay $100,000 for a Camaro.
The fact is that the success rate for early stage investments is abysmal. The general rule of thumb is that only 10% of venture-backed startups are successful. The record for seed stage companies is even worse, since companies rarely make it to exit with just a seed round. Even if we're generous and assume that half of seed stage companies manage to raise a Series A, that's still only a 5% chance of success.
If success consists of a $100 million exit and we assume 50% dilution, the break-even point on premoney valuations is $2.5 million. If we assume that the big winners return far more than $100 million and therefore justify using $200 million for the mean exit, that still only pulls the break-even point to $5 million. That's a far cry from valuation not mattering.
Consider this scenario: Investor X invests in $250,000 in each in each of 20 companies, at a $2.5 million postmoney valuation ($2.25 million pre), and thus owns 10% of each. The total investment is $5 million ($250,000 x 20). Of the 20 companies, one successfully exits for $100 million after raising a Series A and Series B. Investor X, after being diluted by the two rounds of subsequent financing, holds 5% of the common stock, and receives 5% of that $100 million. Thus, after investing $5 million and holding on for some number of years Investor X ekes out a 0% return from the one successful exit in his fund.
Note: You may notice that I am basing my return calculations postmoney rather than premoney valuations. I’ve chosen to make this simplification for two reasons. First, given the small size of most seed rounds (under $500,000), the delta between pre and postmoney valuations is pretty small; and second, no one ever talks about anything other than “the pre,” so it is simpler to stick with that metric.
Since the goal of venture investing is to provide a 3x cash-on-cash return over the lifetime of the fund, angel investors would need to invest at an average valuation of $1.7 million to deliver the desired return.
Most of the time angels refuse to provide information on their returns but we do have one interesting proxy: YCombinator.
Paul Graham, a founder of Y Combinator, recently reported that the total value of Y Combinator's (relatively) mature graduates amounted to $4.7 billion, or roughly $22 million per company.
That's impressive performance, even if the majority of that value comes from two companies (AirBnB and Dropbox). But let's start to apply the same math as before. Assuming 50% dilution, we get an average value of $11 million. Throw in the requirement of a 3x cash return and we find that an angel seeking good, risk-adjusted returns would need to invest at an average premoney of less than $4 million.
In recent classes, Y Combinator companies have been getting $8 million or higher on their valuations. That doesn't bode well for angel returns.
This doesn't mean Y Combinator is a bad business. Y Combinator is a fantastic business. It invests at an average premoney valuation of less than $300,000 ($20,000 for 6% of the common stock). Despite that, Y Combinator is still a great deal for entrepreneurs. The value of the mentorship and branding far exceed the equity you give up.
However, if you won't make venture capitalist-scale returns by investing in Y Combinator companies at more than $4 million premoney, the returns on non-Y Combinator investments will probably be even worse. If we assume that Y Combinator companies are worth double the average, the acceptable premoney for the average seed investment needs to be $2 million or less.
Conclusion
It's an oversimplification but the underlying math is solid. Seed stage valuations are too high. Angels that pay those higher prices might not end up losing money but they won't earn a return that's commensurate with the risk they're taking.
Some entrepreneurs might be upset with this post. After all, aren't higher valuations better? One entrepreneur only half-jokingly asked if he could finish raising his round before I published this post.
The thing is, with a seed round of $250,000 or even $500,000, the valuation doesn't matter that much for the founders. Let's say I were to raise $500,000 at a $2 million premoney. I would be giving up 20% of the company. If I raised at a $4.5 million premoney instead, I'd only be giving up 10%. On a $100 million exit, that's the difference between $80 and $90 million. (Yes, I know I'm not accounting for liquidation preferences, the option pool, etc. But this is an article, not a dissertation)
There just isn't that much difference between those outcomes for the founders. Or let's try something harder. How about a $20 million exit. Ignoring liquidation preferences, we're talking about the difference between $16 and $18 million for the founders. For the angel investors, it's the difference between 4x and 8x their money. That's a huge difference.
Diversity is good for the startup ecosystem. If angels get priced out of deals, not only do angels suffer but entrepreneurs lose out on a lot of expertise and venture capitalists lose out on some valuable filtering.
In short, valuations are too high. It will be better for the entire ecosystem if they return to historical norms.