Valuations are out of whack

Delivered October 18, 2024 @ 5:00pm ET

Happy Friday everyone and welcome new subscribers! My name is Gerry Hays, and I’m the Founder of Doriot (pronounced: dor-ee-oh).

I’m actively in the venture game as a practitioner, researcher, inventor, author, and professor. I’ve built companies and amassed a global venture portfolio entirely from the great state of Indiana, all while teaching the subject to 6,000+ undergrads and MBAs. Obsessed with democratizing venture, I believe I bring a fresh—and, hopefully, practical—perspective.

Why is democratizing venture so important?

The future is uncertain. Humanity needs pioneers and speculators from all walks of life—not just the wealthy and elite.

Thus, I see venture as a platform to attract and educate a broader range of pioneers and speculators who want to build wealth helping shape the future trajectory of humanity, rather than leaving it in the hands of a select few.

Central to this mission is teaching how to succeed in venture as both a founder and an investor without endless capital and elite connections. It involves adopting and integrating what I call Venture Alchemy: a disciplined process that transforms bold ideas and capital into valuable outcomes, where mindset, strategy, and execution converge.

Thus, each week, I explore a component of Venture Alchemy, applicable to many areas of life, along with key lessons on the business of venture as the foundation upon which a new venture system might emerge. Enjoy.

Venture Alchemy - This Week’s Discussion

“All the world's a stage, and all the men and women merely players” - William Shakespeare

The quote "All the world’s a stage, and all the men and women merely players" from Shakespeare's As You Like It suggests that life is like a theatrical performance.

Everyone, like actors in a play, has roles to play throughout their lives, entering and exiting different scenes. Shakespeare breaks life into stages—birth, growth, love, conflict, wisdom, and eventually decline—each with its own challenges and experiences. The metaphor highlights how we all take on different parts as we move through life, shaped by time and circumstance, before we ultimately leave the stage.

Interestingly, his seven stages directly apply to the venture lifecycle. Here’s how the journey of a venture mirrors Shakespeare’s seven stages of life:

• The Infant: Your idea is born, but it’s fragile. It needs nurturing and learning to stand on its own.

• The Student: Now it’s time to learn. You’re testing the waters, figuring out the market, and refining your strategy.

• The Lover: You’re in love with your idea! This is the exciting stage, full of passion and creativity, where you dream big.

• The Soldier: Things get tough. Competition is fierce. You’re fighting for survival, but this is where you prove your worth.

• The Justice: You’ve made it through the battles. Now you’re wiser and more stable. This is the time for growth, but in a smart, measured way.

• The Pantaloon: The venture starts to slow down. New ideas or younger competitors may come in, and it’s time to think about how to stay relevant or plan an exit.

• The Final Scene: Whether it’s a big exit, an acquisition, or closing shop, every venture has an end. What matters is the legacy it leaves behind.

As a Founder, you’ll be fragile, fearless, and sometimes foolish, but that’s the game. The key? Adapt fast, push boundaries, and don't get stuck in one act. The goal isn’t just survival; it's to rewrite the script entirely. Good luck!

Valuations are out of whack

There, I’ve said it. So let me tell you why.

Over the past three years, I’ve reviewed hundreds of startup valuations on RegCF platforms—the only publicly available database for startup valuations (unlike Pitchbook, which costs $25,000 annually for access to Reg D data—boo). I also track the valuations of Y-Combinator graduates and data on AngelList. My conclusion? Most venture investors, who’ve been overpaying, will struggle to deliver returns to themselves, and in the case of funds, to their limited partners (LPs).

Let’s break it down with some basic math. We know that 9 out of 10 startups fail, meaning that as a venture investor, you must spread your investment across at least 10 “credible” startups just to reduce your risk of losing 100% of your capital. Your first goal is simple: don’t lose money. Warren Buffett famously said, "The first rule of investing is don’t lose your money; the second rule is to remember rule #1."

So, to minimize your risk of loss, you need to think about venture portfolio construction, not just venture investing. If your budget is $10,000 for a given year, you should allocate $1,000 into 10 “credible” startups at similar valuations and stages. If 9 of those startups fail, you’ll need just one to return $10,000 (10x) to break even. That’s just the baseline.

So how does this relate to valuation?

Imagine you properly invest $1,000 in 10 seed-stage companies, each valued at $25 million (which is becoming a standard for YC companies). But remember the definition of a seed company. A seed company is "pre product/market fit," meaning it still has a lot to prove beyond to landing a few early customers, including whether it can deliver significant value at scale. If the company doesn’t scale, investors won’t get paid back.

Accepting that 9 of these “seed bets” won’t scale, you’re left relying on one company in the portfolio to succeed. But in this case, for that success to pay off, the company will most likely need to raise significant capital through Series A, B, and C rounds—let's say $100 million total—to be a category leader. This funding typically comes with preferred shares, which dilute your ownership. After all the fundraising, your original $1,000 investment is now worth just 0.0002% of the company (50% dilution).

For that 0.0002% stake to be worth $10,000, that one winning company needs to exit (i.e. a liquidity event) at a $500 million valuation. And if subsequent investors hold participating preferred shares, the company may need to exit at $600 million for you to simply break even. Keep in mind, only 1 in 4,000 startups exit at more than $500 million.

But you didn’t build a venture portfolio just to break even. To turn your $10,000 portfolio into $40,000, your one winning company would need to exit at $2 billion—a 0.00006% probability.

Now, let’s look at a more realistic scenario. If you invest in 10 seed-stage companies at a $5 million valuation, using the same assumptions, the one winning company only needs to exit at $100 million (or $200 million if subsequent investors hold participating preferred shares) to break even. To turn $10,000 into $40,000, the company would need to exit at $500 million. Still a long shot, but far more reasonable than the $2 billion scenario.

Some may argue that investors are chasing companies with $10 billion potential, rendering my argument moot. That’s one strategy, but it’s not mine. My approach is to target a 3-4x return on my portfolio of investments in any given year. And, if I happen to land on a unicorn, I want to turn a few thousand into a few million. Remember, Peter Thiel invested in Facebook’s seed round when it was valued at $5MM, and Jeff Bezos raised his seed round at a $5MM valuation. All the investors in those rounds turned thousands into hundreds of millions, if not billions. Even Jason Calacanis invested in Uber at a $6MM valuation. So, to suggest that seed companies today are 5x better deals than Amazon, Facebook, and Uber is laughable, even if they have a .ai URL behind them.

Next week, I’m going to discuss the opposite side of this equation: why founders should be both strategic and generous with their valuations (i.e., giving investors a credible shot at getting rich by backing you).

Deal Analysis Report released

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Have a great weekend, everyone! We’d be grateful if you could forward this newsletter to anyone in your network and invite them to join the Doriot Community!

Sincerely, -gerry