By Dan Gray
“We’re letting the market price this round.”
This line is often fed to founders in preparation for the notoriously tricky valuation question.
It’s a negotiation tactic. You don’t want to pitch a price that may be off-putting, so you avoid giving an answer. But what does “letting the market price a round” mean?
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In warm markets, when capital flows freely and optimism is high, it means you are confident that interest in your startup will be sufficient to secure attractive terms. As a founder, you leverage market conditions to get what you want.
Unfortunately for founders, it cuts both ways. In cooler markets, as we saw in the latter three quarters of 2022, letting the market price the round means downward pressure on valuation. It is a buyer’s market, and investors are likely to set terms further in their own favor.
In technical terms, it means your focus is really on “pricing” rather than valuation. Instead of focusing on the objective worth of your company, you ask what the market seems willing to pay at that moment. It is in that fine distinction that the trouble begins.
The underrecognized influence of momentum in VC
Early-stage startups are — in theory — fairly well insulated from macroeconomic conditions, being many years away from exit and serving niche market segments. So why have their valuations been knocked around so much?
The truth is that a significant amount of VC activity is influenced by momentum, which manifests in two places: First, the notorious FOMO factor which, for example, drove a lot of Web3 and crypto investments. Second, the reliance on comparables, and how that can compound trends in pricing and cause them to leak into other sectors and stages.
An unfortunate consequence of this behavior is that investors are keen to deploy capital in hot markets when valuations are high and more cautious in cooler markets when there is a greater need for capital and better deals to be had.
“As with most economic cycles, investors’ interest to deploy capital peaks when it is usually a terrible time to invest and the market is overheated, but stay on the sidelines when conditions for investments are at their best.”
Hype vs. rational market
Investors who navigate by market momentum can find themselves with a lot of capital tied up in expensive hype, while great ideas in overlooked segments go underfunded. Rational markets are healthy markets.
It seems obvious that throttling this connection between market momentum and startup valuation would yield better results for everyone involved.
Founders would have more consistent access to capital, and investors would be less vulnerable to the tide turning against them. Overall, a more robust market still delivers the specific risk/return ratio required of that asset class, with more direct focus on the performance of investors and founders. It requires a fundamental change in how we value the startup asset class, and specifically that we look at valuation as more than just a pricing exercise. The process of valuation allows us to dive more deeply into the performance and potential of a company, and build a more analytical picture of the opportunity. Away from the reliance on comparables, we can exercise greater independence of judgment, more rationality and more accountability.
The die-hard momentum investors in venture capital are welcome to steam ahead, but it seems like an odd choice in a market that can change course quickly, with long windows of illiquidity.
Dan Gray is an adviser supporting impact entrepreneurs in emerging markets, and is the head of marketing at Equidam, a platform for startup valuation.
Illustration: Dom Guzman
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