The case for COVID-adjusted early stage valuations
How distributed startup teams may affect private company price
Contrary to general thinking at the beginning of the pandemic, median private company valuations did not mimic the contraction of the broader economy.
According to Pitchbook, from January 2019 to mid-December 2020, a total of 2,478 seed rounds of financing closed in NYC/SF, representing $7.6B in invested capital. Median valuations have remained concentrated around $12M for the last two years. There are several possible explanations for this disconnect, including lag in mark-to-market and the standardization of early stage pricing, but overall it’s a bit puzzling to see such a bifurcation between private markets and the real economy.
In response to the COVID-19 lockdowns, it’s clear that many founders have adopted a ‘new normal’ by adapting to long term team geographic distribution. This evolving dynamic begs the question — Should companies with teams that were previously concentrated in major coastal cities still command premium valuations if their teams are no longer located there?
Pre-COVID, building a company on the East or West coast has been more expensive, but the dilution benchmark for early stage founders was the same, and these same founders were ascribed higher initial valuations. This arguably made a lot of sense when our world was office-centric, but during COVID we have encountered dynamics that were very much envious to some — a complete locational distribution that led to prioritizing quality of life over the engrained notion of the need to be where the team is. The cost of living has dramatically changed for many due to this distributed team model, but the dynamics of early stage fundraising and dilution targets have not. Not only have valuations not meaningfully compressed in 2020, they have actually somewhat expanded — according to Pitchbook, 3Q2020 saw a median post-money valuation at the seed stage of $12.25M across 259 deals. This phenomenon is puzzling given that the cost structure of early stage companies has largely decreased as many have given up expensive office space and employees have relocated to cheaper locales. The same trend continues in real estate prices as 1-bedroom rents are down 27% in SF and 19% in NYC since April 2020.
SF and NYC-based startups have long commanded valuation premiums to the rest of the country because of the aggregation of world-class talent, high real estate prices (both residential and commercial), and a generally expensive cost of living. The pandemic has dramatically questioned these assumptions. Several reasons likely exist for why private company valuations haven’t compressed during the pandemic:
1. VC funds have plenty of dry powder and were even able to add to their war chest with new fund raises. According to Pitchbook, between 2019 and 2020, 520 ventures funds headquartered in the US have raised a total of $96B dollars. 4Q2019 had the largest number of new fund launches, with 134, and the most active quarter was 1Q2020 with $21B in commitments closed on. This influx of capital to the market leads to greater competition for early stage deals.
2.Since the ability to fundraise from LPs hasn’t been a problem, VCs have not pressured founders to take lower valuations. Some potential fund investors took a pause on meetings in the beginning of the pandemic, but as people adjusted to working from home, LPs opened up their pocketbooks once again.
3. It is human nature to exhibit anchoring bias, which proliferates itself through a failure to adjust valuation pricing. Worded differently, founders don’t believe that just because their burn rate decreased and that their team is distributed should mean that their company’s valuation should decrease. That said, if workforce distribution is temporary, there should be clear articulation from founders around future intent of team aggregation, which in turn should justify avoiding a valuation adjustment.
4. Founders are raising to have enough runway between seed and series A. Tomasz Tunguz has a great graph about this, that unfortunately ends in 2018. The length of time between seed and series A has been between 18 and 22 months (although shorter for rounds there were pre-empted). In the past year, when speaking with founders, I have found that the median length of time that they raised for was 18 months of runway. This suggests that COVID hasn’t meaningfully impacted cash burn projections.
In my opinion, it’s in the VC’s self interest to at least have a more open conversation around valuations as for every $100K difference in the size of a round of financing corresponds to roughly $400K in post money valuation delta. This assumes roughly 25% dilution at the seed.
Perhaps it’s time to understand whether the companies that we are investing in are permanently working remotely, and if so, we should start pegging cost of living for a distributed team to the amount of upfront capital. This isn’t a novel idea — Silicon Valley companies have given their employees a pass on location in exchange for a salary adjustment. To the extent it’s currently cheaper to build companies than it was pre-COVID, we as VCs should encourage smaller, more capital efficient rounds, and therefore lower, and more accurate, valuations (assuming similar dilution targets). This will require some education, massaging, and convincing, but ultimately it will make everyone more disciplined along the way.
I’m an investor with Rosecliff Ventures Management, a NYC based fund manager that invests from Seed through Series B. At Rosecliff I focus on Fintech, Proptech, Low-Code/No-Code, and Productivity tools. Feel free to reach out to me at dan@rosecliff.com. The opinions in this post are my own and not those of Rosecliff Venture Management, or any Rosecliff affiliate.