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The Dangerous Myth Driving Mediocre Venture Returns: “Valuations Don’t Matter”

There’s a growing narrative in venture capital that valuation doesn’t really matter, and that what counts is simply “being in the best companies.”  


Of course, we all want to invest in the best companies, but unless your goal is just to put high-profile logos on your website, this concept is not only fundamentally wrong, it’s exactly backwards.  


For example, Uber is on every VCs short list of these “best companies” we’re all aiming to find, and for those who came in at the Seed round, it was undoubtedly the best investment of their lives (having returned nearly 5,000x their capital). But for those who came in at Series E?  Well, if their 1.5x return was even one of the ten best in their fund, they probably no longer work in venture.  


The fact is, when it comes to generating returns, if you get the valuation wrong, nothing else matters.  


While this is most glaring for late-stage funds, entry valuations have a material impact on returns at the earliest stages as well.


The Seed Stage Reality Check


Let’s look at two Seed fund models, one employing the newer, oversized fund, oversized checks, oversized valuations model that we’re seeing more and more of these days, and one employing the more traditional, smaller checks at smaller valuations (i.e., more appropriate to the risk profile) model.  


For both, we used a simplified version of Fred Wilson’s “1/3 Rule”, where 2/3s of the portfolio companies return about half the fund and the other 1/3 drive most of the returns.


Fund 1: The Plus-Sized Fund


  • $225M total commitments

  • $4M per Seed check

  • $5.4M per follow-on check

  • 3x net return target


Average Seed valuation: $20M


Results:


  • Ownership at exit: 14.4%

  • Exit needed for any one company to return the whole fund: $1.6B

  • Average exit needed from the return-driving third of the portfolio, in order to hit the fund’s target: $520M


Fund 2: The Price-Disciplined Fund


  • $100M total

  • $1.8M per Seed check

  • $2.4M per follow-on

  • 3x net return target


Average Seed valuation: $12.5M


Results:


  • 9.8% ownership at exit

  • $965M single exit needed to return the fund

  • $322M average exit needed from the return-driving third of the portfolio


The takeaway? The more price-disciplined fund carries both a substantially lower risk of missing return targets and a substantially higher overall upside


The Late-Stage House of Cards


This is where we go from higher floor/higher upside to, “how did this strategy ever make it off the whiteboard”?  No 1/3 Rule here, these companies all need to contribute (and contribute big), just to get to average, never mind outperformance.


The $2.5B Growth Fund


  • 15 companies starting at Series D

  • $53M per initial check

  • $80M in follow-ons per company

  • 3x net return target


Results:


  • 8.5% ownership at exit

  • $2.1B average entry valuation

  • $29.3B exit needed to return the fund

  • $6.9B average exit needed across all companies

  • $102.7B total exit value required


To put these numbers in perspective, over the past 4 years, there have only been 35 exits at least as large as this fund’s average entry point. In fact, even if this fund managed to invest in each of the top 15 exits of the past four years, its maximum possible return would only be 4.6x, and that’s using far more generous median funding round valuations. Using average valuations? A 3x return is not even mathematically possible.


The Takeaway

Focusing exclusively on participating in the largest exits fully ignores half of the equation.  When it comes to generating logos, that half is irrelevant. When it comes to generating returns, it’s everything.



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