Fred Wilson wrote a great post about start-up valuations on Business Insider earlier today. It is good to hear his take because over the last few months I have been wringing my hands about the insanity going on with early stage valuations. For those who aren’t sitting in VC meetings all day, there is a new movement in the start-up community to go straight from seed investment to Series B, bypassing the smaller $3mm-$5mm Series A round altogether in favor of an $8mm-$10mm round. As someone who prefers to invest in the Series A market this trend is particularly challenging.
The hardest conversations I have are with entrepreneurs, trying to convince them that skipping grades is not in their best interest. Imagine trying to convince someone to raise $5mm at one price when there is a later stage investor at the table offering $10mm at twice the valuation. Add to the fact that the company’s seed investors are pushing the CEO to take the highest price possible so they can get a mark-up. I have seen this movie before and it doesn’t end well. If history is any guide the best strategy for someone with permanent capital is to sit it out and wait.
The reason this eventually falls apart is that while the valuations are increasing in the private market, the valuations in the public market and M&A market are not following suit. As Fred points out, the same small percentage of companies end up becoming very valuable each year. I asked PWC earlier this week to help me find the number of venture-backed companies with exits above $1bn, and the initial feedback is that fewer than 0.1% of venture-backed companies end up above that number. That is 1 or 2 companies out of the one to two thousand digital media companies funded in a given year.
The second reason this doesn’t end well is that while these companies are raising more money they aren’t growing any faster. I have mentioned this before, but digital media start-ups are not constrained by capital, they are constrained by labor. There is a fundamental limit on how fast you can recruit and train people based on the stage of your company.
As I watch this go on, my regret is that another crop of entrepreneurs will have the same bad VC experience that plagued the industry 10 years ago. I have run into so many good managers who have shunned VCs for life because their investors blocked an exit when the company fell short of some imaginary target. That is going to happen again.
The hard lesson is that venture capital money comes at a price. Behind closed doors, later stage VCs all over the country are justifying high valuations for early stage companies. They are promising their partners that deals will exit for over $100mm, and they will hold out until they make good on that promise. Of course, every deal cannot be in the 95th percentile. And when the market comes back to reality the entrepreneurs are the first to get hurt.