We continue our series of blog posts outlining the ten lessons we’ve learned since launching our first fund in late 2020.
Last post, we discussed the Power Law and the importance for funds like ours to underwrite each individual investment to deliver a 50x return.
This week, we discuss the importance of discipline around “Entry Valuations”: the initial valuation of the companies in which we invest.
Why do entry valuations matter so much?
Entry valuations are critical to venture capitalists (VCs) because they directly impact potential returns on investment. The valuation at which a VC enters an investment sets the foundation for their upside potential and risk exposure.
Impact on Returns (Ownership and Exit Value)
The valuation at which VCs invest determines how much ownership they acquire for a given investment. Lower entry valuations mean VCs can secure a larger percentage of the company for the same amount of capital. If the startup grows and exits (via acquisition or IPO) at a high valuation, a larger ownership stake translates to higher absolute returns.
Example: If a VC invests $1 million at a $10 million valuation, they own 10% of the company. If the company later exits at $100 million (assumes no dilution due to subsequent investment rounds), their stake would be worth $10 million—a 10x return. However, if the entry valuation was $20 million, the same $1 million investment would only secure 5%, and the return at a $100 million exit would be $5 million—a 5x return.
Valuation Discipline Affects Risk and Return Trade-offs
Entering at a high valuation increases the risk for VCs. If a company is overvalued at the entry point, the future exit valuation has to be much higher to generate a meaningful return. Overpaying at the start limits upside potential and puts more pressure on the startup to achieve extraordinary growth to justify the valuation (remember that each individual investment needs to have a strong possibility of delivering a 50x return).
Follow-on Rounds and Dilution
Valuations also matter for future fundraising rounds. If a company raises money at too high a valuation early on, it may struggle to meet the growth expectations implied by that valuation. This can lead to difficulties raising subsequent rounds, potentially resulting in a down round (raising at a lower valuation), which can negatively affect the company’s momentum, reputation, and morale. It can also lead to greater dilution for both founders and early investors. We believe that founders should hold onto as much ownership of the company as possible throughout subsequent rounds of financing, to ensure motivation to continue to grow aggressively
The Ugly Underside of “Down Rounds”
If a startup raises at a very high valuation but underperforms, its next round might require it to raise at a lower valuation (a “down round”). This can dilute the ownership stake of earlier investors and founders.
A down round may send a negative signal to the market that the company has issues, and make it much harder to raise money in the future.
Is a Higher Valuation Always Better?
In the very early stages of a company’s growth, it’s often hard to establish a fair valuation.
Understand the dynamics at play: Founders typically want to maximize valuation, so as to minimize their personal dilution. Also, typically there is some pride/ego at play, and a higher valuation is not only a transparent external validation of investor excitement in the concept, but also provides a bragging right to the world.
However, bad things can happen when a company gets ahead of itself from a valuation standpoint and subsequently struggles to drive the underlying business metrics to warrant this valuation in the next round (see “Down Rounds” above!).
Market Sentiment and Competitive Landscape
VCs often operate in a competitive environment where multiple investors may be interested in the same deal. As a result, valuations can be bid up, especially in "hot" sectors. In auctions, this is often referred to as the “Winner’s Curse.” However, VCs need to maintain valuation discipline because paying inflated prices during times of hype can severely limit returns, especially if market conditions or investor sentiment change.
Power Law Considerations
As we discussed in an earlier blog post, the venture capital industry operates under a “Power Law” where a small number of investments generate the majority of returns. Entry valuations influence how well a VC can capitalize on this dynamic. If a VC enters at a lower valuation, the potential for the investment to follow the power law and provide exponential returns is much greater. Conversely, entering at a high valuation may limit upside potential, even if the company succeeds.
Conclusion
Entry valuations are crucial to VCs because they determine ownership percentage, affect potential returns, influence risk, and impact future funding dynamics.
At Automotive Ventures, we invest at the Seed or Pre-Seed stage, targeting entry point valuations of <$20m USD.
A disciplined approach to entry valuations allows VCs to maximize upside potential while mitigating risks, positioning them for better returns under the power law distribution of venture capital outcomes.
Join us on the journey,
Steve Greenfield
