Perspectives from fund managers on the "valuation question".
There is a lot of talk about valuations. Growth valuations have corrected following public market valuations, and the pressure is moving into the earlier stages. And venture fund managers are adapting.
In this post, we dive into: What drives valuations? Should they impact investment decisions? How do fund managers approach the “valuation question”?
If you only have a few minutes, here are some key considerations on valuations:
- Valuations matter (of course). Venture is driven by a power law where a very small number of companies return most of the profits, but if the fund relies on the extremely rare $10B+ exits just to return the fund, you might be relying far too much on luck.
- An attractive company isn’t necessarily an attractive investment. Know the difference. To achieve venture returns, you will likely have to pass on great companies because the valuation is too high.
- But, get into the right companies. Without large exits, you’re unlikely to achieve venture returns. The spread between valuations for “cheap” and “expensive” companies is often much smaller than return multiples from outliers.
- Have a clear strategy for valuation. And, stick to it. Routinely overpaying undermines your strategy. It’s OK to make exceptions but be thoughtful and well-reasoned in the decision.
Shoutout to Abe Othman (AngelList), Anamitra Banerji (Afore), Eric Bahn (Hustle Fund), Hunter Walk (Homebrew), Jonathan Hsu (Tribe Capital), Julian Shapiro (Julian Capital), Linda Xie (Scalar Capital), Mahdi Raza (Exponent), Nikhil Basu Trivedi (Footwork), Rick Yang (NEA) and Terrence Rohan (Otherwise Fund) for contributing to this post.
What drives valuations?
Valuations carry information. They tell a story about the company, demand from investors, and often a reflection of the overall market.
Here’s a good breakdown from Semil Shah on what drives valuations:
“A valuation during a funding round for these types of companies are driven by:
- Investors’ willingness to pay (the most important driver!).
- Competition among investors hungry to get into a deal.
- Demand for companies of similar quality, scope, scale, (and) market.
- A host of other items like team, technology, etc.”
Mahdi @ Exponent on what drives valuations
Exponent is an early-stage fund investing in founders tackling Payments, Infrastructure, Security, App Software.
When setting valuation, some fund managers triangulate several drivers of valuations:
- Company: Team, traction, market opportunity and other company factors
- Market: Entry-valuation comps and other market factors
- Fund model: Entry-valuation ranges/guardrails/fund size/threshold to return the fund
Mahdi also discusses the difference between the attractiveness of a company and the attractiveness of an investment. Not all great companies make great investments.
More from Mahdi:
“On valuations for pre-PMF companies, we triangulate it:
Exit opportunity (more intrinsic valuation-ish): We think of it as ‘if everything goes really right (the pre-parade), what could the company reasonably exit at?’. This is meaningfully based off the market opportunity (we are clear to describe it for "known, existing markets" vs. "new, fast growth markets"), competition, etc. That implies a certain amount of revenue, gross margin, and an exit multiple on it. Backing out from there - what should the entry be to achieve a 100x or more outcome for the fund?
Next-twelve months (NTM) Comps: Where do we see entry valuations trending next twelve months and is this in line with that?
Fund level guardrails: We generally don't believe pre-PMF should be above $15M post (some sectors more, some less). We want the fund average/median to be at or below this; we are open to exceptions, but they have to be crystal clear as to why they are the exception.
We increase valuation commensurate with "de-risking" of clear milestones with team, PMF/ velocity/traction, market and exit opportunity.
There's also a clear difference for us between the attractiveness of a company vs. the attractiveness of an investment (company + valuation + risk) and the above is focused on the valuation side for pre-PMF teams. We value post-PMF teams more precisely.
At the end of the day - the core long-term drivers for all valuations are:
Growth of free cash flow (and the drivers for it)
Risk of free cash flow.
The above helps us to think clearly about both aspects.
If this company is humming with $1-1.5M of revenue or another highly implicative traction milestone, where would the Series A be priced at? We typically want the seed vs. Series A delta to be 2.5-3x. Early-stage investors should be compensated for the risk they’re taking and being first advocates.”
— Mahdi Raza (Exponent)
Are valuations efficient?
Investors are either price-setters or price-takers for every investment they make. Most commonly, lead investors “set” valuation in negotiation with the founders and follow-on investors invest at that valuation, although this isn’t always the case.
You can’t typically set valuations unless you’re putting in ~50% of the round or more, are the first check-in, or investing off-cycle (i.e. not a part of a formal round). If you’re not setting the valuation, you need to have a point of view on “Is the company worth what the market is saying they’re worth?” This leads us to the question “Is early-stage venture capital efficient?”
While perspectives differ, Abe Othman from AngelList’s Quant Fund has a unique vantage point on this topic:
“One of the most stunning things I've found about early-stage venture capital is that the market is relatively efficient. Put another way, founders convert positive signals about themselves and their companies into higher valuations that capture most (but not all) of the boon from those signals. Venture "alpha", if it exists at all, will really only be in overlooked places: That's why we found that the best schools to invest in are UW, Waterloo, and Brown, not Harvard, MIT, and Stanford.
I would say, then, that within like a 2-3x band all valuations are probably "the same" – they don't in fact matter since you're probably paying for an informative signal. Beyond that, valuations are only worth it if the exit could be that much higher, and similarly, companies playing in a smaller space can be equally deserving of investment at lower valuations.”
— Abe Othman (AngelList)
Do valuations matter?
Venture managers are responsible for driving venture returns. This is ultimately a function of the investor’s check size, entry valuation, and potentially follow-on investments to maintain or increase ownership. All things being equal, higher valuations cut fund returns. A fund with great companies but very minimal ownership may yield average returns or worse.
Here’s more from the Spearhead blog on how entry prices impact venture fund returns:
“Valuations for pre-traction companies between 2005-2010 were $1-5M pre-money for the first non-friends-and-family round. Funds that invested during this time period made 4x-100x returns.
These valuations moved to $4-6M pre-money after 2010, with some demo days in the $8-10M range. This likely cut returns by 2/3 or more.
You can’t build a portfolio of pre-traction investments at $8-10M pre-money and expect to make a venture return. On occasion, you can make an exception, but you can’t do all of your investments at this price.
You will have to pass on great teams because the valuation is too high. You will have to pass on future iconic technology companies because the price is too high. But passing on a future iconic company at a $40M pre-money gives you the capital to take 10 shots on goal with unknown companies at $4M pre-money.”
Anamitra @ Afore on why valuations matter
Afore invests $500K or $3M checks into pre-everything founders, managing $300M in AUM across three funds.
Venture capital returns are driven by outliers, but it’s impossible to predict the exit value of an investment. Anamitra at Afore talks about the importance of focusing on what you can control: The entry valuation and why it matters.
More from Anamitra:
“If you are an early-stage investor in a company that exits at a $1B or $10B, then you can argue that it doesn't matter whether your entry price was $10M or $50M because you'd do very well. It's obviously better if you could invest at $10M but you'd still 20X if you invested at $50M. This means that if you have high conviction in the outcome, you should not be deterred by small deltas in the entry price.
However, most investors don't know how big the outcome could be at the time of initial investment. I'd argue that it might be impossible to know. So, the outcome is unpredictable. However, the investor does have some control over the entry ownership. That's predictable. And since realized returns is a function of outcome size multiplied by exit ownership, the goal should be to maximize entry ownership. You can get high ownership by targeting a low entry valuation, increasing the investment check size, or both. So entry valuation does matter greatly. But it's a balance, because at the end of the day, high ownership in $0 outcome is still $0.”
— Anamitra Banerji (Afore)
Julian @ Julian Capital on why valuations matter
Julian Capital is an early-stage fund investing in frontier teach, marketplaces, and B2B SaaS.
“A low valuation won’t get me to invest in a deal, but a high valuation absolutely can get me to walk from a deal.” — Julian Shapiro (Julian Capital)
Approaches to valuations
We collected approaches from fund managers on how they approach valuations. Our goal here was to collect perspectives from a diverse set of funds across fund size and investment focus.
How Rick Yang @ NEA approaches valuations
NEA are investing out of an >$3B VC fund investing across stages.
The traditional VC model, popular among funds with a concentrated strategy, is optimized around ownership targets. This approach prioritizes ownership, over valuation, although they’re related as funds are finite in size. Rick Yang talks about NEA’s ownership-driven approach to investing.
Note: See more in the “Have a target ownership” section of this post on portfolio construction.
More from Rick:
“I am a believer that fund size and the associated business model driven by that is a big factor in how to think about valuations and deal structures for new prospective company investments. We care more about ownership than valuation for new investments in some sense, although those two things are coupled very closely together. Especially when you normalize historical averages for liquidity and public market valuations, ownership matters a lot when we are considering a new investment.
The other part of the ownership equation other than valuation is dollars invested. That becomes a discussion around portfolio construction and the risk/reward with a specific company and space. And of course competition for the round sometimes dictates ultimate valuation, and it's also often why we end up sitting out rounds even if we do really like the team and company. Not the simplest answer, but we like to be thoughtful about structuring initial investments since each NEA Partner isn’t making many new investments per year.”
— Rick Yang (NEA)
How Hunter Walk @ Homebrew approaches valuations
Homebrew is an evergreen fund investing primarily in pre-seed, seed and Series A rounds.
Like NEA, Homebrew takes an ownership-driven approach to investing. They view valuation as an important guardrail in evaluating an investment opportunity. Hunter also breaks down their framework for evaluating an investment opportunity when achieving their target ownership exceeds their maximum check size, and the “opportunity cost” of doing so resulting in less diversification.
More from Hunter:
“In our historically concentrated approach to seed stage investing, hitting our ownership target mattered more than valuation *but* valuation was an incredibly important guardrail in evaluating an opportunity, for it has great impact on the company and our portfolio management overall.
We set a ‘max check size’ for our initial investments which was meant to get us, on average, 10-15% ownership and if held to, would overall guide us to an investment period that provided both time and company diversification for the fund. It also drove our reserves strategy. So in any negotiation, whether we wrote our ‘max check’ to get the target ownership was a factor of round size, company stage, and so forth. But we would rarely walk away from an opportunity based on valuation if it fits within that target ownership and check-size box.
In situations where targeting the 10-15% ownership would have required a commitment larger than our ‘max check size’ we had to decide whether (a) the opportunity here was worth 1.5 or 2 slots - ie are we going to make one fewer investment out of the fund in order to do this one or (b) would we stick with our check size but take lower ownership as a result or (c) walk away. Of these three, (c) was the most common decision for a variety of reasons that were about being consistent in our strategy and product offering.”
— Hunter Walk (Homebrew)
How Nikhil @ Footwork approaches valuations
Footwork is a $175M fund leading rounds at the early stage focused on Seed and Series A.
Another strategy among venture managers is back-solving the valuation from the exit value needed for an investment to return the fund, accounting for maximum check size. Nikhil at Footwork talks about their framework for using this approach. For investors who aren’t setting valuations, the same method can be used to check if the valuation fits with your fund model.
Another important consideration for investors is if the valuation sets the company up for a successful round in the future. The higher the valuation for this round, the higher the valuation hurdle it needs to clear for the next round.
More from Nikhil:
“Valuations do matter to us, to a degree. We have to believe that the valuation makes sense relative to the stage of the business and that the valuation sets the company up for future fundraising success (i.e. the valuation isn't so high that it won't be cleared at the next round).
The other calculus that informs our thinking on valuation is how our check size and ownership can lead to a return-the-fund investment for us. What do we have to believe for this single investment to return the fund? Our first fund is $175M, so if we're investing $5M to own 20% of a company, assume that we'll be diluted down to 12% over time, the company has to get to $1.5B or more of exit value for that investment to return the fund. We use this framework and work backwards to the valuation (in the example's case, $25M post-money), check size ($5M), and ownership (20%), that we believe could achieve that goal.”
My general principle is that valuation is *right* when it's mutually disagreeable; that is, both company and venture firm feel a bit uncomfortable about where it lands.” — Nikhil Basu Trivedi (Footwork)
Jonathan Hsu @ Tribe Capital approaches valuations
Tribe capital invests in companies in $1M-$20M of annualized revenue raising at valuations between $30-300M with round sizes in the $5M-50M range
Venture managers want to ensure that the following round is as low risk as possible. Valuation is one part of that – the higher the entry valuation, the higher the valuation hurdle the company needs to clear for the next round to register a markup. This is an important consideration in the valuation strategy many fund managers take.
More from Jonathan:
“At a high level, I think about valuation in terms of what-needs-to-happen-next round. For example, say you are at X revenue/scale and raising $Y (because you're burning $Z). Then, presumably, if you raise it, once you spend it, you will be at some new scale and will need to raise some new larger amount because of your presumably higher burn. We want to make sure that the following round is as low risk as possible and the current valuation is a part of that equation. More specifically, if you raise at a low valuation now and you exceed your expectations, it will make it much easier to raise the next round. If you raise at a high valuation now and exceed expectations, you may be at a disadvantage in fundraising because the prior round set a precedent that will be hard to match. In some sense, fundraising for startups is like a frog jumping between lily pads until they get big enough that capital sources become more continuous. We want to have a good feel for the size and distance of the next lily pad and your odds of hitting it. Current valuation is a big piece of determining that.”
— Jonathan Hsu (Tribe Capital)
How Eric Bahn @ Hustle Fund approaches valuations
Hustle Fund is investing into pre-seed software startups out of its $46M fund.
The majority of entire fund returns tend to come from single or a few "home run" investments. Venture fund managers like Eric keep that in mind while approaching valuations. Central to their approach to valuations is giving each investment the ability to return the fund. They ask themselves: “Can this investment be a 100x return?”
More from Eric:
“We have a simple approach to how we think about valuations: At the post-money valuation that we can invest in a founder's company, do we think that this team can 100x?
As a simple example: say we invest in Vedika's company at a $1M post-money valuation, do we think that this founder, in her given market, can get to a $100M exit outcome (IPO, acquisition, etc)?
If the answer is YES, then we are excited to invest! And that is somewhat rare.
This simple approach to portfolio math works for small, pre-seed funds like ours (sub $50M AUM for the given fund) because it means that even small checks we write have the chance to return the entire fund. I don't think it works with larger AUM funds, where there requires a lot more financial engineering to get to fund returning opportunities, and the expected multiple tends to be a lot lower the more you subsequently invest into your winners.” — Eric Bahn (Hustle Fund)
Why Terrence Rohan @ Otherwise Fund doesn’t focus on valuations
Otherwise Fund is a small, early-stage fund focused on seed and Series A (they don’t lead rounds).
Power law returns dominate venture. Another perspective among venture managers investing in the earlier stage is getting into the right company is more important than getting in at the right valuation. Of course, there are not always mutually exclusive. When they’re in conflict, fund managers like Terrence Rohan first optimize for securing their investment and then for ownership.
More from Terrence:
“My short answer: I do not focus on valuation. I focus on finding the right companies, and then consider allocation or valuation; given this, I will never pass on valuation (early stage).
My longer answer: If you look at early-stage venture capital over the past few decades, the power law of returns (i.e., a handful of companies drive the majority of the returns) may be the data's defining pattern.
Given this, my primary heuristic is to get into the right company. If you are in the right companies, even with subpar ownership and high valuations, you will have top returns. Once you secure a place on the cap table, I then try to optimize for allocation – but this is a secondary consideration, and will never gate an investment. This logic holds for early-stage companies, and price becomes more important the later stage you go.”
— Terrence Rohan (Otherwise Fund)
How Linda Xie @ Scalar thinks about valuations
Scalar is a ~$50M fund focused on investing in pre-seed and seed stage crypto companies (non-lead).
Linda at Scalar believes that passing on a company based on valuation, as long as it falls within a reasonable range, is a missed opportunity. Of course, this has limits as valuations serve as important fund guardrails. She highlights how too high of a valuation at the current round increases the risk of a company raising its next round.
Here’s Paul Graham on the topic:
“Valuation matters far, far less than the decision of whether to invest or not. The spread between bargain and outrageous startup valuations can't be more than 5x, in a world where the best investments can return 1,000x.”
More from Linda:
“We are typically less sensitive to valuations at these early stages. If we have a strong belief in the team and what they’re building, I feel it’s a missed opportunity to pass as long as the valuation is in a reasonable range since we're ultimately aiming for major hits in the long run.
There’s only been a handful of pre-seed and seed stage deals I've wanted to do but passed solely due to valuation. A major consideration if the round is priced too high at pre-seed and seed is making sure it’s not too difficult for the founder to raise future rounds so I will mention this to the founder as a consideration and many have taken that into account.” — Linda Xie (Scalar Capital)
How Ryan Hoover @ Weekend Fund approaches valuations
Weekend Fund is a ~$21M fund investing $200-400K checks in pre-seed/seed rounds (non-lead).
The macro climate is outside of any single fund’s control and an investor’s job is to deploy capital over a reasonable amount of time. Managers can influence valuations but the market will have the largest influence on the portfolio outside of significant strategic changes.
More from Ryan:
“Weekend Fund started in 2017. Our first fund's median entry price was ~$7M post-money. Since then, market valuations have climbed. The equivalent companies are raising at 2-3x higher prices.
As an investor, we have to ‘play the ball on the court’ (a phrase I believe I first heard from Sarah Tavel at Benchmark) and recognize that credible founders are looking for a fair or favorable deal, and have options. But that doesn't mean we don't care about the valuation. They matter.
We focus on meeting founders early and investing at sub-$10M post-money valuations. Every company we back should have the opportunity to return our fund (or more) if they achieve a $1B+ exit. That said, we aren't overly dogmatic and will flex up to participate in promising opportunities. It’s more important that our overall portfolio aligns with our strategy and model. Occasionally founders will award the fund with advisor shares to get us to our ownership target (and effectively lower our entry price). This only works because we have a relatively small fund size to return and if founders value our partnership.”
— Ryan Hoover (Weekend Fund)
Advice for fund managers on valuations
We asked experienced fund managers for advice they have for emerging fund managers on approaching valuation.
Have a clear point of view on valuations (and defend it)
“Now matter the approach, it is important for new managers to have a clear point of view on valuations, and be able to defend it. The safest philosophy (i.e. the most accepted by LPs) is to be valuation sensitive and have a concentrated portfolio.”
— Terrence Rohan (Otherwise Fund)
Compare your level of conviction to the price the market is setting
“The ‘valuation question’ is one that comes up frequently in our discussions with the emerging managers we back via Screendoor (where we will invest up to 10% of a fund’s target raise and bring them into a community of investors ongoing for these types of questions). While situations can differ, my general rule is that the market determines the price, so you have to kind of decide whether your conviction in a company is equal to, greater, or less than price the market is telling you they are ‘worth.’”
— Hunter Walk (Homebrew)
Be disciplined to ensure you can hit a minimum portfolio size
“It’s a power law business so an EM wants to be able to show the quality of their access, picking, and winning. Having hard and fast ceilings on what you’re willing to pay, or trying to over focus on the upper bound of your ownership target too early in your venture lifecycle might make it tougher to prove selection success. So don’t routinely overpay or outbid, especially when you don’t believe in the company as much as the market does, but potential LPs will be more interested in the number of successful investments you picked than your entry price in them. Just maintain enough discipline to ensure you can hit a minimum portfolio size."
— Hunter Walk (Homebrew)
Don’t over-engineer your fund model (at least at the early stage)
“We have institutions, family offices, and high net worths as investors across our three funds. Rarely do we field questions that are onerous about our fund's mathematical model. Given that we raise relatively small fund sizes, and that pre-seed is more about an LP's belief in the talent of the GP – I wouldn't worry too much about over-engineering your portfolio model. You should have a model that you follow, and you need to explain it—but pre-seed is too early a category to model for absolute accuracy, in my opinion.
Late-Stage funds however have a much higher expectation of portfolio math by LPs, and I think that is warranted.”
— Eric Bahn (Hustle Fund)
Valuation negotiations can reveal a lot
“Besides the math of it all, valuation negotiations can tell you a lot about what matters to the founders, the type of relationship they want to have with their investors, and the goals they need to achieve to complete successful next financing.”
— Hunter Walk (Homebrew)
If you’re a fund manager, thinking of starting a fund, or just curious, subscribe to Signature Block if you haven’t already. If you think this might be useful for others, share on Twitter.
Lastly, let us know what topic you’d like us to cover in the next edition.
Subscribe to Signature Block
Portfolio construction & how to model your fund
It’s critical to understand the drivers and their influence on returns as a fund manager. Here are tips and a template for your model.