They go up and to the right so I’ve been told.

The days of bargain valuations are over. Bigger outcomes & more competition means higher prices are here to stay.

Finn Murphy
Oct 1, 2020 · 12 min read

Disclaimer — raising at higher valuations in the current environment closes more doors than it opens — only push for this if you’re happy reducing your optionality to increase your potential rewards. If you’re a first-time founder, raising smaller amounts of capital at lower valuations gives you a margin for error to make mistakes as you learn along the way.

As sure as the sun will rise in the morning the one constant of the startup world is that investors will complain about startup valuations. It’s part of the performance theatre of the industry; If people stop complaining about valuations a great wall might fall and prices will rise to ‘dangerous’ levels that ‘hurt’ founders.

I get it. The mental gymnastics and risk appetite required to be successful in the venture industry certainly puts some of the best conspiracy theorists to shame. I get anxious when I hear that a company with a solo-founder, no employees, and a product made out of paper mâché is raising on a SAFE at a $20m post. It feels insane. But what if it isn’t?

What if software markets actually support much bigger outcomes than most investors had originally thought, and VCs could be paying 2x what we currently are in the right companies at an early stage, and still driving incredible returns for our funds? What if the current acceleration in private company valuations at the top of the market is the smart money coming to this conclusion ahead of the rest of us? To answer these questions we first need to talk about pricing, and then we need to look at data.

Three questions drive pricing

1. How much money is required to get to some kind of future milestone? (cashflow breakeven, product launch, $Xm ARR)

2. How much of the company are the founders prepared to give away? (Usually more than 15% but less than 30%)

3. And most importantly, what funds in the market are willing to pay? The more you can get bidding for your company’s equity, the more efficient a market you create to get the right price.

Ok. But what is the right price?

The fund perspective

To fully understand these questions you have to put yourself in the shoes of the VC. Say I run a fund. I’m looking for a net 3x return on my investor’s cash meaning that for safety, I need to return 3.7x the money if I’m recycling 100% or more of the fund. (this is reusing proceeds from early exits to double down on existing ones and invest the full principal). This means if I’m running a $100m seed fund I need to own 37% of a 1 billion dollar company at exit to achieve my goal. This situation will never happen unless you’re Sequoia leading every round of financing in a company like Whatsapp or Medalia.

One of the GOAT seed funds, IA Ventures, in two of their top-performing companies at IPO, owned 20% of The Trade Desk, which started trading at a $1.1B market cap, and about 2% of Datadog, which started trading at around a $10B market cap. Both outcomes returned their fund several times over but in isolation neither was enough to get to that 3x net return on their own.

That’s how hard the business of venture can be. Easy to do, almost impossible to do well. Investing in just one company that makes it to IPO is tough so you want to make sure that if you get one, you own enough of it. That’s why the majority of seed funds target owning 5–15% of their winners (companies who can return the fund nX times) on exit.

To put this even more clearly. At the very top of the VC game, data collected by Horsley Bridge (a large fund of funds that invests in many top tier VCs), shows that 60% of the returns are driven by just 6% of outcomes and HALF of all investments lose money. This is amongst the best funds in the world. And this sadly means that the vast majority of companies you invest in as a VC will have little to no impact on your performance. So whether they shut down or get bought for money back to investors, it makes no real odds. If you’re in a few winners (fund returners) they’ll more than cover the difference.

If it weren’t for brand (so founders will provide a reference for you when you’re trying to get into that next hot deal) and basic human decency, many VCs would cut non-performing companies the moment they start to stutter and move onto the next thing.

Some funds do and to be fair, if you just look at the math they’re making a logical decision. It’s not our style at Frontline, but it’s hard to argue with the numbers. More data from Horsley Bridge notes that they have never seen a fund that got to 3x net without at least one investment that returned the entire fund — therefore your focus in VC is solving for this first, and helping your portfolio with their struggles (startups are hard) when you get some spare time.

Looking at the wider market

But you can’t look at fund size, ownership and exits in a vacuum. You have to look at the wider market trends. Specifically the trends on the way out (i.e. exits).

The data below was pulled from Crunchbase based on the investment criteria at Frontline Ventures. SaaS, b2b software and enterprise software M&A activity and IPO market caps for a series of time periods across the US and Europe. I’ve excluded all exits below $50m as in our job they don’t matter.

Welcome to the wonderful world of venture capital.

What you can read into this is that back in 2014, a fund manager thought, ‘ok there’s certainly some big outcomes and the average exit in the sector is over $1B — but the median is only $375m — so for me to return my $100m fund just once I have to own 26.6% of company X on exit. But I still need to have 25 investments to give me a good chance to make that happen a couple of times. Fast forward to 2018 I only need to own 18.7% and I still only need my 25 shots on goal to give myself a good chance.

Now in 2020? I only need to own 8% to get my fund returning outcome.

VCs can only spread themselves so thin in terms of volume of investments. They also don’t want to own ‘too much’ of a company as often a misaligned cap table puts a limit on potential value. So funds are now paying more to own less of companies but their returns are staying the same or slightly improving as detailed in this great post by Seth Levine.

According to Pitchbook, between 2010 and 2019 entry prices in top quartile angel and seed rounds in the US increased from just north of $6m to just less than $12m and have stayed roughly the same in 2020. At the same time those round sizes increased from $1.4m to $2.6m — almost following a linear path between valuation rise and dilution. (even though the pies have gotten bigger, investors still want to own the same amount)

Looking beyond just the seed stage and into early-stage (Series A, B, C), there has been a much more aggressive expansion in valuations, particularly in the top quartile companies with data up to Q1 of this year spiking at close to $70m up from $20m in 2010.

But valuations haven’t just been rising because people have noticed there are returns to be made. A function of that equation is competition.

The number of new funds in the US shot up from 140 new funds in 2010, to 580 in 2018. These new funds are deploying a lot more capital as well. In 2010 $31.4B was deployed in US venture across 5,444 deals. In 2019 those numbers were $136.5B — across 10,777 deals.

In Europe, the number of funds is also increasing and dollars have doubled from $17.68B in 2015 to $36.05B in 2019, but the total number of deals in the same time period has declined substantially from 5926 to 4275 — Europe will get there, it’s just going to take some time.

5x the number of new funds, 4x the amount of capital and only 2x the number of deals in the US. Price elasticity has started to kick in and now there’s a lot more venture capitalists looking for the next big thing than there are potential big things searching for venture capitalists.

What does this tell us about valuations? in all of the new funds referenced above, expansion in potential outcome size and extra capital should produce an aggressive expansion in early-stage valuations. There just aren’t enough great companies to fund to meet the supply needed to keep prices stable.

But they aren’t at seed stage, valuations are hovering at about 2x where they were 10 years ago. For Series A,B & C investors? They’re certainly catching up but it’s still only a 3.5x increase for the top quartile.

There’s always going to be a lag time between investors and the market. The best ones are ahead of it, the vast majority are chasing. Looking at the numbers though? Valuations have been lagging where the market should have been pushing them. They’re catching up now, and that’s not necessarily a bad thing. Will they overrun? Probably. That’s ok too — the market will never be optimally priced, sometimes you’ll get a great deal other times not so much — that’s where time diversification comes in.

Seed Fund Dynamics

So let’s go back to the 100m seed fund. They’re making 25 bets. Getting 10% upfront. Say they beat the odds and own close to 10% at exit — the median home run exit is $1.275B & the average is $2.99B — They need to hit a median & average home run + change to hit their 3x net — if their 25 bets start off with a 1.5m entry cheque (37.5% in initial cheques / 62.5% in reserve) then a $15m post-money cap doesn’t look that wild provided they can play aggressively for their pro-rata in the companies that count.

In reality these numbers are still really, really hard. To have a shot at delivering the 3x net you can’t follow a playbook or run a model. You have to have conviction in the bets that you make and a hell of a lot of luck to ensure that some of them are outliers. From a fund perspective that’s what’s important, particularly when it comes to valuations. You have to think outside of medians and averages and think about how you can get into those companies that can become more valuable than you can possibly imagine when you write that first cheque.

As a founder you have to remember that all this depends on the fund you’re dealing with, how they think about portfolio construction, and a tonne of externalities that — if I were to go into detail — would literally bore you half to death. It’s just good to know that while your job is the harder one, VCs have their work cut out for them too.

What does this mean for founders & investors?

Founders shouldn’t be afraid to push on the price button when you’re raising — don’t get too stressed about the next round, if you don’t achieve your milestones with the money you’re raising now (and you’re putting yourself on a venture track) you’re likely *screwed* anyway so be VERY conscious of how high you’re setting the bar.

Top 10% valuation implies top 10% performance — if you need a bridge round don’t be angry when it’s a down round. If you don’t have multiple funding options, you don’t get to set the price, so don’t be offended when a VC offers you 2 on 6. When capital is critical to your success you take what you can get at the end of the day.

For VCs there’s a quote from the M&A world that I wish I could find the source of, but to paraphrase: ‘What something costs isn’t important, what matters is what it’s worth — when you look back on any price in 10 years time you’re either going to look like a genius because you got it for a fraction of what it was really worth, or you look like an idiot because it turned out to be worthless. But you can only look so stupid on the downside while your genius and upside can be unlimited.’

Admittedly this is a first pass on this research, but it drew me to an interesting conclusion that I thought was worth sharing. Either public market valuations & M&A exit prices are overheating like crazy right now (these numbers are all @ IPO so it doesn’t include the latest Fed & Softbank fuelled bull run — if it did the numbers would be even wilder) and due for a downward correction (probably in the 70% range) so prices are currently about right at seed and overheating at A,B,C. Or you can take what I think is the correct view.

Software markets support much bigger outcomes than originally thought. Most VCs could be paying 2-3x what we currently are in the right companies at an early stage, and still driving great returns for our funds. Provided you’re looking to invest in true outliers. (If you ain’t, you’re not doing venture right)

The Europe View

Most of the data here is US-focused as what happens in the US tends to come to Europe a few years later so even if I got the timing wrong for this take on one continent I’ll have another shot to be right in the future. But looking at the European data it actually tells a similar story.

Valuations are certainly lower in Europe than in the US, 50+% by these numbers, but they’re moving up in line with their US counterparts. The only argument for European valuations to be lower than US valuations has been that the potential outcomes are substantially smaller than the US.

In the past, this was very much the case. Looking at historical exit data, Europe wasn’t particularly lucrative in b2b software in the past 5 years other than Adyen & iZettle. Before then Criteo, Mimecast & Zendesk achieved great outcomes but still, the number of venture-backed billion-dollar enterprise software outcomes of the past 10 years, could be counted on one hand.

If you believe in Europe as a global player and is a worthwhile place to invest your venture dollars then you have to believe that a correction in outcomes is coming and we’ll begin to see similarly large exits come from our shores. If not? We need to do a better job of getting our best entrepreneurs to take their companies stateside sooner rather than later.

There’s a tonne of highly valued and extremely promising companies that could bring many similar sized mega outcomes to Europe. (Accel Euroscape covers this very well). The trends in venture and software markets we see in the US will make their way here. It’s just a matter of time.

VC is about playing for the biggest outcomes, to do that you have to partner with the most ambitious entrepreneurs. People for whom the windows of reality are completely unhinged. The only way to get to a big outcome is to aim for a huge one — if that’s you, let us know.

Thanks to Deepka, Shamillah, Lola, Judith, Carolina, Imran and all the other kind folks who read this and opted not to stop me shooting myself in the foot in all future negotiations. You are the real heroes.

At the Front Line

Frontline is the venture firm for globally ambitious B2B…