The Best Startups Are Valued, Not Priced

Are Startups Valued or Priced? What’s The Difference?

Pricing refers to a standardized, comparative approach, such as applying a market-based multiple to the revenue run-rate of a company. Think about how you might price a can of coke in a supermarket, relative to similar products. This is especially prevalent in well-understood sectors like SaaS, and particularly in “hot markets” where the deals move quickly due to increased competition from investors.

On the other hand, in more rational markets (usually reeling from a bust) there is a logical aversion to building a house of cards on procyclical comparative pricing. Instead, investors are obliged to look more carefully and specifically at investment targets. They’ll return to more disciplined allocation and non-consensus themes that aren’t likely to be as capital intensive. This means valuation plays a much larger role in how startups end up being priced, while the comparative element takes a back seat in providing context.

Essentially, hot markets seduce investors into comparative pricing because it’s an inflationary force that accelerates the theoretical growth of their investments. What these investors don’t factor is that all cycles end the same way — with a crash and a hard reset. Trying to time the market with public stocks is already immensely difficult, but when you’re dealing with illiquid investments on a 10+ year horizon? It’s a fool’s errand.

This is an unfortunate truth of every cycle (so far), because each downturn results in a significant churn of investors. Those that timed their exits well and rode the momentum to a profitable exit get to stay in for another round, while their less fortunate peers will wash out. Thus, the lesson is never really learned. Just as we see this behaviour with AI today, we saw it in 2022, and also in the dotcom boom.

“Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple (also known as the price/revenue or price/sales ratio) was quite trendy back during the Internet bubble of the late 1990s. Perhaps it is not peculiar that our good friend the price/revenue ratio is back in vogue. But investors and analysts beware; this is a remarkably dangerous technique, because all revenues are not created equal.”

Bill Gurley, GP at Benchmark [source]

Incentives and Outcomes

Venture capital firms raise funds from limited partners (LPs) like pension funds and deploy capital into startups, seeking outsized returns. Their model includes:

• Compensation is formed of guaranteed management fees (typically 2% of assets) and carried interest (20% of profits) which may have a performance hurdle.
• VCs invest in a large portfolio of startups, betting on a few “unicorns” to offset a majority of losses. This is referred to as the “power law”.
• Liquidity is often 10+ years out, so short-term ‘paper markups’ are used to understand growth, typically based on the latest funding round price.

However, in hot markets, VCs are inclined by these incentives to deploy money rapidly, pushing startups toward ambitious growth targets. This created a “venture capital treadmill,” where startups, needing more funds to meet growth expectations, became dependent on further rounds, often at the cost of financial health.

• The unconditional and stackable nature of management fees incentivizing rapid deployment, to raise more capital and maximise fee income.
• The need to deploy capital quickly incentivizes investors to concentrate on sectors that are well understood and easy to quickly price.
• The focus on short term markups encourages a trader mentality, where the goal is to quickly inflate prices and exit before the market busts.

This approach, however, had unintended consequences, as evidenced by research and market outcomes. There is not a simple correlation between capital raised and future growth, challenging common wisdom that founders should aim for the highest price and raise as much capital as possible. There is a u-shaped relationship between the two, indicating the best outcome for a startup raising money is actually to strike a balance: raise enough money to competently execute a strategy, at rational terms that align both parties on future expectations.

“All too often I see companies raising too much money too early on. Why? Firms want (need) to invest larger and larger sums of money to deploy their larger and larger funds. As a founder, you may go out looking to raise a $50m round, and before you know it you’re getting offers for a $100m+ round.”

Jamin Ball, Partner at Altimeter Capital [source]

Evidence and Implications

The standard pricing approach, relying on metrics like ARR multiples, led to several issues:

• Startups raised more than needed, leading to excessive spending on growth before achieving product-market fit, straining finances. VC Funding Can Be Bad For Your Start-Up by John W. Mullins highlights how this pressure can misalign founder and investor goals.
• Overfunded companies often burned cash rapidly, with distorted pricing strategies (e.g., competing on capital) eroding margins and sustainability. Indeed, there are more than 600 private companies at a public company scale today that aren’t in good enough shape to actually list on public markets.
• The Startup Genome Report, in Startup Genome Report Extra on Premature Scaling, identifies premature scaling as a top reason for failure, with startups expanding too early, before validating assumptions, leading to operational inefficiencies.
• A study of 7,481 venture-backed startups in the UAE, detailed in The Impact of Funding on Market Valuation in Technology Start-Up Firms: implication for open innovation, found a U-shaped relationship between capital raised and post-money valuation, indicating an optimal funding point beyond which valuation declines.

“The fact is that the amount of money start-ups raise in their seed and Series A rounds is inversely correlated with success. Yes, I mean that. Less money raised leads to more success. That is the data I stare at all the time.”

Fred Wilson, Partner at Union Square Ventures [source]

How the Best Startups Behave

For founders aiming for long-term success, the strategy shifts from pricing to valuing:

• Base fundraising on financial projections, considering burn rate and key milestones. For example, you probably want to raise enough to prove a major assumption in your vision, so the next round you raise can be a meaningful step-up in valuation (and thus less dilution). On the other hand, you may only need one round of funding.
• Valuation should reflect your growth goals and unique potential, not just industry multiples. If you use a pool of comparable companies to justify the price you want, beware that that same pool of comparables will be used against you later if the market dips. If you focus the conversation on your own growth and ambition, then you will remain aligned with investors.
• Prioritize testing your core assumptions over rapid growth in the beginning, aligning with research showing less early funding correlates with greater likelihood of success, as per Wilson’s insights. Constraints breed creativity, and creativity is the entrepreneur’s superpower.

“New founders in last 10 years have ONLY been in environment where money is always easy to raise at higher valuations. THAT WILL NOT LAST. When the market turns, and it will turn, we will find out who has been swimming without trunks on: many high burn rate co’s will VAPORIZE.”

Marc Andreessen, General Partner at Andreessen Horowitz [source]

Common Practices vs. Best Practices

To illustrate, consider the following table comparing common advice based on VC incentives, versus what the competent founders should aim for: