Startup Valuation Trends: AI and Mega-Funds [The Equidam Podcast - 15]

In this conversation, Daniel Faloppa and Dan Gray discuss the current state of the fundraising environment for startups in 2025, analyzing trends, challenges, and opportunities. They explore the impact of economic factors on valuations, the importance of cash flow, and the evolving landscape of venture capital and private equity. The discussion emphasizes the need for founders to navigate uncertainty and make informed decisions about fundraising strategies while considering the long-term implications of their choices.

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Takeaways

The fundraising environment in Q1 2025 shows more activity compared to the previous year.
Valuations have decreased globally, indicating a challenging market for startups.
Founders should focus on cash flow models to ensure sustainability.
The uncertainty in the market requires careful planning for fundraising.
Investors are increasingly looking for companies with solid cash flow and growth potential.
The convergence of VC and PE could create new opportunities for startups.
Founders need to be aware of the cost of capital and its implications on growth.
The AI landscape is evolving, with a focus on sustainable business models rather than hype.
Choosing the right investors is crucial for long-term success.
The historical context of venture capital highlights the importance of sustainable growth.

Takeaways

Chapters

00:00 Understanding the Fundraising Environment
01:56 Global Trends in Startup Valuations
06:19 Regional Insights: A Closer Look at Geographies
08:07 The Impact of Economic Factors on Fundraising
14:55 Navigating Uncertainty in 2025
21:49 The Shift in Investor Risk Profiles
30:35 The Changing Landscape of Fundraising
34:33 Understanding Capital Needs and Risks
41:08 Navigating the Current Investment Environment
44:08 The Shift Towards Hardware and Physical Goods
54:00 The Importance of Sustainable Business Models

Transcript

Daniel Faloppa (00:00)
All right. We have quite a few things to go through today, think. like trying to understand the fundraising environment. How is it going this year, Q1 2025, and then how is going to be for rest of 2025, what can founders do, what should founders do in terms of positioning, in terms of fundraising, and…

Hopefully, we have some data to back up some of these things and some of our considerations. then, yeah, hopefully, it’s going to be an interesting episode.

Dan Gray (00:37)
Yeah, it’s funny. We did the last episode, I think about a month ago now, and that was like titled like the state of venture capital in Q1 2025. Looking at the early signs and the early reports that had come out looking at the end of last year. It feels like an awful lot has happened since then. And like for sure, I don’t think either of us is any more optimistic than we were when we did the last one.

Daniel Faloppa (01:00)
Well, I don’t know. We started the year better, right? So that’s the, I think the first thing to state is that it’s a different start compared to last year. Yeah, we ended the year already with optimism and with more movement. The fact that the US presidency got decided, I think, removed some uncertainty from the last month, month and a half of last year.

Dan Gray (01:15)
Mm-hmm.

Daniel Faloppa (01:29)
Then founders got ready, investors got ready. And then this year, the fundraising market is more active, or at least so far, it’s been more active. Or it feels more active. There isn’t a whole lot of data about it. is our data out now, but the others haven’t yet published any numbers. I don’t think about Q1 2025.

So yeah, maybe that’s where we start, right? We start from our numbers.

Dan Gray (01:56)
Yeah, I’ll share a few slides we’ve got on that. I also just add that like it’s always difficult to tell, to like to reconcile what people are talking about. They’re like the narrative about startup fundraising with what’s actually happening because there’s weird incentives where if you’re a VC, you want your investors to believe that everything’s great and things are moving and investments are happening. And it may not always be the case. So yeah.

I guess that’s part of what we do is try and find the thread of truth

Daniel Faloppa (02:26)
Yeah.

maybe you want to raise more either as a startup or as an investor, right? So there is this like inherent incentive in hyping up everything, which is something that we want to go against trying to have some data on things. And yeah, here’s the first data.

Dan Gray (02:46)
Yeah, so this is interesting. This is like a weird idea that came to me this morning. I was looking at the fundraising figures from our latest startup valuation Delta report on Q1 and particularly how every region has taken a hit, but especially Southeast Asia.

And second to that, Europe, think, took the next biggest decline in pre-seed valuations at a median level. And I was reflecting on that versus the tariffs that were announced last night in the US. And I thought, maybe there’s some, not necessarily a causal link, but some correlation it would be interesting to look at. So you can see here, the two plotted on the two different axes there. And there is an interesting correlation.

Daniel Faloppa (03:24)
Yeah.

Yeah, so valuations have decreased. So this is Q1 versus Q4 of last year, right? So in these last three months compared to the last three months of 2024, you can see valuations have decreased between like 35%, 38 % of Africa to like a Middle East kind of staying stable, right? And yeah, it’s interesting. Like we were talking about it, right? I don’t know.

if there is like, seems almost too incredible if this was like such a tight relationship between the two things. But like what we saw during COVID and well, and before and after is that fundraising is very susceptible to optimism in the world in general, right? Especially because like start-up fundraising is such a long-term game.

And every little change in optimism that kind of changes the narrative three to five to 10 years out does have an effect on the fundraising environment. Maybe not this immediate, but yeah, this is definitely interesting to see.

Dan Gray (04:41)
Yeah, the only

one, you know, with all of those regions, I think you can make some assumptions about what’s driven the change. Like, Europe’s had a lot of political instability, the election in Germany, there’s like chaos in France, there’s still like economic issues. The only one where I was puzzled and what kind of generated this question was Southeast Asia, because there was nothing obvious to suggest why it should drop by this much.

So maybe there in that region, because you could have anticipated that Southeast Asia might be hit quite hard by tariffs, know, long before yesterday, probably. you know, that’s one region where maybe it could have been a bit causal, but in general, you know, probably not that much. It’s more about the instability of the regions.

Daniel Faloppa (05:25)
Yeah, and probably like a lot of capital there, same story for Africa, comes from the US, right? And so like when that capital pulls back, then valuations retract a lot. I was talking yesterday with some of our Australian partners and they are seeing like good figures and a good activity in the environment for Australia, for like sort of the South Pacific.

Dan Gray (05:31)
Mm-hmm. Yeah.

Daniel Faloppa (05:52)
But yeah, of course, things that were really pushing towards economic growth and startups as well, like Indonesia, Vietnam, Malaysia, I think they have been a little bit more conservative as of late. So the overall trend looks like globally towards a valuation decrease, right? We will talk about the global trend, but if we wanna close up the chapter on geographies, valuation decreased pretty much worldwide.

Dan Gray (06:10)
Mm-hmm.

Daniel Faloppa (06:18)
in terms of geographies and a little bit more contained in the Middle East where they’ve made that decision, I think a year, year and a half ago to look inward more, right? To where Saudi investors or anyway, Middle Eastern investors are investing more within their own country. They haven’t limited, but they are looking in a different way towards outside capital and outside companies raising their capital.

That’s, think, probably protecting them a bit from the outside world. And in a sense also, it’s still an environment that is developing very fast and that does have the internal resources to develop very fast. So yeah, it’s quite interesting actually to see that as maybe one of the best spots to develop startups these days.

Dan Gray (07:02)
Mm-hmm.

Yeah, certainly in terms of stability, there was a big push. think in 2023, a lot of US venture capital firms are going to the Middle East, UAE, Saudi Arabia, particularly looking for that the sovereign wealth funds to fund the mega funds in the US. But yeah, I think in the last couple of years, they’ve really looked to kind of stabilize internally to their benefit, it appears.

Daniel Faloppa (07:35)
Yeah. And

yeah, I think so. And then also like they’ve been, they’ve been fairly open to crypto, right? There was a lot of crypto there. And then also to AI, like in that sense was, I think it was more in terms of investments and special economic zones, lowering taxes for AI companies. But yeah, you know, good, good moves. Definitely. If you want to position

the countries for the technological future and use your own advantages that they have.

Dan Gray (08:07)
Yeah, absolutely. Before we move on completely from the regions, there’s just a couple of other charts we can look at. And I’ll cut this out because I put them in the wrong order. So this is a quick look at the trend in Europe since the start of 2023. And you can see it’s actually been fairly stable since then. A lot of that volatility from 22 was contained there and has been

less obvious since. think 23 we can see generally around the world. You’ll see this in the US data as well. was like middle of 23 was the peak of the AI hype. Everybody had a bit of an increase around there, but mostly flat since. Decreasing valuations in the last three quarters. know, again, probably connected to the political stability and economic issues we discussed, but quite flat on the dilution.

which is, I guess, a good sign.

Daniel Faloppa (09:01)
Yeah. it like we… Well, so first of all, right, three quarters of down valuations. Do we call that a valuation recession? It’s an interesting point. I mean, the narrative still in Europe is we’re losing competitiveness. We have difficulties scaling these companies. Here we are looking at pre-seed. We have…

Dan Gray (09:11)
Yeah.

Daniel Faloppa (09:28)
improve the way that we identify pre-seeds. So it’s companies that are up to MVP that haven’t received institutional funding yet. So no VCs yet. And so the targeting is quite nice. The valuations now at the post money of like five and a half million raising about 500k, 600k pre-seed and keeping that stable. yeah, the dilution keeps on being stable.

My theory, and maybe that’s the next topic, what we see in other markets and also in other reports, I think the KPMG report from the end of last year is an increase of dilution because there is an increase in investment. So valuation staying stable, higher amounts raised are bringing more dilution to founders.

One of the things that we talked about before in other episodes, and then I think I’m convinced of is the alphas and the real gains are moving into more capital intensive startups, hardware startups, deep tech startups, research intensive startups that are able to create that mode, or they are being…

if we want to be pessimistic, burnt in the AI high-stake games. So I think the fact that Europe remains at the same 10%, does it signify that we are still remaining on the previous startup business models? Are we still doing SaaS? Are we still doing very low-capital requirement type of things that might be out-competed more easily?

I think the whole game is changing quite a lot and the fact that we are seeing the same here is, I don’t know, my opinion, not a good indication of progress.

Dan Gray (11:30)
That’s a good question, actually, and frames the next one nicely. But before we get to that, just two other quick points. The first is on the dilution. We consistently see, I think, all time periods in all regions, founders shooting for a relatively low, surprisingly low amount of dilution compared to what the market average is for pre-seed, which is like 15%, maybe up to 20%.

Daniel Faloppa (11:31)
man.

Dan Gray (11:57)
Our data always shows lower and that’s presumably because founders looking to go out and fundraise who do evaluation with us and have that in mind as their plan may target a lower raise initially. But then once they speak to investors and the investors are interested and want to invest, they actually want more of the company. So the investors may press them to take a bit more money.

Daniel Faloppa (12:19)
Yeah.

Dan Gray (12:19)
or

perhaps to pull their valuation down a bit one way or another, but they want to increase their ownership.

Daniel Faloppa (12:23)
Yeah, but that still would reflect, like if you see the other geographies, we have an increase in ownership, in average ownership, and not in Europe. yeah. No, I agree. Ultimately, they might go out and fundraise and give out more than 10 % of the companies. But yeah, it would be very interesting to have data which I don’t think exists from before the SaaS era.

Dan Gray (12:30)
Mm-hmm.

Daniel Faloppa (12:51)
because SaaS has this repeatable, stable, low-risk business model that doesn’t require a lot of capital. And that’s why you’re seeing now all these startup loans and different ways of financing these types of cash flows because they are so stable. It will be interesting to see what was happening before SaaS and what was the ownership percentage of founders there after first and second round.

Dan Gray (12:57)
Mm-hmm.

Yeah, but also like a very different environment for a number of reasons. You know, if you go back far enough, you’re looking at a time when startups would exit in four years, like, and then you’re not doing like 18 rounds of venture financing before you exit. So the dilution calculation is very different, but yeah, it would be interesting to see.

So this is the other data you’re alluding to. This is the U S and you can see here, the dilution has increased quite a bit. And my interpretation of that was potentially that the founders in the U S are anticipating a chaotic year and they’re getting in more money now. But I think actually what you’re saying also aligns with what appears to be happening that there’s more interest in, in hard tech, know, space tech, defense tech, energy.

Daniel Faloppa (13:51)
Mm-hmm.

Yeah.

Dan Gray (14:03)
All of those sectors seem to be booming in the US and they are all more capital intensive.

Daniel Faloppa (14:07)
Yeah, pharma in addition to that. Yeah, no, that’s true. That’s true, but that’s definitely also something, right? So let’s talk about this year, right? Indeed, I think the key word is uncertainty, right? Not only for startups and investors, but even like for public markets. And we are recording this on the 3rd of April.

Dan Gray (14:09)
Mm-hmm.

Daniel Faloppa (14:33)
The day after the tariffs have been introduced, Financial Times is talking about the start of a global trade war where we come from the most tightly integrated globalized economy that ever existed to a trade war is very much unpredictable where things are going to go.

so if we look at, where is this year going and what could change for startup founders and startup investors? And we’re really looking at like pre-C to series A, right? Like series B and like mega rounds and things, they have their own dynamics. But if we look at the early stage, in my opinion, we’re in for like fairly difficult year, similar to last, if not…

potentially worse. The positives maybe are that there’s a convergence and it’s super interesting probably it’s on episode, but this convergence between VC and PE means that there is a ton of money from that side that could potentially provide exits and provide buyouts for founders, for investors, for everybody that could create liquidity. saw a chart from

Thomas Tunguz and maybe we like that’s topic on its own, but 70 % of VCXs are secondaries or were secondaries last year. If that continues this year, could create quite a bit of liquidity for early stage investors that then could be re-employed in early stage, right?

Opportunities, my opinion, are there. We’re not in a market that lacks opportunities for startups. When there is a lot of shake-up, there are a lot of opportunities. When there is a lot of layoffs, which unfortunately are happening, there are a lot of startups created. the demand for capital is there. The supply, even if these things come through, we started here with slightly better IPOs.

than last year, last year, but like we’re still coming down from like good years for IPOs. So some liquidity is being created there. Some liquidity is being created on &A and exits for investors and founders. We might see that reinvested, but that’s a cycle that in my opinion takes at least six months, right? So if you are planning to raise or you need to raise this year, I don’t think there’s a like…

Dan Gray (16:39)
Mm-hmm.

Daniel Faloppa (17:03)
there’s a better time on realistic horizon. Like you shouldn’t hold off raising now because September is going to be good. Or at least I don’t think anybody can say that. There is also, don’t think, I mean, again, the word is uncertainty. There isn’t a lot of a reason to rush the fundraising right now because September is going to be horrible. Like I would plan for like a stable, fairly bad environment.

Dan Gray (17:12)
Mm-hmm.

Yeah. Yeah. And I

think that kind of reflects the situation with IPOs as well. know, investors have been saying for a couple of years now that like it’s a bad market for IPOs. It’s a slow market for IPOs. Nobody can exit, et cetera. But the truth is, as has been shown by, by IPOs like Reddit, for example, if you’re a good company in the right position and you have the financial health, you can do it. It’s just,

You know, it’s not that there’s a problem with the market, it’s that there’s a problem with a lot of the companies who would like to exit right now, but the ones that are in good health can do. So.

Daniel Faloppa (18:03)
Yeah,

and that’s because we flipped 180 from cash flows are the least of our issues. Nobody’s looking at them. We don’t even care to like, please show me a cash flow. And nobody can find anything that has cash flows. And this is not even a startup problem, I don’t think. It’s just a general worldwide problem. Because there is inflation,

Dan Gray (18:16)
Yeah.

Mm-hmm.

Daniel Faloppa (18:29)
Because there is extreme uncertainty and also because all the sort of stable things are at record highs, commodities, real estate, like all the traditional money parking places. There would be and there is like a ton of energy behind the search of cash flow positive companies, in my opinion.

And also because those companies don’t need much capital, right? Especially in an environment where all their competitors are folding or they’re firing people or they’re struggling. So yeah, the people that can raise capital in an easy way, they don’t need it. Everybody else needs it. And like there is so much capital, in my opinion, searching for destination. But yeah, not enough of those companies. And that’s because we haven’t really…

Dan Gray (18:55)
Mm-hmm.

Daniel Faloppa (19:18)
grown those companies, right? Like there was no intention of making a cash flow positive company up to like four months ago. So yeah.

Dan Gray (19:19)
Mm-hmm.

Yeah.

It reminds me of the quote by Demoder and he talks about VCs as investors that ride the momentum train until it turns around and runs them over. there’s a good description of what’s happened. If you price to revenue and focus on nothing but revenue growth, you create companies with terrible health and they can’t turn that around quickly. So then you get a situation like today. And going back to what you were talking about before with secondaries

Daniel Faloppa (19:35)
You

Yeah.

Dan Gray (19:50)
There’s interesting research that looks at past cycles in venture, particularly the dot.com crash and how private equity tends to do quite well when there’s a dip in the venture market. And that’s because you get a situation just like today where a ton of companies can’t exit because they don’t have the financial health. But the ones that are closest can be picked up by P and

given an injection of cash, made more efficient, turned around, get to rule of 40 and then get bought by someone else. And like, does pretty well from that every time. I’m not surprised that there’s an increase in secondary activity.

Daniel Faloppa (20:28)
Yeah, and like, if you think about this, in terms of evolution, PE evolved to be good at that, right? So to be good at finding cashflow positive companies, raising a ton of debt, taking the risks, taking the waste out of those companies and improving them and selling them. They ended up doing very poorly for a while because like they had to…

much free capital, right? And they were, I think they were managing things too close to the edge. But they were the first ones, there are a lot of reports in the US, even in Europe now starting of these P companies buying up like a bunch of electricians or a bunch of dentists. And we’ve seen a lot of consolidation in like those more traditional industries. And we were talking about this last year. If software is not a mode, if building software is like 10X to 20X cheaper,

Dan Gray (21:00)
Mm-hmm.

Daniel Faloppa (21:23)
like these physical word moats are actually becoming more valuable in terms of alpha and relative return. So it looks like private equity is very well positioned for that. And indeed, yeah, they’re doing well. What I think is the lesson here, which we started to repeat, but we’re not repeating enough, is if you do look into these things, if you stop…

jumping on hype trains and try to look at fundamentals, returns, cashflow generation, potential revenue generation. You don’t have to jump on the train and then wait until it turns back onto you. You can investigate these companies, these sectors, these trends, understand them, and go after them before everybody else does. That’s why…

Dan Gray (22:05)
Mm-hmm.

Daniel Faloppa (22:17)
PE already started doing these things, like last year or the year before. We’re seeing now this increase in ownership of VCs, maybe because they finally are understanding that the industries are changing. Or maybe there is data to figure this out, but either because of that or because they’re dumping a lot of money in AI. Or yeah, because founders are raising more because of job security, basically, or variability of the environment. But…

Dan Gray (22:36)
Mm-hmm.

Daniel Faloppa (22:45)
It can be done. It can be done. We don’t need to just manage based on like what everybody else is doing. We can look into the numbers, look into the fundamentals and trying to make sustainable companies that create sustainable growth.

Dan Gray (22:56)
Yeah, there’s a lot to be said for the fact that that VCs need to start thinking about what exit timelines they expect and what kind of metrics they look for as the company matures to make sure it can get to a good exit. There’s a lot of people saying as the like big multi stage VC firms expanded in the last few years, a lot of people were saying like, this it starts to look a lot more like PE.

But actually, if they’re not using P.E. metrics when they invest, it’s not like P.E. And at the same time, there’s a lot of criticism of the huge venture rounds saying, oh, it’s like the company’s doing an IPO without really doing an IPO. There’s a great article from Bill Gurley in 2015 where he talks about that’s kind of a dangerous way to think. Because when you go through IPO, the diligence that you have, the accounting standards you have to apply, that’s the important bit.

The companies that come out are certified high quality-ish. At least you can see what’s going on with some degree of transparency. But the mega rounds and the huge firms, they have not been exercising that kind of discipline. And that’s kind of the problem.

Daniel Faloppa (24:06)
Yeah, There’s a couple of things there. Like, this is turning into PE, in my opinion, is great. It’s the same greatness of startups turning into normal companies and entrepreneurship coming back and us thinking not in terms of like, you know, what is the term that is going to make what I do the most hyped, but like, what is the term that is going to lead me to learn?

about how my industry works. If you read about startups, you’re not going to learn a whole lot as a founder, I don’t think. If you learn about entrepreneurship, you’re going to learn a lot more, or at least broader. And the same goes for VCs. It’s a longer history. It’s a different type of thing. As a founder, what does this mean? It means that…

the risk profile of investors is shifting. And in my opinion, and this to connect with what you were saying about very large rounds is the risk profile of investors is bifurcating. So you have more and more of this sort contrarian investors that are going for like lower returns, shorter maybe plays, more like less hype managed companies.

Dan Gray (25:14)
Mm.

Daniel Faloppa (25:27)
And then you have the hyper rounds, right? And the mega rounds doing an increase in risk basically when they invest, right? As a startup founder, I think it’s very beneficial to think, and especially now in history, to think about which kind of investors you want and to manage and build the company and the pitch and everything.

towards a specific type of investor. If you go with a mid-growth vision that creates a little bit of cash flow, it’s not going to appeal to either. So it’s either almost no cash flow or at least no short-term cash flow and an incredibly large vision and go after the mega funds and the signature funds. Or is like, okay, build a stable company, build a successful one, a cash flow positive one.

Dan Gray (25:58)
Mm-hmm.

Daniel Faloppa (26:23)
and go to those type of investors as well. The middle way doesn’t really look successful these days.

Dan Gray (26:31)
Yeah, yeah, I agree. And I think this is a good illustration from from Rob Go about what you’re talking about there, particularly, like the thing I focus on here the most is that dynamic with the mega fund VCs. And when they invest, they’re investing huge amounts of capital because they want huge amounts of growth. And effectively, they’re kind of resetting the risk of the company like back up to the top each time, because the goal

gets stretched further and further, higher and higher, there’s more and more to try and achieve. And if you fail, the cost of failure is much greater. Usually these are more crowded markets. You have bigger competitors who also have this kind of funding dynamic. And then, of course, it has all of the problems with if the market turns while you’re in one of these companies, then it can go really badly. Whereas if you’re in more of like,

the traditional early VC and late VC described in the other graph there, there’s more bandwidth to try and turn things around.

Daniel Faloppa (27:29)
Yeah. And that’s always the case with like when you go for a very high valuation that is difficult to sustain, you as a founder reduce your margin of error. And like the first thing that goes wrong, the hire that doesn’t ramp up as fast as you want them to, or the first wrong hire that sets you back like four to six months if it’s the first head of sales or something, you’re already off the, you’re sort of your growth ramp that you need to hit in order to keep up with the story.

that you’ve sold, right? Because that valuation was based on a story that you managed to sell and that investors bought as well, right? That it needs to come from both sides. Yeah, it’s funny. I’m reading the strategy book from Seth Godin, which I think is like one of the best books on strategy. It’s a bit of a meta book on strategy, but yeah. So one of the key aspects of a business model for him is…

business model is a way for the company to do something that can be repeated afterwards, where the earnings of that business or the way that you do that thing allows you to then do it again. One of the key aspects of that is that every iteration allows you to reduce the risk of the next iteration. It makes the future more likely. It makes the next client more likely to happen.

And that’s what you see there in the normal risk progression. That’s the normal risk progression of a company. You build a brand, you build a reputation, you build assets, whatever it is, technology, so that the next client is easier than the previous one. Then you raise normal VC capital. Let’s say every VC, just naturally because of the auction model, you’re going to raise from the ones that like you the most, the highest bidders.

Dan Gray (28:54)
Mm-hmm.

Daniel Faloppa (29:17)
and you want to raise at a fairly high valuation because of hype, because of many reasons. So that straight line is like you trying to catch up with that little hype. Maybe it’s like 5%. If it’s 10%, it’s like one month. 6 % is a month. So let’s say that’s it. And then you end up on the other side, on the mega round side, is this idea of like, hey…

We got our product, we got our first customer, we did YC and we raised our first five million or maybe 10 because already the first raise was hyped. And now we are raising 100. We’re raising 10x what the average startup is raising and our vision is also 10x what the average startup is doing.

And then at that point, you need to go after the 10X. That 10X is not that the other startups don’t want to do the 10X, right? Like everybody wants to. So the probability of you doing it is like still pretty difficult to attain, right? So in that sense, the risk is increased. Like if you do achieve it, then like great, great returns for you, also for the investors. But that probability of achieving it is like if before it was like 40%, I think more or less is always around 30 to 40 % of startups.

managed to raise the next round, at least from Series A onwards or something like that. Much lower in the pre-season stuff. So instead of being 30 % that you managed to raise the next round, it’s going to be maybe 10 % or 5%, which means that you go from one chance in three of never having to work again as a founder, basically, to one in 10, one in 20, one in 50. And that’s a big difference.

Dan Gray (30:39)
Hmm.

Daniel Faloppa (31:02)
If you’ve already spent five years on the company or more and somebody comes with a choice and then at that point you have the choice of continuing or doing let’s say either scenario one or scenario two in this chart versus doing scenario three. It’s a bet and it’s a bet that for some companies might make sense.

I think it’s also still a vestige of this winner-take-all theories of Facebook type of growth and moats But what are the companies these days that have those kind of moats?

Dan Gray (31:39)
Yeah, yeah, there’s a there’s a quote from from Bill Gurley that I think describes describes this quite well, which is valuation isn’t a reward for past behavior. It’s a hurdle for future behavior. And that like illustrates this this point about the the acceleration of the risk with the the mega fund rounds. And like essentially, like kind of what you’re doing in a sense is rather than what might be like a

a three year target for a regular startup raising from regular VCs, like you’re kind of pulling forward what would be the one after that to get there even faster, compressing all of that risk and all of that growth requirement to get there much sooner, which is obviously much more difficult. Some companies can do it. But the main worry that I have there is if you’re not properly measuring the progress and the growth of these companies, like for example, if you’re focused solely on revenue,

Daniel Faloppa (32:09)
Mm-hmm.

Dan Gray (32:28)
you incentivize a lot of bad behavior. Like A, you’re not measuring progress properly, but B, you’re also incentivizing bad behavior. If you look at like the peak of like ZIRP behavior and particularly FinTech, FinTech was being priced with quite high revenue multiples. And guess what? There was a spate of fraud in FinTech with people faking revenue. you you tell me the incentives, I’ll tell you the outcome.

Daniel Faloppa (32:49)
Yeah.

Yeah. Yeah. And I think that that’s something that is fairly surprising for founders is that like the more capital you have does not correlate at all with the probability of success. Right. And I think a of lot of founders when you manage from inside out, you have this thought of like, hey, you know, one million means that I can survive for 12 months with these people. Two million.

the same story, but then I have a million safety net in the bank. That’s not how it works. If you do raise those two millions, you’re going to have to spend them. You’re going to have to spend them twice as fast with twice the likelihood of making mistakes because of haste. And now here we’re talking between one and two. When it gets to between five and 100, the change is even bigger. So that’s what we are trying to suggest.

Dan Gray (33:21)
Mm-hmm.

Daniel Faloppa (33:41)
is to really think about what are your individual needs? What are the individual needs of the specific company? What can it sustain in terms of capital? And what does it need in terms of capital? And just to realize that too much capital is not good at all. On top of this pressure, it also creates moral hazard. If you do have the money, then why do you need to look for a good engineer when you can have five?

Dan Gray (34:09)
Mm-hmm.

Daniel Faloppa (34:10)
But that doesn’t work. Like in all the scientific papers that we saw, it doesn’t work. And just in general, it doesn’t work. figure out the specific needs of the company. In this case, what we were talking about is fine tune a little bit your proposition based on the market and the investor appetite that you can foresee. And in this case, my idea is like,

Don’t go for the half play. Either go for the cash flow generating, more like conservative, let’s say, play, or just the hugely hyped one. This depends also on character, depends on the team, depends on how you want to live your life. It depends on a lot of things. But consider your own needs and then understand how much you want to raise. And just know that if you get offered more, there are these risks.

Dan Gray (35:02)
Yeah. Yeah. Interesting example of where this gets kind of wildly difficult to understand is Ilya’s company, the guy who left OpenAI, created Super Safe Intelligence, which is like an AGI or ASI research lab, and it’s currently valued at 20 billion. And I saw this this morning as part of a chart that was breaking down companies by

valuation per employee and it has 20 employees so it’s worth a billion per employee. It’s like I understand what he’s trying to do and how important and impactful it would be but like how do you how do you get to that number?

Daniel Faloppa (35:40)
Yeah,

yeah, yeah, I was I was speaking some years ago was speaking with a with a friend of mine. He was telling me about this company and he’s a traditional accountant, let’s say. And he was telling me about this company and they they raised a bunch of capital. They had a very fancy office. They had a very polished PowerPoint and like he met them through a friend and he was like really. Admiring them, right, and like convinced that that those are all good signs, right? And.

I was thinking already at the time, like those are already three bad signs, in my opinion, right? Like there have been very few companies that had those signs and that I’ve seen being successful, right? Pre revenue fancy office, yeah, a lot of money raised and spent on a product that nobody has ever seen so far. See Magic Leap, for example. And.

Dan Gray (36:22)
Red flag.

Yeah.

Daniel Faloppa (36:33)
And like, yeah, again, no customers and all these things done before and building in secret. It normally doesn’t work.

it’s clear also for the case of Ilya that, yeah, we understand what he’s doing. We also understand what those investors are doing, right? They are jumping on that train, as we said before, and they hope to jump off before it goes into the wall, right? Or like there is a 0.0001 % that they figure out AGI, in which case, you know, we’re not going to have to make podcasts anymore.

Dan Gray (36:56)
Yeah.

Daniel Faloppa (37:05)
So that’s fine.

Dan Gray (37:08)
Yeah. Yeah. I’m just going to give one more fun example of like, let’s call it VC bad behavior. And then I’ll stop there before my head explodes. I saw a post this morning of a VC kind of bragging that they were, they were reinvesting in a previously successful founder, someone they’d backed before that went on to exit and, you know, build a great company. And they took a screenshot of the email, censored the names, et cetera. But the email said to this guy,

who is pre-idea, he’s just said, like, I’m kind of thinking about starting a company, I’m not sure what yet. And the investors already asking him like, yeah, what kind of cap or valuation are you thinking about for your first fundraise? It’s like, come on. If it’s an AGI company, that’s one thing. If it’s a hardware company, that’s another. If it’s a SaaS company, like, you can’t, like, this is just ridiculous.

Daniel Faloppa (37:44)
Yeah. Yeah.

Yeah.

Yeah. And there was something about this, right? I think there was some research over this being a bias, right? That a lot of capital goes into second time founders almost without even looking at the company. And then that’s actually less successful. It’s not less successful in general. It’s just less successful relative to how much capital goes into it, right? So second time founders are…

Dan Gray (38:24)
Mm-hmm.

Daniel Faloppa (38:27)
more successful, they are more experienced. Yes, but what investors do is they overestimate that compared to what it actually is. And this is a clear example. You need to go back to the basics at that stage. Yeah, to figure out the industry, figure out the capital need, figure out all that.

Dan Gray (38:29)
second time successful founders, particularly.

Yeah, there’s,

I think there’s two, the two major biases that affect investment decisions. The first, like the, the, largest by some margin is overconfidence. And that basically results in over concentration into certain founders or ideas or companies or industries. And then the second is the, human capital bias, putting far too much weight onto, do you like the founder? Do you know, do you think that background is promising all this kind of stuff?

It’s a real problem.

Daniel Faloppa (39:18)
Yeah, indeed. But yeah, so I think overall, I don’t know if we have anything else on the fundraising environment. I think overall, this is like what we’re experiencing this year. Definitely a focus on cash flow or a focus on extreme hype, which we are not definitely suggesting, but that is something that people do. And again, we…

Dan Gray (39:40)
you

Daniel Faloppa (39:43)
can always be wrong. And I think one of the nice things of entrepreneurship is that the successful one is often the one that goes against the current enough. So it might be that the next super successful company has done all the hype things. But just in general, if you do them, you should know what they are and you should know what you’re doing and what are the risks. So then…

Dan Gray (40:09)
Yeah.

Daniel Faloppa (40:09)
Yes, then cashflow models working probably better, especially in places with less capital, which is probably everything aside from the US and maybe even the US soon. To be honest, there has been like an extreme outflow of investment in the US in the past three months from all private equity, which then trickles down to VC as we said before. Right. So focus on cashflow. And then in terms of where the environment is going,

What I would keep an eye on is acquisitions and IPOs, see if there is a change there that might create some liquidity for investors that we might see reinvested towards the end of the year. But aside from that, I don’t think there is any recommendation in terms of raising straight away or raising in six months. The keyword remains uncertainty. There is no reason to say six months from now it’s going to be

better or worse, so average prediction is, I think, the same.

Dan Gray (41:09)
Yeah, raise

when it’s the right time for you to raise, when it makes sense.

Daniel Faloppa (41:12)
Indeed.

Yeah. When you need it. we did see, maybe this is also something useful. We did see still last year and continuing this year, founders raising for two years of runway or more, rather than the previous 18 months. And I remember a webinar that we’ve done where people were really strongly arguing for raising every six months at the top of the hype in 2021.

And so, yeah, so that was a different world compared to now. Now it went definitely back to 18 months and likely better 24 months.

Dan Gray (41:52)
Well, probably that was another consequence of like the bad behavior, because if you’re in 2021 and you’re being priced to revenue with every round you raise and you’re calculating your run rate based on the last month’s revenue annualized, then yeah, probably raising more regularly kind of makes sense if it’s also easier.

But the problem is that whole system is stupid. So it’s actually just better if everybody raises based on strategy. And there’s good rules of thumb. Like you don’t want to be raising more than every, you know, at the moment, 24 months, maybe because it’s more difficult. It takes longer. Yeah. It’s more headache. It’s more stress. But also like if you, if your strategy tells you that you don’t need to raise for 36 months and you think that’s a

Daniel Faloppa (42:16)
Yeah.

Yeah, because next time, yeah.

Dan Gray (42:37)
relatively good bet, then that’s fine too. Like follow the strategy.

Daniel Faloppa (42:40)
Yeah,

indeed. And there is also a thought towards what are the other companies that are in your same market doing right now. And likely they are struggling and or they are folding. And so it might be that the sector consolidates. And if you are the one that actually manages to survive.

Dan Gray (43:05)
Mm-hmm.

Daniel Faloppa (43:06)
you know, things might actually turn out better for you in terms of fundamentals, revenues, cashflow, profitability, customer satisfaction, customer attention, churn, things that actually make the company valuable.

Dan Gray (43:18)
Yeah, yeah, on that note, maybe there’s one last post we could look at. This is from from Rick Zullo. And he’s talking about some of his predictions for the year ahead. Thinking particularly about like the AI industry, the boom there, but how that’s shaking out now with there being more and more competition, less and less evidence of moats.

Daniel Faloppa (43:28)
Yeah.

Dan Gray (43:38)
So it’s bringing down pricing in an industry that has been priced to revenue. you know, you have all those problems of how do you meet the metrics you were expected to hit if your revenue is being compressed by pricing being reduced. That’s a problem. And then he also makes his second point is talking about like partly an impact of the tariffs, but also generally where the market is moving. like focus on hardware particularly.

Daniel Faloppa (43:44)
Mm-hmm.

Dan Gray (44:03)
more capital intensive industries and maybe that like this is where the balance starts to tip this year between the two.

Daniel Faloppa (44:09)
Yeah, yeah, it’s incredible. So first of all, I would say the fact that AI for now, because we are still extremely early on what AI can do and where AI can go. But like LLM foundational models for now have been demoated. They don’t have a moat by open source, right?

Dan Gray (44:33)
Mm-hmm.

Daniel Faloppa (44:34)
And

in my opinion, that’s bad only for investors. For the world as a whole, it’s incredible. We’re adding physical intelligence at rates that are almost free. I think Google is still subsidizing their AI to customers way more than everybody else, because even the pro model…

cost like 1 15th of Claude. So by like the cheap things like smaller models, lighter models to run, like they are already incredibly powerful, right? And models that have like 70 billion parameters or 20 billion parameters performing as well as like the best models of last year, right? So in my opinion, that’s a huge win for everybody.

Dan Gray (45:26)
Mm-hmm.

Daniel Faloppa (45:27)
And it’s incredible that despite everything that we have done to it, open source is still doing some positive things. For me, it’s completely baffling and amazing. But yeah, definitely, AI per se, the models don’t seem to be a mode for now. So then what is, right? Access to GPUs, access to engineers that can engineer GPUs or…

And then you get into the hardware, right? Like things that have actual moats. Physical goods is insane for me. Physical goods, like the fact that the table costs like three times on iPhone is, for me, is insane. And that’s why I’m also very bullish on traditional services, more traditional industries.

Dan Gray (46:05)
Yeah.

Daniel Faloppa (46:16)
It’s incredible. And if you want to talk about mass, like a TV, a very large TV costs half as much as a table. So definitely physical goods are very interesting. Hardware is very interesting. Things that can be patented, drugs, research.

are becoming more important. We said we don’t care about patents for many, years and famously Elon Musk giving away the supercharger designs and stating that patent doesn’t actually add to the protection that they get of the technology and so on might actually come back into fashion because they do become a way for people

Dan Gray (46:35)
Mm-hmm.

Daniel Faloppa (46:59)
not being able to copy you because otherwise, yeah, it’s becoming easier and easier to copy things, right? And as well as like maybe specialized AI, right? Medica research AI or engineering type of AI that can help on a specific industry, maybe can have a mode for a little longer, a data mode, right? Like the only ones that have that data can have a potential mode on it. But yeah.

We go back thinking about these things, which in my opinion is very nice. Go back thinking about the Porter five forces and proper strategy, positioning, advantages.

Dan Gray (47:42)
Yeah, it’s funny. I think you can see that in every cycle. You have a period where investment accelerates significantly and it tends to go into, you know, hot crowded markets with software that’s easier to scale, easier to build, has less in the way of a moat, perhaps. But then after that cycle ends, you know, in

After the dot com boom, was like the the first clean tech boom after that, which like investors putting money initially more into hardware. After the GFC, there was the fintech boom, which is not hardware, but it’s like a regulated industry. It’s harder to build in. There’s like a bit more in the way of moats there. Then after 2022, there was dynamism, defense, energy, like all of these, you know,

more hardware related but certainly industries with more defensible propositions that got funded and I think that’s a pattern we’ll see again and again in future.

Daniel Faloppa (48:38)
Yeah, yeah, I agree. I agree. And then as founders, especially of software product or AI products, then it becomes something that you need to learn about and you need to think about for sure. How are you going to be able to defend your revenue, defend your customer base, defend your margins, create margins and create growth?

Dan Gray (48:52)
Yeah. Yeah.

Daniel Faloppa (49:04)
That’s going to be one of the key questions. Much more than can you create the product. When it stays into software, let’s say SaaS and stuff. And then, when you go into more advanced research type of companies, then, yeah, can you make the product? And all that part comes back as well. But still, after that, how do you defend it? And yeah, in my opinion, again, like…

Dan Gray (49:12)
Mm-hmm.

Daniel Faloppa (49:32)
Awesome, right? Very interesting. A different type of challenge, not necessarily harder, right? And just different. And one where different type of founders, different profiles, different locations, and different stories can actually win and can have a better chance at winning. So yeah, awesome.

Dan Gray (49:42)
Mm-hmm.

Yeah, yeah,

I’m not in that position myself, but I, you know, I’ve been in, let’s say in similar positions in the past and I can tell you, I would much rather have the challenge of building something incredibly difficult than the challenge of trying to outmaneuver and outgrow five competitors that are like hot on my tail. Like the latter is a nightmare.

Daniel Faloppa (50:20)
Yeah, yeah, yeah. It might be one of those things that the neighbor’s grass is always greener, right? Like you see a lot of, I see a lot of software engineers that do three years when they work for a company and then three years they work freelance. And while they work for the company, they would like to work freelance. And then while they work freelance, they would like to work for a company, right? Because yeah, it’s, you know, each has their benefits, but.

Dan Gray (50:27)
You

Daniel Faloppa (50:44)
Yeah, super, super interesting. In terms of, I think, AIs and early stage rounds, right? I think we have gone up and down in terms of mode level of rappers, right? And there was a period where rappers were just rappers and demonized and stuff. And then there was maybe a month or so in January where…

Like we were talking about the foundational models don’t have moats, but maybe the rappers do have moats. know, yeah, exactly. It changed name because rebranding always helps. I think where we are now is a more critical look at AI, right? So investors that understood a little bit the game, even though it’s changing so rapidly and it’s going to change more in the future.

Dan Gray (51:17)
The application layer.

Daniel Faloppa (51:39)
but they have understood the game more. They are looking more at cashflow, even if the company is talking about AI, even if the product is AI-based. Looking more at customer satisfaction, churn, traction, all the more standard startup metrics. Does it mean that you shouldn’t converge everything on AI? Well, probably…

You should have never conversed everything on AI, but I do think there is still a bit of a premium in AI things. If you do have a reason to use AI properly in the company, you probably should, but then if it becomes just a venture signaling or window dressing, then at this point, I think the game is up a bit on those.

Dan Gray (52:33)
Mm-hmm.

Yeah, I think so. There’s…

Yeah, I’ve listened to investors pontificate a lot about where like, does value accrue at the application layer or the model layer and all these like meta questions about AI and the future of AI. But it just it seems a bit pointless to me, like, look at the look at the company, look at what it’s doing. Is it a good business? Does it have moats? Because I’m sure you could, you know, a model company like Cohere that does enterprise AI built for enterprise use cases specifically.

Like they probably have a reasonable moat, I would guess. If you’re just building a generic LLM, probably not. the point is, and this is reflected in so much of what we talk about and what we do, you have to look at the specifics of the business to really understand it.

Daniel Faloppa (53:18)
Yeah, yeah, especially like, is it delivering value to customers at a sustainable cost for the business? Because if it’s delivering value, but it’s losing a lot of money on every single customer, then it’s not sustainable. you know, can that grow over time? Right. And then, like once that’s established, then can it defend that as well? Right. And I think like six months ago,

Like the AI was a ticket to go through these questions for free, right? It’s not anymore, which again, is probably a good thing. And yeah, it’s interesting.

Dan Gray (53:50)
You

Yeah, I think so.

Daniel Faloppa (54:02)
There is one last point that we were talking about that could be interesting, is this idea of startups and general companies including the cost of capital into their project selection, which is something that in my opinion more founders should think about. When we look at cost of capital of startup companies is anywhere

Dan Gray (54:05)
Mm-hmm.

Daniel Faloppa (54:27)
and this is going to be very wide, but anywhere between 30 and 150 % per year, which means that the seed stage, pre-seed stage type of company more or less needs to double in value every year if it wants to go after that VC type of traditional startup trajectory. When you raise capital, that becomes…

Dan Gray (54:49)
Mm-hmm.

Daniel Faloppa (54:53)
your cost, right? If you take these deals, you need to then pay them back at that cost. You need to grow the company at that speed. As we said before, this can be fine for certain companies, can be not fine for other companies. What doesn’t change is when you consider projects internally, expansion projects, new product, or new features or whatever, you should take into account this. If those…

new things don’t have a chance to grow at these rates, then they don’t have a chance to pay back the cost of capital that goes into creating them and testing them and advertising them and so on. So yeah, just a little thing that connects, I think, finance and strategy and management that a lot of founders don’t think about. And to be honest, not even public companies or

almost anybody thinks about, but capital itself has a cost, which is the technical term for what we were saying before. This pressure to deliver is basically the cost of capital. You need to pay back those investors with growth in their investment ultimately.

Dan Gray (56:06)
Yeah, which is why you end up with the venture capital treadmill and founders that raise money and then through raising money, either explicitly or tacitly agree to certain growth goals in the future. And if they can’t hit them and reach profitability, then they have to hit them and raise more money. And then they go through the next cycle of trying to hit the next load of goals. And again,

If they can’t hit them and be profitable, then they have to raise again. And it’s just like, it’s a never ending cycle because when you’re growing that fast, it’s also very difficult to become profitable. It’s kind of a trade-off between the two. So you end up stuck on the treadmill. And I think there’s a lot of, a lot of conversations at the moment, know, founders, think more aware of this problem and trying to avoid it. More funding models that aim to offer an alternative, which I think is good.

But certainly, at least as you say, the awareness is the most important thing. Founders need to know the bargain that they’re signing up for.

Daniel Faloppa (57:02)
Yeah, yeah, yeah, and like, I think we are trying to do more in this space. We are trying to…

We’re trying to bring more data into the environment. We’re trying to bring this knowledge that we accumulated over the years into the environment with the idea that the methodologies, the tools, the knowledge is now advanced enough that you don’t just have to listen to the hype and just use your intuition and figure out how these things work, but you can actually use examples, use data, use calculations, at least to understand these things in theory.

Of course, valuation is part of it and we’re seeing a change towards this as well, where valuation is not anymore just calculated on hype or just the five companies that raised last month and their average. But both investors and companies are looking more into the projections, into proper discounting those projections, into looking at different valuation methods. yeah, in my opinion, that’s definitely…

a good thing, bringing the environment forward, taking the hype out things. And of course, the valuation theory and practice is so new in a sense and so uncertain that it might not be correct. But at least we’re testing it. At least we’re looking into these things and already looking into these numbers allows you to have better results. Just because you know, at least you know…

starting point and next time you’re gonna figure out if it’s right or wrong. Yeah.

Dan Gray (58:41)
Yeah, it’s the same old question though of can we make this case? Can it be proven with performance and data before the cycle comes back around and the market heats up and all the same problems happen again? And then we have to go through another crash and then we get a second crack at like trying all of this again and like maybe this time it sticks. I mean, I think that’s it’s an industry that has been stuck in cycles.

for as long as it has existed. And probably always will be, but they could be smaller, they could be better managed, they could be less damaging.

Daniel Faloppa (59:18)
Yeah, it’s interesting. I think it’s really very much connected to the time incentive. Because if your time incentive is to make something successful in 30 years or 50 years or 100 years, you’re not going to follow the hype much. Because then the train is for sure going to crash by that time.

I think you see this everywhere, right? You also see this with professional management and the way companies are managed and large companies when you have management that lasts for three to five years. Plus, I don’t know if this is a new trend, but in the last 20 years, seems that just quitting is fine. You make a big change in a big company, you make it worse, and then you just quit. Not a big problem. Somebody else cleans it up.

I don’t know. feel and politicians the same story. I feel is something fairly new, but maybe it’s always been the case. yeah, so like this sort of not caring about the long term makes you do this like short term optimized plays, which are almost like crack pools, right? Like you, know, or speculation rather than investing. But I think and that’s where

founders need to look out, right? Because founders are the ones that have the 10, maybe even 20, 30 years time horizons. For sure, they know how long five years are on the same project, right? And investors don’t care, right? So as a founder, you need to look out for these things. You need to look out for investors that do invest with the right principles in mind and not just because of the hype and the type of investors that you bring in will determine the type of company that you’re gonna make.

Like 100%. They’re going to be on the board. They’re going to be the ones that discuss strategy with you. They’re going to be the ones pushing you when you’re not pushing enough or in their sort of benchmarks. So I think, yeah, it’s really something that founders need to look out for.

Dan Gray (1:01:21)
Yeah, are they the kind of investors who are investing to ride the momentum train and then escape through secondaries as soon as they think they’ve got the best return they’ll get? Or are they going to be there with you, you know, at the ringing the bell at IPO? It’s definitely the second group that you want.

Daniel Faloppa (1:01:35)
Yeah.

Yeah, and I think at the beginning, you had Sequoia and the original VCs in the Silicon Valley. It was almost like very, very good operators. It wasn’t like professional investing. The money was part of the deal, but it was good operators. And they were definitely in for the long term and to create a sustainable business and so on, because otherwise they couldn’t sell it. Nobody would have bought back then a bad business.

Dan Gray (1:01:48)
Mm-hmm.

Daniel Faloppa (1:02:05)
And so yeah, so it’s definitely something to look

Dan Gray (1:02:10)
but also the Horizon was four years back then.

Daniel Faloppa (1:02:13)
Yeah. Yeah.

All right, I think we talked about a lot of things and we still have many more to think about and to talk about. We did want to make these episodes more regular. Let’s see if we manage to do that. yeah, as always, if anybody has any questions or comments, please send them to us either on LinkedIn or on the podcast software that you’re using and we will likely see them. yeah, hope you enjoyed the episode.

Dan Gray (1:02:41)
See you in the next one.

Startup Valuation Trends: AI and Mega-Funds [The Equidam Podcast - 15]

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