This is a problem for founders, and investors like Jenny Fielding, managing partner of Everywhere Ventures, who said, “Every Seed investor’s dilemma: All my Series A buddies want to meet my companies early! All my companies are too early for my Series A buddies.”

To attach some data to this, we can see that the median step-up in valuation from seed to Series A has gone from $19.5 million in Q1 2022 to $28.7 million in Q1 2024. Series A firms seem to be looking for much stronger revenue performance, with targets of $2 million to $3 million in ARR, compared to $1 million to $2 million just a few years ago.

The outcome is that while 31.8% of Q1 2020 seed startups closed their Series A within two years, that fell to just 12% for Q1 2022 — which should worry everyone.

Why are Series A investors so much more demanding?

Today’s Series A investors are looking at startups that raised their seed between 2021 and 2023, which identifies the root of the problem: it spans the Q2 2022 high-tide mark for venture capital.

For example, there were 1,695 seed rounds of more than $5 million in 2021, rising to 2,248 in 2022, then falling to 1,521 in 2023. As a comparison, there have been just 137 so far in 2024.

The result is two categories of startups that are looking to raise their Series A today:

• Pre-crunch startups that raised generous seed rounds and stretched the capital out as far as they could, to grow into inflated valuations.
• Post-crunch startups that raised modest seed rounds on more reasonable terms, with shorter runways and less demonstrable growth.
  Strictly speaking, neither is more appealing than the other; the first group has less risk, the second offers more upside, and both are adapted to current market realities. It shouldn’t cause a problem for investors, provided they can distinguish between the two.

The cost of market inefficiency

Venture investors have a market-based lens on investment decisions, which means looking fairly broadly at trends in revenue performance and round pricing to determine terms, e.g. a typical Series A is within certain bounds of revenue performance and valuation. While that approach may be serviceable and efficient under ideal conditions, the past few years have been far from ideal.

Without distinguishing between the two cohorts, investors are now looking at the performance of Series A candidates that spent more than $5 million on a war chest for two to three years of growth alongside the valuations of candidates that raised around $2 million to prove scalability. It just doesn’t work as an average, and thus the unreasonable expectations.

The breaking wave of zero-interest rate madness

Fortunately, it’s temporary. Series A investors are facing this today because of what happened two years ago. Roughly four years from now, it will be the turn of Series B investors to look at an oddly divergent class of startups. In six years, as it hits Series C investors, the ripples should be hard to detect.

What frustrates many is that this is a mostly avoidable phenomenon. Yes, the venture asset class is cyclical, but venture investors do not need to lean into those cycles with maddeningly procyclical behavior. Roughly as many startups have shut down in Q1 2024 as in the whole of 2020. Companies closed. Jobs lost. Dreams ended. And it’s not because of rising interest rates, but rather because of how venture investors acted when rates were low.

 Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation, and a venture partner at Social Impact Capital.

However, there is a divergence of views about the role multiples play in venture capital investment decisions. A generational divide opened up over the past decade, with a younger cohort of investors using multiples more aggressively.

So, what is the purpose of multiples, and how should investors apply them?

First of all, let’s consider the origin: public markets.

When looking at public market stocks, you have a wide range of data available thanks to the associated reporting requirements. In search of alpha, traders will analyze multiples such as EV/revenue, EV/EBITDA, EV/FCF or P/E.

Each metric provides a slightly different perspective on performance relative to the share price, and is used to understand whether or not the company is currently underpriced by the market.

Multiples are also used to understand public and private market trends, more broadly. Two recent examples of this are Mark Suster’s conversation with Harry Stebbings about recognizing inflated valuations, and Bill Gurley, Brad Gerstner and Aaron Levie talking about the market for software companies.

In that second example, Gurley also comments on the contemporary application of revenue multiples, which we’ll explore further: “Silicon Valley has the crudest, least intelligent view of valuation. They always rush to price to revenue because it’s easy, and quite frankly it’s easy to be optimistic.”

Over the past decade, driven by the brisk pace of deals during ZIRP, revenue multiples have become understood as a shorthand tool for valuation. In theory, you find a similar company which recently raised capital, derive its revenue multiple, and apply that to the revenue of another company to determine the relative valuation.

It’s certainly easier than a typical valuation process, but does it work?

Fundamental problems

First, there’s just not enough data in private markets. Finding similar companies is challenging; getting a good picture of their financial performance and deal terms which produced that valuation is often near impossible.

It’s procyclical. Relative valuations work when your comparable companies are priced with some underlying rationale for intrinsic value. Unfortunately, pricing with multiples is now so prolific (e.g. 71% of European VCs) that there’s a tenuous connection between price and value — which makes venture capital more vulnerable to inflationary cycles.

It’s a bad way to look at outliers, which are fundamentally what venture capital is all about. What multiple did Mistral AI use for its seed round? What about Anduril? The logic quickly falls apart when you look at the category-defining startups that investors should be chasing.

They don’t actually calculate valuation. Finally, pricing with multiples may seem appealing due to its convenience but, much like pricing based on ownership targets, it isn’t actually a valuation exercise. In reality, multiples are used as a way to justify assigning a number that feels right (or voiding a deal entirely) based on a roughly intuited view on value. Most of the time, it’s a lie.

The role that multiples should play, as demonstrated in the earlier examples, is understanding trends and providing context.

That generally means two things: comparing terms to the broader market to see how a startup is positioned relative to its peers, or analyzing trends in the fundraising market more generally, such as how expectations shift over time and between stages.

Fundamentally, multiples are a tool to compare and analyze valuations, not a shortcut for calculating them. Crude comparisons that lack specificity will continue to generate bubbles, damage returns and do a disservice to the outliers.

Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation, and a venture partner at Social Impact Capital.

Illustration: Dom Guzman

The pace of investment accelerated over the next decade, and without sifting too finely through recent history we can reflect back on a quote from Andreessen’s essay:

“Too much of the debate is still around financial valuation, as opposed to the underlying intrinsic value of the best of Silicon Valley’s new companies.”

Andreessen’s sentiment lines up with reality: At that time, the risk and potential associated with high-growth software companies were not well understood or adequately reflected in the financial models used to compute valuation.

Forward-thinking people in venture found this frustrating, and practices began to diverge — drifting toward simpler financial models and crude comparison tools like revenue multiples.

The sheer momentum of software investment over the following years encouraged the growth of private capital inflows, allowing startups to stay private for longer. Valuation was seen as an arbitrary milestone on the road to IPO as investors ratcheted up the price and exit expectations to produce ever more impressive (paper) returns.

Somewhere during this period of easy money and endless growth, investors stopped thinking seriously about valuation. All that mattered were comps based on trends in similar transactions. A startup would be awarded a market-based multiple based on its growth rate, revenue and — where investors were unusually diligent — their margins.

Eventually, even smart investors started saying things like “only market-passing valuations matter,” as a way of dismissing sincere attempts to understand and rationalize private company value.

We had entered an overcapitalized environment where financial discipline was no longer valued, and those muscles were starting to atrophy.

The importance of a common vocabulary

Most investors have since forgotten what valuation is supposed to represent, as the nomenclature of venture capital has failed to keep pace with the growth. Consequently, you can ask a dozen of the sharpest investors what they think of valuation, and get a dozen different answers.

The danger is that investors end up overthinking valuation, conflating it with pricing and seeking a convoluted consensus through averages that have no real place in an asset class focused on outliers.

That approach also misrepresents the simple fact that the price of a nonfungible asset is agreed between the two sides of a transaction, not a universal truth.

(Pricing based on comparison can make sense as a fund strategy for mature companies or in a more concentrated sector like B2B SaaS, but that falls apart quickly when you look elsewhere.)

A definition of startup valuation

Fundamentally, without getting bogged down in methodology, valuation is a framework through which investors can better understand a startup by analyzing qualitative and quantitative factors which reflect risk and potential. It enables a more complete and comprehensive understanding of that particular company, the business model and the implied scale of returns.

We can clarify this further by establishing two things that startup valuation isn’t.

Valuation is not pricing. If your estimation of value is based purely on market momentum, similar transactions, investor demand and competition, then we end up with a mindless procyclical environment like 2021.

Valuation is not fund math. Having a binary investment decision based on a given price and a target ownership percentage does not imply a valuation, it just implies a threshold of tolerance.

So the complicated answer is that valuation is actually a component of pricing, along with market conditions and fund math.

Price — determined by a combination of valuation, market analysis and fund math — is ultimately the number that gets the deal done and is the topic you hear investors talking about most frequently, regardless of how they refer to it.

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

It’s a common sentiment in a market known for risk-averse investors focused on “number crunching,” which makes the idea worth further scrutiny.

In theory, the greater risk-appetite of founder-VCs would benefit founders by relieving pressure on due diligence. However, while raising money could get a little easier, the same is true for other startups competing for that capital. It might expedite the process, but it won’t necessarily change outcomes.

More critically, founder experience doesn’t appear to aid investor performance. A 2022 working paper from the National Bureau of Economic Research looked at investment outcomes for 13,000 U.S.-based VC firms. The results of that study, in terms of the percentage of successful investments, were as follows:

• Founder-VCs (successful startup): 29.8% (12.4% IPO)
• Founder-VCs (unsuccessful startup): 19.2% (7.1% IPO)
• Professional VCs: 23.3% (9.4% IPO)

From the paper’s cited 29.7% rate of entrepreneurial success for founders that become VCs, we can determine the following:

• Founder VCs (all): 22.3% (8.7% IPO)

So founder-VCs, in general, underperform vs. professional VCs. It’s a bitter pill to swallow, but it lines up with the data that suggests the risk-averse number crunchers have outperformed their peers across the pond for the past 20 years.

The halo effect

An interesting component of this, which the study attempts to quantify, is the “halo effect.” It begins with how founders make their entry into VC: 89% of successful founders join a firm that invested in their company, compared to 85.4% of unsuccessful founders.

In theory, that should compound future success. Failed founders join firms that made a bad investment (likely worse), and successful founders join a firm that made a good investment (likely better). This introduces a spectrum of intangibles, such as brand strength of the firm, access to deal flow, trust from their partners, and quality of mentorship, which will shape these statistics.

The operator handicap

This is all very counterintuitive. Surely founder-VCs will have a better understanding of startup growing pains and a keener understanding of running and scaling a company. Shouldn’t they be the ideal partners?

Fred Wilson of Union Square Ventures, a legend of Silicon Valley, shared his thoughts on this back in 2017: “I think that VCs who aren’t handicapped by operating experience bring great respect for operators. And that helps a lot.”

Fundamentally, founders are executors and investors are strategists. They are highly complementary skills, but one could not typically do the job of the other and experience on the other side of the table can actually lead to confusion.

What ‘Europe needs more founder-VCs’ really means

The argument that we need less due diligence in venture capital is a hard sell after the past few years. Then you rule out performance and end up with one remaining concern: There is simply less money flowing into venture capital in Europe, and almost everyone would benefit if that were to change.

It just makes no sense to reflect this as pressure on VCs, who aren’t in control of the available inflows. Instead, the asset class needs to make itself appealing to bigger pools of institutional capital. For example, public pensions provide a staggering 65% of U.S. venture capital, but just 16% in Europe and 12% in the U.K.

This leaves two crucial lessons for all stakeholders in the future of European startup ecosystems:

1. Venture capital needs to adopt better standards which enhance transparency and accountability, because European LPs are certainly also more conservative than their peers in the U.S. More capital requires greater accountability.
2. Governments must also do what they can to enable and encourage institutions to invest in venture capital, which may also include enforcing such standards through regulation.

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

With every new wave of technology, there is a corresponding bubble in private markets. Entrepreneurs join the gold rush, chasing the edge offered by innovation, and investors lend out picks and shovels to anyone who promises to deliver outsized returns.

Most will fail. This is the normal for venture investing and a natural product of the high failure rate at early stages.

Consider the dotcom bubble. After a period of historically low interest rates, money poured into internet startups through venture capital. When interest rates rose again and capital dried up, many of these companies found themselves with unsustainable economics and were forced to close down.

This is a pattern that has replayed throughout humanity’s history. From “railway mania” in the U.K. in the 1840s, to Japan’s “bubble economy” in the 1980s, low interest rates and irrational enthusiasm produced businesses that simply weren’t viable in normal conditions.

While we have exited the ultra-low rate era, returning to more normal interest rates of around 5% (the U.S. averaged 5.42% from 1971 until 2023), it’s worth noting that VC firms are still sitting on a huge amount of dry powder from that period.

Combined with the incredible enthusiasm around AI, evident in some of the high-profile funding rounds, there are clear signs of a bubble.

The larger that bubble grows, the more the transfer of wealth in venture capital becomes a net-negative for the majority. Considering that, and the already potent hangover from VC excesses in 2021, you would imagine that we’d all be a bit more cautious.

Crude comparisons allow prices to inflate

In every instance of a bubble, the root cause is the simple idea that if a particular investment seems to be lucrative in one instance, the same will be true elsewhere. For startups, the term is “comparables” — the practice of pricing an investment by looking at similar investments.

The cruder the comparison, the wider the net is cast, and the faster a bubble develops.

Throughout 2021, when deals were being completed at a record pace, investors started relying more on comparables as a shorthand way to price rounds. Specifically, multiples on revenue (similar to price per square foot for real estate) became the go-to approach. This has a number of problems, including the huge incentive to manipulate revenue reporting, and suffers from being particularly low-resolution.

For example, fintech startups were understood to be priced based on multiples of up to 30x, while ignoring a lot of scrutiny on the underlying business model, profitability and the specific sector of finance.

The importance of specificity with valuation

Multiples shouldn’t be used simply to justify investor appetite for a technology, but to reflect a similar estimation of future potential. Valuation, after all, is always based on the future.

In simpler terms, multiples should be considered as a reflection of business model and industry, not technology. For example:

• An AI SaaS tool using the revenue multiple of a hot LLM R&D company might reflect investor appetite to a degree, but it says nothing meaningful about the value of the company.
• An AI SaaS tool in freight logistics using the multiple from another company in that industry would be properly reflecting the calculations about market size, growth potential and risk.

The purpose is to offer up a price which aims to reflect the value of the investment in terms of exit trajectory, not a price which fits investor hype and momentum behind a technology at that particular moment. Focusing too much on the latter is how we end up in procyclical spirals, inflating markets and ultimately crashing them.

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

Recent coverage of private market data from Cambridge Associates has surprised many by revealing the extent to which European venture capital has outperformed American venture capital in recent history.

Over the past 20 years, 10 years and 5 years, Europe led in net annual returns by 0.31%, 1.92% and 6.24%, respectively.

Many in the venture world have responded with disbelief, expressed in three main sentiments:

First, aren’t European VCs painfully risk-averse?

Second, don’t American VCs have a lot more cash?

And finally, when did the U.S. lose its lead?

In fact, these points illustrate exactly how Europe has managed to capture the lead.

Risk aversion hurts founders, not VC returns

Venture capital in Europe has often (and fairly) been criticized for risk-averse behavior in an intrinsically high-risk asset class. Whether it’s extended due diligence or downward pressure on valuations, it hasn’t been as “founder-friendly” an environment as the U.S.

Unfortunately for founders, the performance of venture capital (measured by rate of return) does not correlate with the scale or pace of deployment. It is connected to the quality of the investments, which is where European investors have focused more of their energy.

Consider the major embarrassments in startup-land: FTX, Theranos, Yuga Labs, IRL, Frank. … The obvious examples tend to be U.S.-based companies, with U.S. investors.

While European investors haven’t been immune (see Virgin Hyperloop), examples are much harder to come by, which speaks to their greater caution.

More capital is good for founders, not VC performance

Dry powder is a controversial topic, but the difference in capital availability between the two regions is significant and relevant. Currently, the U.S. has about 2,361 venture firms with an estimated $271 billion under management. Europe has 199 firms with about $44 billion under management.

To put that in context, the U.S. has 55,079 startups, while Europe has 39,668. These counts are based on an analysis of Crunchbase data of active private companies funded since 2014. That means the U.S. has $4.9 million per startup and 23 startups per VC firm. In Europe, that’s just $1.1 million — and as many as 199 startups per firm.

Abundance doesn’t appear to drive better outcomes for venture capital. To understand why, a good case study is offered by the rise and fall of ZIRP-era VC.

Over the past decade, we’ve witnessed the influence of cheap capital on VC, with a drive toward pumping the price on consensus bets and dumping companies onto public markets. VCs became more like traders than investors, focused on riding trends and harvesting management fees.

This practice was sustained — at cost to fund performance, VC reputation and LPs’ returns — until the public market started rejecting inflated valuations and interest rates drove up the relative risk for LPs. Europe, not suffering from quite as much capital boat, has seen proportionally less corruption of the asset class.

VC stopped being data-curious

Despite the impressive status and reputation, U.S. venture capital hasn’t led on returns since the dotcom boom.

If you’ve followed the data published by Cambridge Associates you will have known of Europe’s lead since at least 2019. It was emphasized again in this year’s “State of European Tech” report from Atomico.

The sense of surprise about these findings is yet another hangover of ZIRP. The focus of venture capital has shifted so far toward relationships (logo hunting) and hype (momentum), there is little curiosity about the data that typically informs investments and benchmarks performance.

It’s an industry running on anecdotes, not evidence.

As we feel the ripples of that 2011-2022 strategy collapsing, with startups closing at a record rate and markdowns across the board, it is clear that much will have to change as sentiment swings back toward real performance.

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

With each cohort that graduates from Y Combinator, the same debate emerges: How can such early-stage startups justify such high valuations?

According to YC President Garry Tan, 75% of the current summer cohort is pre-revenue and 81% are looking at raising their first external capital. Many of the founders will have entered the accelerator without much more than an idea.

Despite this, YC has developed a reputation for launching startups into the investment market at eye-watering prices. This is particularly striking in H2 2023, coming off a real downturn for startup fundraising. Investor Erik Bruckner has reported $15 million post-money caps as the most common terms among the sample of startups he’s met from this batch, at a time when the median U.S. pre-seed valuation is closer to $8.7 million.

How can YC justify promoting these terms to a more conservative venture market?

YC is not setting any valuations

While the partners at YC can make recommendations on terms, the terms of any subsequent raise are up to the founding team. Founders will attempt to raise at a price they think reflects the opportunity they offer, and — for YC startups — the market is on their side.

Secondly, startups raising out of YC are typically doing so with a capped SAFE (simple agreement for future equity) agreement, which determines the maximum price at which capital converts to equity in a future priced round.

Conflating caps and valuations is an easy mistake to make. They share many of the same characteristics, and if it is set reasonably, a cap may well end up reflecting the valuation of a startup. But they aren’t the same. Fundamentally, a valuation is a determination of value while a cap is a ceiling on price.

While it has implications on value, a cap is effectively meaningless up until a startup actually goes through a proper valuation for a priced round — and not all YC startups will manage to raise at or above that cap.

Venture is a power law game

A well understood concept in venture is that the majority of any fund’s returns will be driven by a handful of companies. Maybe 1% of investments will be a 100x return, 5% will be 10x returns, and 50% will lose money. Identifying those outliers is the whole ballgame, so even a marginal improvement to selection can have a huge influence on fund performance. This factor has driven significant investment into VC “platform teams” since 2010.

With that in mind, consider that roughly 4.5% of Y Combinator startups have achieved “unicorn” status since 2010, according to analysis by Inside. That’s head and shoulders above similar accelerators, which makes it such an appealing target for investors.

The increase in price is worth every penny if it can increase your hit rate.

The end justifies the means

Ultimately, if YC didn’t deliver high-quality opportunities for investors, they wouldn’t be able to secure investment at above-market rates.

In fact, YC’s performance even stands up outside of power law shenanigans. Analysis by Jared Heyman of Rebel Fund, a VC that exclusively targets the top 5%-10% of YC startups each year, shows that an index of all YC startups would yield an impressive annual return of 176%, net of dilution.

There has been speculation over the years that YC has lost its way, that it has grown beyond some optimal size. That criticism doesn’t yet appear to be supported by any data, and comes largely from the group which would benefit from lower entry prices: the VCs who will inevitably be queuing up to invest in the next cohort.

Related Reading

• The Problem With Letting Market Momentum Determine A Startup’s Valuation
• The Science Of Startup Valuation
• Garry Tan Interview: How An Early-Stage Investor Spots Future Unicorns

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

As startup fundraising appears to be stabilizing after a few tumultuous years, there’s one topic which has reliably featured in that conversation: dry powder.

“Dry powder” refers to the amount of money that limited partners have committed to venture capital funds. Rather than being delivered upfront, that capital is requested in increments by VCs during the first few years of a fund in order to meet funding obligations to founders. That estimated number stood at around $580 billion at the end of 2022.

Depending on who you listen to, this mountain of capital is either a bullish signal — as VCs take advantage of the post-bubble environment to snatch up equity at bargain prices — or it’s meaningless, as poor fund performance, slower exits and higher interest rates incentivise LPs to direct their money elsewhere.

The truth, as always, is complicated.

Similar to VC term sheets (funding agreements with startups), we’ve learned that LP capital commitments aren’t as binding as the industry would have liked to believe two years ago. However, that theoretical pile-up of available capital is still a positive signal.

Not all of it will materialize, and VCs will have to be more disciplined with their deployment, but it is certainly better than starting with less, or zero.

Not everyone is affected equally

How this plays out will differ significantly between early- and growth-stage funding, emphasizing the distinct nature of the two disciplines, capital requirements and their recent behavior.

Generally speaking, pre-seed- and seed-focused firms aren’t suffering too much from the excesses of 2021 and 2022. Mainly, there’s greater recognition that they can no longer just pass hot deals up the chain for a bumped-up valuation, that era is over.

Growth-stage funds are in a real predicament. Remember that scene in “The Hangover” where the protagonists woke up in the hotel suite? Well, growth VCs are staring, bleary-eyed, at funky cap tables, down rounds and zombie companies. Lots of aspirin required.

In addition to the bifurcation of early- and growth-stage VC, we must also consider performance. Generally, the smaller, specialist firms are more likely to have maintained discipline, and the faith of their LPs, over the last few years, while the bigger generalists are more likely to have fallen victim to momentum.

What LPs are looking for

The model which emerged in venture capital over the last decade is dead. There is no appetite for the consensus-driven megadeals, nor the promise of exits that can support them. The asset class must return to its roots: identifying outlier opportunities in large markets. Finding winners, rather than trying to manufacture them with cheap capital.

If I was an LP in an early-stage firm I’d be comfortable seeing the pace of deployment on par with the past two years. I’d be looking for managers whose theses are rooted in that pursuit of outliers, who are guided by a degree of sectoral expertise rather than the ‘flavor of the month’ technology.

If I was an LP in a growth-stage firm I’d be hoping they were looking at ways to clear the minefield. Bridge rounds to reach profitability, zeroing out the zombies, doubling down to support the strongest performers, and continuing to look for good bets. Not sitting on the sidelines, waiting to see how things shake out.

The capital is out there for high-performing firms that have a compelling vision to share with prospective LPs (similar to the fundraising advice given to founders earlier this year). Transparency, discipline and standardization should be priorities if this industry wants to accelerate on this road to recovery, and a better model for the future.

Related reading

• Bootstrap, Sell Or Recapitalize? A Tech Entrepreneurs’ Guide To Surviving A Capital Crunch In A Downturn
• The Problem With Letting Market Momentum Determine A Startup’s Valuation
• The Science Of Startup Valuation

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: Li-Anne Dias

“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?

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 Rachel ten Brink of Red Bike Capital wrote in a Forbes article:

“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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How much of a startup investor’s success can be attributed to luck?

Pablo Ventura, general partner at K Fund, believes that luck has a significant influence. His personal retrospective provides a fascinating opportunity to look at the philosophy behind venture capital and early-stage startup investment. I applaud the humility, but would like to suggest a different outlook.

Defining luck

Winning a high-stakes poker tournament as a beginner requires luck. Making a comfortable living as a professional poker player requires ability.

Of those two scenarios, it’s the second we’re likely to identify with venture capital, given the shared focus on analytical thinking and consistency. The first is a better reflection of a founder’s journey.

We all know the stories about VCs taking risky bets on early-stage companies with big ideas. Surely that’s evidence of a major luck component?

The greatest hurdle to understanding venture capital is that VCs expect most of the companies they back to fail. That sounds unintuitive, but it’s the simple and natural trade-off against potential.

You might have heard this concept referred to as the “VC Power Law,” well-explained by Luke Mostert, head of investments at Future Africa, in his recent Twitter thread.

In essence, the nature of a startup’s category-leading ambition means a lot of small losses is worth it for a few massive wins for investors. VCs want to back founders who will blow their company up trying to break the stratosphere, rather than those seeking a modest exit.

The corollary is that if every company in a VC’s portfolio produces a return, that’s a bad signal. It’s a sign that the VC is playing a low-stakes game: Not thinking big enough, not taking enough risk, and likely not producing the scale of return people expect from that asset class.

If that ratio of failure to success is intrinsic, and priced into the VC model, can you really attribute success or failure to luck?

Professional poker players will talk about the curse of “variance” (the deviation from expectations based on chance), but ultimately agree that luck is not a factor on long-term results. How the cards get dealt, how you deal with those situations, and the times you just have to take a loss on the chin are all assumed and accounted for. Only bad players refer to luck as an excuse.

If you want to see luck at work in venture capital you can certainly give it the opportunity: Dump your whole fund into one company, invest exclusively in sectors you don’t understand, or throw a dart at a board of opportunities. Just be wary, because while you might cite luck when you’re being humble about success, LPs certainly won’t accept it as an excuse for failure.

The smart approach is always to eliminate your exposure to luck with the usual combination of careful long-term strategy, observation and calibration.

“Hilariously-early stage” VC firm Hustle Fund offers a useful example to illustrate this philosophy: as the descriptor implies, it focuses on founders at the riskiest end of the spectrum, with the most untested assumptions.

Writing a lot of small initial checks allows it to convert that uncertainty into a strategic advantage: it gets the inside track on a startup before others, saves its seat at the table, and makes better decisions about involvement in larger future raises. It is smart, systematic and works out well for everyone.

The bread and butter of investors is consistency and repetition.

Leave luck for the founders, they need it more.

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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