Venture Capitalists Will Overpay For Seed Rounds But For Reasons You Likely Haven’t Considered

Do you know the parable of the Blind Men and the Elephant? The lessons of one’s subjective truth being espoused as an absolute one based on their own experiences carries beyond zoology. So when I tell you what I’m seeing in venture financing these days if you disagree with me, it might just be that we’re touching different parts of the elephant.

Like parenting a toddler coming off a sugar high, the last 18 months of startup activity has been marked largely by tears, shrieks, and occasional throwing of toys. And while I’m quite optimistic about the coming years, we’re not yet through the pain for many existing companies navigating the transition from a hypergrowth market to one which rewards a different style of operating. Haystack’s Semil Shah wrote up his POV on what this has all meant for the seed market and one point in particular caught my eye. Semil asserts,

Seed-stage valuations have generally been left-unchanged, and I could argue even they’ve gone up since the beginning of 2022. Looking back now, it makes sense – VC firms have lots of dry powder, and while they may have slowed down relative to 2021, they’re still making investments. Early-stage is perhaps a more attractive stage to deploy smaller dollars these days – a friend remarked everyone wants to gamble, but no one wants to sit at the whale tables just yet.

I think he and I are touching the same region, but different parts, of the elephant, so here’s where we differ (and all of this is “AI Startups excepted” obviously).

A. Valuations for the Top Decile of Seed Startups Have Fallen Less YoY While the Second Decile Have Been Hit Harder. I’m defining Top 10% and Second 10% as “degree to which their founders, markets, and milestones pattern-match for the average seed investor.” This is obviously imperfect and to truly segment quality would take 10+ years. But think of this as equivalent to average salary of Top 10 picks in the NBA draft vs picks 11-20. I’m saying that 11-20 were hit harder by the downturn where as before they were often evaluated similarly by the venture community and rewarded commensurately. Whereas at peak of the boom, picks 1-20 were often raising the same (or substantially similar) rounds.

Why are the Top 10% less impacted? Well, the obvious reason is they look like better risk/reward opportunities, but I think it’s also because generally the better brand name firms are doing the Top 10% deals. They have stable capital bases, care less about the different between a few hundred thousand dollars in entry price, and so on. So to continue my NBA example, let’s say you basically only had Big Market Teams making the top draft picks – salaries would be higher right because they could pay more (no player salary cap in venture 🙂 ).

Reminder: I’m not saying the Top 10% of seed startups are, startup for startup, better than the Next 10% – that gets figured out later.

B. It’s Changing Venture Portfolio Models Towards Concentration, Not Just Dry Powder/Gambling. Gotta own enough of your winners. Nothing is more true in venture but this math got a bit perverted during ZIRP. When $20B outcomes occur everyone on the cap table eats well. When it’s $2B, you better have gotten your ownership. It’s just math. Funds, especially new ones, who believed otherwise are now preaching greater ‘concentration’ and at seed, this creates a floor on valuations. Why? Because you start to care more about basis points than the cost to get those basis points. In order to get your 5%, 10%, 15% target you’re willing to increase round size and valuation a bit to make the math work for the founders and any other investors they want to include.

Curious what part of the seed market elephant you’ve been touching and where you agree/disagree