Price inflation in the startup world is running rampant.
This isn’t new. But I do wonder when it’s going to peak. We’re not there yet. If anything, it’s getting worse.
I’ll give you a recent example. I was talking to a founder yesterday who heads a seed-stage company whose software improves workflow. It achieved $250,000 annual recurring revenue (ARR) last year. It’s projecting $480,000 ARR for this year. It sells mostly to small companies and students, but it’s also signed up a couple of big companies. Students like the company’s freemium offering.
The company is raising a seed round at a $27 million cap. Strictly speaking, caps are not the same as valuations. Cap terms allow investors to convert their investment into shares in a future equity round at a “capped” price. In this company’s case, investors from this round won’t pay more than $27 million in that future equity round… even if the company is priced at, say, $50 million.
But in essence, the founder is saying that $27 million is a fair maximum price for the company. His justification? He said that according to an AngelList report, seed stage companies are raising at $20 million and higher. I looked up the report. He was right. His $27 million cap is a little above the $24 million that marks the beginning of the 75th percentile for seed rounds.
Now, let’s be generous and project that the company exceeds its $480,000 ARR this year and reaches $500,000 in revenue. Its revenue to (capped) valuation multiple would be 54 times. Even with a 100% projected growth rate (which may or may not be realistic), that valuation sounds mighty high.
But the AngelList study says otherwise. And the founder of this company would argue it’s simply the price of doing business these days for investors.
Fair enough. But it’s still worth asking — has that price become too high?
Valuation Inflation Is Nothing New
It’s a question I’ve been asking myself on and off since 2014, when I first began making and recommending startup investments. Because — whether it’s houses or companies — price matters. Buying high is never a good idea.
Nor is buying at the top of a market. Remember the devastating housing crisis of more than a decade ago? At the end of 2019, 3.5 million homeowners were still underwater (meaning that loans secured for the property were at least 25% higher than its market value). Since then, the pandemic-driven jump in housing prices has pulled more than 1 million homeowners out of their mortgage-related debt. So things have gotten better recently. But buying high at market tops has long-term consequences that are hard to shake.
In a way, what’s happening now with startup price inflation is nothing new. I’ve seen valuations increase throughout the funnel over the years. In the mid-2010s, valuations of pre-seed companies went for $2 million to $5 million. Seed companies went for $5 million to $8 million. Series A companies went for $8 million to $10 million. I don’t remember seeing a startup raise at a valuation higher than $12 million.
But prices took an unusually big jump last year.
As this chart from AngelList shows, there is an unmistakable trend. As you go from the early to the later stages of raises, inflation increases at a faster pace. I strongly suspect the uptick in valuations is even steeper in the later stages beyond Series D.
If this trend persists, early stage investors need not worry. While they may be buying at higher and higher prices, they’d also be selling at the later rounds, where prices have gone up even faster.
Still, I see danger ahead. Here’s why.
If price increases flatten or reverse, it’ll happen at the later stages first. You’ll see IPO prices drop first, then pre-IPO, then the later stage and eventually the early rounds. Venture capital firms are raising insanely large funds these days because the price of money is near zero. But the Fed raised interest rates this month for the first time since 2018. And it’s penciled in six more increases this year to combat inflation.
Money is no longer cheap. Institutional investment capital won’t be nearly as plentiful as it has been. And more investment capital will be going into bonds as their interest rates move higher. For startups, this sure looks like the top of the market. Prices are still going up but should soon peak. I believe we’re entering a dangerous time for startup investors.
IPO prices are already under pressure. Many startups are seeing their prices drop once they join public exchanges. Capital scarcity will only make those drops bigger.
That’s why I’m not buying the “price of doing business” argument. That said, I’m not bowing out of the startup investing game. But I’ll be less forgiving of high valuations moving forward. A startup has to fully justify its price… and not by referencing an AngelList report. For starters, show me product/market fit, a pathway to rapid revenue growth and a strong competitive edge.
I’m still open for business. But that business calculus has changed.