This is a fallacy. People use this term "priced out" as if it meant some sort of process, but it means nothing more than that the investor thought the startup's stock was too expensive. And it is very stupid to let valuation decide which startups you invest in, because the variation in outcomes between startups is orders of magnitude greater than the variation in valuations. I.e. there is no value investing in startups.
What we have here is a case of anecdotal evidence. A founder happened to get some investors who hadn't invested in other startups because they felt the valuations were too high, and those investors turned out to be really helpful. But there are other investors who are willing to invest at high valuations who are helpful, and investors who seek out low valuations who aren't.
Right, Investors should be willing to pay any price. Except YCombinator who invests at a valuation of around $0.25M. Which isn't value investing, because value investing doesn't exist for startups. ;)
When a startup is crazy successful, it doesn't matter what price you paid to get in. But in terms of portfolio, price does matter. The higher the average price you pay, the fewer deals you can afford to be in, and the lower your chances of getting into that one runaway success. Sure, its far more important to choose the right companies. But it is rational for YC, and others, to be price sensitive.
The higher the average price you pay, the fewer deals you can afford to be in
That's only true if you have to get a certain amount of stock, which is the case for VCs doing series A rounds, but not for angels or VCs doing seed rounds of the type Chris wrote about. How many deals an angel or seed investing VC can afford to be in is a function of the average amount invested, not the average valuation.
startup => company
company !=> startup (a company isn't necessarily a startup)
Startup meant to be very-fast growing companies and then, in this condition, what an investor should ask himself is only: is this company a startup? If yes, the investor must invest at almost any price because the company will be 10x or even 100x bigger tomorrow. At least, buying 2x for the price of a share is ok.
The phrase might be a fallacy, but the idea is not. Founders often think about getting investors to pay a premium for a great startup. However if your goal is to get helpful investors, founders should consider paying a premium to get the investors that they want on board.
Of course this only works if you are capable of choosing investors well.
This idea is a really powerful concept in my opinion. The street goes two ways, and there are definitely awesome investors out there. Giving them a premium deal is so worth it if they will really be involved and move the needle overall. A great, well connected, involved investor can mean the difference between a 10x result and a 100x one. These sorts of people tend to have highly robust deal pipelines and can pick and choose who they want to work with. Remember, honey tends to attract more people then vinegar. Giving a few more percent when the pie grows geometrically is so worth it in my opinion.
I know this is a generalization, but I think his comments about commitment are spot on. I would expect that high valuations decrease investor commitment and involvement because they reduce ownership in the outcome.
Sure you do. You are confusing fur coats with investments. To how many companies in your 401k portfolio have you offered free consulting? With an investment, ownership matters. If you could spend $200k on a company for a 1% share or $100k for a 50% share of a similar company with similar prospects for growth, I would easily bet you would spend more time on the investment on which you could get the cheaper deal. More ownership means a greater return on your time investment.
It's more realistically the one where you spent $2mm for a 20% share or where you spent $500k for a 20% share. Most investors seem to target percentage ownership, not amount they're investing.
(I guess you could consider the case where you got one at a huge discount through luck -- getting a $100k product for $10k. Then, I'd basically treat it as a $100k asset for the purposes of how much to help -- the 10x gain on the $10k already happened the moment you made the deal, even if it's unrealized. I'd be happy to buy $100k negotiable assets for $10k, but in general, bargains aren't -- there is a reason you're getting a discount, ranging from the founders being noobs who will equally be likely to get taken advantage of by others later, or the deal has more risk than you thought, etc. There may be some cases where assets are systemically mispriced -- I think Dave McClure thinks non-US startups are one, especially from LatAm and SEA.)
If I were making an investment into a public company (or a really late stage private company, like investing in Facebook the year before the IPO), I wouldn't think I'd have as much to contribute, true, but I'd assume I could help a $2.5mm valuation startup about as much as a $10mm valuation startup.
(Actually, my #1 metric on helping would be "is it fun for me to help" -- I'd probably end up spending all my time helping portfolio companies with security or infrastructure issues, and would avoid helping with design, HR-fiasco, or fundraising issues. And, if I could get Apple, Tesla, etc. to value my advice, I'd almost work for them for free ($50k/yr?) just to make them 10x more secure than they are now. It's just easier to get someone to value your advice when he's paying you $300/hr.)
I don't dispute that some people would behave like you're saying, but I would not, and most of the professional investors (super angels/VCs) probably wouldn't. I think this might be the difference between "professional" investors and angels.
Let me add to his anecdotal evidence - of the angels I personally know (~15), the vast majority are price sensitive. If I expand that to angels I know slightly, the percentage of price sensitivity increases.
You can argue that they're irrational/stupid, or that they're not the investors you want (some of them actually are very good, you'd certainly recognize them by name), but it doesn't change the fact that they exist.
I can't comment on relative usefulness of valuation sensitive and valuation insensitive investors.
Are there any statistics to show that YC companies who optimize for bigger valuations reach product market fit and then the scale stage more than YC companies who optimize for the most compatible investors? (Which may or may not mean lower valuations)
It seems like that data wouldn't be anecdotal evidence, but cover a fairly large sample size.
And it is very stupid to let valuation decide which startups you invest in
And it is very stupid to let valuation decide which [house] you invest in
And it is very stupid to let valuation decide which [career] you invest in
And it is very stupid to let valuation decide which [spouse] you invest in
These are equally non-sensical. just shows your valuation methodology lacks any/appropriate resolution. so all you are saying (at best) is you (or one similarly situated, etc) doesn't know how to "value a startup". Even if this is true, it does not follow that "the market" knows more than the sum of its participants. And therefore it does not follow that "the market" knows how to value starups either. The market works only if someone at least knows what they are doing. You are essentially promoting the idea of index investing, which is one thing in public markets (with public info) but another altogether in opaque and thinly traded private asset classes (b/c: paradox of efficient markets, etc)
Whether or not this observation changes anything is uncertain. but self-awareness is usualy highly valuable when one's at the resolution limit of their reasoning.
 There is an abstraction issue relating to "black swans". Namely, is the valuation of a portfolio of startups easier/more tractible than the valuation of individual startups? If so, one value the pool X and tha assign X/n(a) to any individual startup, where N is number and (a) is proportionate variable. This is one way to say or reconcile the investment in startups with the statement that investing in any one startup is not an analytically tractable problem. But notice it just pushes the Valuation question out to one level: you still need to make a bet on the valuation of the pool. eg, the following are contrasted idea:
Ex A: And it is very stupid to let [company] valuation decide which startups you invest in
Ex B: And it is very stupid to let [pool] valuation decide which startups you invest in
Hypothesis: A rational person/investor needs to believe they have a grasp of one of the two formulations, otherwise they are like monkey throwing darts at a list of stocks.
This comment is a bunch of babbling that lays up a smoke screen to avoid Graham's actual point.
I don't know whether it's true or not that variations in outcome are orders of magnitude greater than variations in valuation. But (a) it does not sound like an overtly crazy insight, and (b) if that's true, then Graham's argument is mathematically obvious: get in to Youtube or Heroku at 1/10th the stake you'd get in Carsabi and you're still way ahead.
For the inevitable long reply you're going to provide to make sense, it must directly engage Graham's core point. Maybe he's wrong on the numbers, and seed-stage valuations range as widely as outcomes (you're probably going to find out you're wrong about this). Or maybe there's some signaling you can uncover that shows lower-valuation companies tend to outperform those that receive outsize seed valuations. But it will be something like that, not, respectfully, a series of allusions to careers and spouses and draft horses and whatever else it was you said.
[if] variations in outcome are orders of magnitude greater than variations in valuation [...], then Graham's argument is mathematically obvious: get in to Youtube or Heroku at 1/10th the stake you'd get in Carsabi and you're still way ahead.
That assumes that variations in outcome are correlated with variations in valuation. If they are not (which may be the point of mentioning “black swans”), then an investor is better off investing at lower valuations.
And it is very stupid to let valuation decide which startups you invest in
This is only true if the math is hard. If the math were trivial, people would just do the math. The math is hard. Therefore math is of no use/irrelevant/stupid. Does the last sentence follow? Not obviously.
PG wrote a nice essay on why the math is hard.
There is some argument that the complexity can be simplified at higher levels of abstraction. There is another argument that the goal of a VC is to make the math work at a higher level of abstraction. There is empirical evidence that both arguments are pretty good.
So, its not unreasonable to (1) agree with PG that the maths are hard; but (2) disagree we should dis-regard maths altogether...so we don't throw the baby out with the bathwater.
[Addendum: YC invests at a fixed valuation in its companies, wich are selected via a competitive admission process. This is a logical approach if you believe the math is hard on a granular basis, but is more tractavle at higher level of abstraction. The co-hort is thus the unit of investment, not the company.]
This is sophistry. Some math is hard. Some is very easy. The math you're referring to is hard. The math of "what to do if startup valuations vary multiple orders of magnitudes less than startup outcomes" is very easy.
This point is so obvious that I find it hard to believe you wrote the above comment in good faith.
The math of "what to do if startup valuations vary multiple orders of magnitudes less than startup outcomes" is very easy.
If "what to do" was "very easy", everybody would do "it". But that doesn't happen. Investors are not all created equal, and investor returns show massive variance (ie, they are not observed to be uniform.) So something is very wrong with your approach/level of abstraction.
You might want to also read this comment from paulsutter that PG responded to, if you think this is a personal attack on you.
What if we tried to re-phrase the question: out of the entire pool of valuable angel investors (in terms of what else they bring to the start-up besides their cash investment), how many of them are staying away from investing because they feel "they've been priced out of the market", the fallacy or otherwise of that perception notwithstanding?
If they are there, then the point being raised is that they're not being sufficiently utilized, and founders would probably do well to utilize them.
A bit like deciding whether to open a Toyota dealership in an area dominated by Maybach dealerships. The issue is not whether or not Maybachs are value for money, but rather that there might be a good market for selling Toyotas.
Indeed there isn't. VC returns are incredibly power law driven - i.e. they come from the 10-15 companies per year that end up being monsters. The valuation that you invested in is (almost) irrelevant - either you are part of the big successes and have a business as an VC or you didn't participate and don't have a business.
That is yet another very counter-intuitive thing about the startup world. In basically every other finance vertical, terms matter greatly. Not so much with VCs. That's why a lot of finance guys make poor VCs, they fundamentally misunderstand the game.
> VC returns are incredibly power law driven - i.e. they come from the 10-15 companies per year that end up being monsters.
You're almost right. Early stage investing is very much power law driven, later stage (more VC than incubator territory) comes in several flavors, some more relying on outliers than others.
Plenty of VCs won't even look at companies that are not yet capable of generating substantial revenues and profits, they are there as growth accelerators or to diversify founder (and early stage investor) risk.
There are as many risk profiles as there are VCs, you can't just lump them all on one pile.
The problem is that the investors mentioned in the post aren't VCs-- they are angel investors. Putting in $100k on a $10M valuation and then getting diluted down over several rounds of venture means that angels don't get compensated for the risk they are taking, even with big exits. These investors also most likely don't have the bank accounts to keep participating pro rata.
CB Insights says that 50% of seed companies will go away. And the reward that angels are given to take this risk is a 20% discount to the next priced round.
However, one of the benefits of writing smaller checks or running smaller funds is that you're less dependent on monster exits. For investors who are going smaller, valuations and terms do matter a lot more than at typical venture funds (that are very dependent on monster exits).
The fun thing about power laws is that they are fractal. Meaning that if you look at a random angel's investment portfolio, most of their returns come from just a handful of their investments. With a smaller pool, those investments may not be the giant monsters that VCs are hoping to get a piece of, but you should still be planning on a power law.