Valuation Matters
What entry valuation price should VCs pay for a new investment? It’s a perennial question, even for the most seasoned venture capitalist. And for up-and-coming investors in particular, there’s a fundamental tension between paying too much and risking the ire of colleagues; and paying too little, potentially losing out on an investment opportunity altogether. This post explores that tension.
The High Price of (Not) Winning
Bidding a higher price than perceived competition to win a financing deal certainly comes with risks. Notably, the first impression it leaves with colleagues in your firm may not be the compelling founders or the exciting business itself, but the hefty price paid to secure the deal. This initial perception can endure, overshadowing other attributes of the investment while it develops, particularly if the company’s performance falters. Paradoxically, your coworkers are more likely to remember that you overpaid when a portfolio startup goes sour than if it’s successful (which is actually when it matters).
You always wish that you owned more of your winners, regardless of the initial price that you paid. But in those cases, the initial deal impression is overshadowed by its success. Whereas with your losers, that first negative impression is only amplified.
Playing it Too Low
On the flip side, aiming for too low a valuation in a competitive process while seeking a “bargain” risks losing the deal and attracting these self-identifying lesser-quality ventures. In VC, there’s no reward for “value investing”: success hinges on identifying and backing upside outliers, not securing deals at relatively attractive prices. Playing a game of ‘subprime’ venture capital leads to partnering with ‘subprime’ entrepreneurs, a strategy unlikely to yield the outliers in the power law curve that defines our venture success.
Navigating Valuation Considerations
Still, a critical tension exists: valuation matters less at the individual company level than at the portfolio level. This summary applies both to a firm’s fund portfolio as well as a single investor’s personal portfolio. If you do the math on venture portfolio construction, systematic changes in entry valuation directly affect exit multiples and thus the return profile of the fund. Of course, you’d much rather have richly paid to be in a winning company than to have passed on it altogether. It’s permissible, and even expected, then, to make exceptions and occasionally pay a premium for potentially transformative companies. However, these special cases cannot become the norm without jeopardizing the portfolio’s overall cost-basis… as well as the investor’s reputation within their firm. By definition, not all investments can be exceptions.
In recent decades, VC has transitioned from an idiosyncratic cottage industry to a sophisticated, competitive market. The era of so-called ‘proprietary deals’ has given way to a landscape where all talented world-class entrepreneurs engage multiple VC firms in their fundraising processes. Accordingly, the final price of a round is determined by market forces, making it imperative for prospective investors to bid market rates or even slightly above to put themselves in the mix to win.
But the strategy for VC success is not to systematically overpay. It’s to truly differentiate oneself on dimensions other than price. It’s best for founders to chose you, and not merely the highest bidder who happens to be you. Overpaying not only risks the winner’s curse but can also cultivate a negative reputation internally within a VC firm which can yield deleterious effects on the tenure at your firm.
How to approach valuation, then? Pay market, win by differentiation. Remember that exceptions aren’t never, but are just that — exceptions.
