What The Rapid Rise In Startup Valuations Means For Investors

The venture-backed startup ecosystem has become increasingly overheated, fueled by what the economists call money seeking rents, at a potentially precarious pace we haven’t seen in two decades. It has significant implications both for investors and the companies themselves.

Rent-seeking affects more than just venture-backed startups of course. It’s fueled the wild gyrations of cryptocurrencies, and the speculative fever of NFTs. It’s spurred the explosion in SPACs, and the retail investor plunge into short squeezes and meme stocks. Even Super Mario has been, ahem, getting into the game.

Similarly, rent-seeking cash has absolutely washed over the high-risk, high-reward startup sector, setting records for the first half of the year even in the earliest stages of fundraising.

With so much money sloshing around, there’s no better time to start a company. It’s even better than the late ’90s, when I started my company, but investors should remember some caveats. Otherwise, they risk losing a lot of money.

In the four years since I sold my startup for a nine-figure exit, I’ve invested in a diverse portfolio of dozens of early-stage tech companies. It’s a fun process to imagine what the world will look like in 20 years, and to use my money to help shape that future.

As I began investing, I spent a lot of time studying the startup ecosystem, learning what works and what doesn’t, adapting my strategies as the market rapidly evolved. One big change has been the rise of startup valuations, which are skyrocketing.

Last year, even amid the pandemic’s disruptions, the average seed round was $2.2 million, at a valuation of $6 million, according to Fundz.net. And the prices only go up from there.

For example, Evernote co-founder Phil Libin launched conferencing software company Mmhmm.com last summer, found quick success, then raised $100 million from SoftBank Vision Fund, Sequoia Capital and other heavy hitters without even using a pitch deck. Libin said he was just “showing them what’s already on our website.”

As Libin says, “It’s a pretty good time to fundraise.”

And it’s not just prominent veterans such as Libin who are grabbing early-stage gold. Some 1,733 deals received angel or seed-round money in the last quarter, according to Venture Monitor, a quarterly report from PitchBook Data and the National Venture Capital Association. Those initial-stage deals have totaled more than $7 billion in the first half of the year.

Individual rounds were bigger too. The number of seed and angel rounds valued between $5 million and $10 million has roughly tripled since the 2013–2015 period. A record 23 deals of more than $25 million also closed in the quarter, in what’s shaping up to be a record-shattering year.

The money comes from several directions, including revolving funds that are recycling cash from previous big exits, and an influx of “non-traditional venture investors,” including mutual funds, private equity, hedge funds and family offices.

“These investors use venture as a supplement to other strategies, whether they be public equity investment or corporate R&D,” PitchBook says. “The sums of capital being aggressively invested have confounded the market, increasing competition for deals and helping boost deal prices ever higher.”

Those non-traditional investors previously hadn’t taken part in venture-backed startups, especially in early stages. But by 2020, those rent-seeking investor groups joined more than three-fourths of the U.S. deal value, and just about all of the biggest rounds, according to PitchBook.

That provides lots of cash for some companies, but creates even more reasons for caution among other investors. The more they buy into early-stage companies in new sectors they don’t know well, all in search of more big hits, the more likely they are to overvalue or just plain miss.

Non-traditional investors typically seek relatively quick returns, which is why they’re likely to join late-stage “mega rounds” that often precede a big public exit and provide prime positioning for post-IPO shares. But they’re buying into earlier-stage deals too.

“On the positive side, crossover investors with significant public-market expertise can add value during late-stage investments, changing conversations in the boardroom for the better,” PitchBook said. The downside: “applying public-market discipline during early-stage investment can prove counterproductive when companies are not ready for that degree of oversight,” and can lead to “irregular deal terms and valuations that are unappealing for traditional VC investors considering follow-on investments.”

In other words, all the new money makes valuations look good, and it will provide more competent management practices and the chance for some mature startups to remain private far longer than in the past. That can allow a company to focus on long-term development initiatives rather than chasing the quarterly results grind of public markets.

But the flood of new investors also warps traditional funding relationships and corporate-development arcs, especially in young companies still building out their business. The flood of money brings heightened expenses, expectations, and requirements that can make it difficult to find the gold amid the dross.

To thrive in this increasingly pricey deal derby, investors should use some prudence and a thoughtful strategy to maximize their chances of success:

• Do your homework.

• Invest in what you know.

• Find a “sherpa,” someone you trust who can guide you in the sector.

• Know your co-investors, and why they’re investing.

• Practice a portfolio approach, spreading risk with smaller stakes in as many companies as possible. Most venture-backed companies will fail but a few huge hits will pay for the rest. That’s how the startup business works.

Valuations will keep growing as long as investors have successes here, and a better risk/reward payoff doesn’t surface elsewhere.

But even with all the cash now in the industry, startup investing will continue to be a risky, complicated business, now with a fast-rising price of entry. Smart, educated investors can still generate big returns over time, but they need to invest thoughtfully and broadly across crucial sectors with companies that have a chance to grow and innovate.