For over a decade Equidam has supported founders (and investors) with the challenge of setting a fair valuation for their ventures.

When we started, in 2012, valuation was a hot topic in the fundraising process and venture capital was not as easy to come by. In the years since, a variety of factors produced a more relaxed attitude toward deal terms. Notoriously, by 2021 term sheets were being sent over the weekend with exorbitant revenue multiples and not significant amount of due diligence.

Today, valuation matters again. While the return to earth has been painful for many, it’s ultimately a good thing. We’d like to address some of what has happened, and the responses to it, given our perspective on valuation across stages and industries.

Capital incentives have fallen out of alignment

Many have pointed the finger of blame at low interest rates, and this does tell a part of the story.

In January of last year, we wrote about how the supply of capital had saturated many other asset classes, and early stage equity was becoming more attractive to a greater number of investors. We shared a hope that this abundance of capital would lead to greater levels of investment in overlooked areas.

“Fierce competition for SaaS rounds, combined with outstanding returns for VCs, could free up capital for overlooked industries such as hardware, environmental projects, health and pharma.”

Unfortunately, we underestimated the subtle shift in how venture capital operates: incentives were no longer aligned behind finding outliers. The glut of capital resulted in a gluttonous ecosystem, with LPs throwing money at GPs who – in their haste to deploy it – were just shovelling it into the hottest deals they could find.

This environment had the most benefit for ‘in group’ founders in trendy industries like web3 and fintech; most of the excess capital went into the top of the market at inflated valuations. These valuations then cascaded down the market in the form of comparables, creating a compounding trend which peaked in Q1 2022.

Prices are always going to rise in an environment where the supply of capital goes up, that’s elementary, but investors who signed term sheets at 50x multiples in 2021 didn’t have a gun to their head. For every Yuga Labs, there were a hundred other opportunities with more meaningful traction offering their equity at a fraction of the cost.

Investors chose to seek consensus, using peer-validation to gain the confidence of LPs, and relying on those peers for access or capital support for the biggest deals. It was the easiest path to raise ever-increasing amounts of capital, and demonstrate to LPs that it was quickly being deployed into good investments (on paper), and hold more assets under management.

VCs chose the path which maximized their reliable ~2% management fees, while neglecting their ~20% exposure to the upside of their investments.

What this means for the early stage equity market

The bubble has brought current practices sharply into focus, and the need for a course correction on practices and incentives.

The remit of venture capital is to provide financing to ventures who would not be able to get it elsewhere. Ideas too risky for a bank loan, for cash flow financing, or traditional investors. The purpose of venture capital is to back outliers. To take big risks, in the pursuit of great returns.

That mission, critical to the success of entrepreneurship, is diametrically opposed to the consensus-seeking incentives in venture capital today. There are, we believe, two main drivers of those incentives which must be addressed:

  1. The insecurity associated with an asset class with such long feedback loops. How do GPs track and demonstrate fund performance to LPs?
  2. The overreliance on comparables for valuation. How do VC firms get a more objective and independent read on the value of a startup?

It’s a short list, but the two points encompass a wide range of flaws, from consensus-seeking behaviour to conflating hype with value. Were these issues resolved, we’d open the door to a new generation of venture capital with greater autonomy and a set of incentives which was much more closely aligned with the role of financing innovation.

The key is understanding fair value

‘Fair value’ represents what a startup would be worth in an orderly and rational market. Looking at the intrinsic value of a company, with a discount for the associated risk. This is not an easy calculation to make, but you can get as close to it as possible with the right combination of methodology and data.

Another way to look at this is by considering the cost of capital.

Broadly, venture capital has acted as a conduit for capital going from LPs into startups. In good times, when the LP taps were wide-open, this cheap capital flowed directly through VCs into bloated rounds for overvalued companies. Now that the taps are running at a trickle, VCs have a much more conservative approach to deployment.

Were VCs to control for cost of capital over the course of their fund lifespan, there would be two desirable outcomes:

  1. Valuations and round sizes would be kept within more rational bounds.
  2. VCs would have more consistently available capital, rather than being overinvested during expensive periods and underinvesting in cheaper periods.

The most obvious way to address this is for the venture capital industry to return to some of the more robust practices of the early-2000s. Valuation methodology which is focused primarily on the company in question, rather than the temperature of the market. Drawing closer to the concept of fair value, rather than pricing.

Of course, nothing is priced in a vacuum – market conditions have a role to play – but this should be a secondary influence on the outcome of a valuation, rather than a steamroller flattening all of the independent characteristics of a particular company. This is why fair valuation is a core tenet of Equidam.

It’s not like we don’t know when we’re in a hot market. As Carey Smith, founder of Unorthodox Ventures, put it in August of 2021:

“The VC industry is (flimsily) built on bubbles, and their investments have always had a notoriously low success rate. It’s just that they now have even more ungodly amounts of money to play with, thanks to the dismal returns available elsewhere. And thanks to the booming market, they’re saddled with great expectations. Gee, it’s almost possible to feel sorry for them.”

So the other side of this coin is for VCs to understand the nature of the market, how freely capital is flowing, and to build that into their investment strategy.

There might be pressure to deploy more quickly and chase hotter deals, either internally or from their LPs, but the best firms will resist this temptation and instead focus on their actual mission: finding the most valuable outliers.