In Our Thoughts

This interesting tweetstorm by Dave McClure caught my eye. It was regarding entrepreneurs not wanting to accept a 2x return clause on notes and the high valuation caps on those notes that are running around the Silicon Valley right now. Then at the end Sam Altman of Ycombinator jumps into the fray, who replied:

When our research team and I saw the 10,000x, we thought we’d have some fun with it.

Wow – 10,000x. That’s an over-returner for sure – probably the unicorn to end all unicorns. But how would you get one and would anyone have experienced one already?

Let’s do some back of envelope calculations. Assume you’re a seed investor like Dave. You could take companies in the unicorn club and divide their current post-money valuations by 10,000. This would theoretically determine what their seed valuations needed to be in order to return 10,000x for the company’s early angel investors.

But then, you’d have to take into account the dilution that occurs by the time a startup is a unicorn. Our principal, Tom, built this ownership model to show the typical ownership dilution each round experiences on its way to series E.

You could stand to lose 50% of your ownership, assuming nothing else bad happened funding wise along the way, on the way to unicorn status.

Let’s take Uber. It’s valued at $40B right now. If you take $40B and divide by 10,000, you get $4M. But then divide by 2 to account for the ownership drop and you’re left with $2M POST money. Essentially this is the valuation of a seed round you would have needed to invest into in order to achieve a 10,000x at the $40B valuation.

Back to Dave’s twitter rant about high valuations pervading in the Valley. Does any reader of this post think they can get in on a high flying, unicorn-esque startup in today’s world at $2M post money valuation?

Still, has anyone ever even achieved a 10,000x? Uber is worth $40B, but its exit story hasn’t been written yet. We poked around and came up with Peter Thiel’s reported $500K investment into Facebook at a $5M valuation. It makes sense on paper that at $5M seed valuation you’ll get a >$104B exit – that’s 20000x! Unfortunately, he must have suffered some dilution and/or sold off stakes early because he arrived at the IPO with an awesome return of 5000x! Dang – only halfway there.

OK 10,000x is a worthy goal. But what’s the odds of you getting that kind of return?

Cowboy Ventures’s Aileen Lee wrote in her infamous unicorn post, Welcome To The Unicorn Club: Learning From Billion-Dollar Startups that she found that since 2003 to the date of the post in 2013, there was a .07% probability of a startup reaching unicorn status. Remember, that’s .07 PERCENT, which means 7 out of 10000 startups have reached unicorn status. Pretty long odds assuming that you even had a shot at investing into one of those pre-unicorns.

Looking back at my investing past, I was scheduled to meet with Uber (what was then Ubercab) but was one of the last investors they talked to. The round was oversubscribed, and I was shut out. I was there at YC when Airbnb started out but sharing rooms in my home wasn’t something I personally believed in, so ultimately I didn’t pursue. I was also there at YC during Dropbox’s demo day. I was in the running for investing, but yet again was shut out as other larger and more prominent investors pushed me out. For every other unicorn, I never even had the chance to even review the deal, let alone invest.

But from what I could remember about Uber, Airbnb, and Dropbox’s funding valuations – sorry about my very fuzzy memory, but those were the days when $4M pre was still possible – I don’t think I could have achieved a 10,000x return coming in at the seed round – maybe >10x, maybe even in the 100x range but definitely not 10,000x.

By now, you may see how absurdly rare a 10,000x is, potentially even unachievable. So what are Sam Altman and Dave McClure really talking about?

It’s the golden age for entrepreneurs. Entrepreneurs have all the power. You can go raise seed at valuations higher than anytime ever in history. New investors on the scene are naive; they haven’t had the history of investing in less bubbly times. They are forced to take whatever deal is in front of them. They think these valuations are normal. And with small checks, they have no ability to affect the terms of the round. But the first naive seed investor that pulls the trigger inadvertently validates the terms.

But the risk is also higher; competition abounds and there literally is an app for anything. So investors pay more for higher risk. It’s also why those who know me, know I like to say that the seed market is bubbly and that it’s the worst time to be a seed investor with no dry powder to follow on. Angels and funds who only invest in seed rounds take all the risk yet get lower/no returns if a company goes unicorn-ballistic through severe dilution. This risks their ability to break even or make money at seed investing.

Entrepreneurs win no matter what the outcome. As many have replied on Twitter to Dave and Sam’s tweets, even a small win is notable or even life changing for the entrepreneur. It is not a bad thing to get acquihired into Google or Facebook, right?

Dave is probably the only guy out there willing to publicly say something about the current attitude of entrepreneurs. The rest of the investor crowd needs to toe much more lightly and quietly; it’s too easy to be shut out of deal flow. Who wants to be shut out from Ycombinator demo day? The entrepreneur forums are quick to denounce investors who are too this or too much that. You don’t play by entrepreneurs’ rules nicely, your reputation is shot, and you’re blackballed from deals.

High valuations at seed are all over the Valley. Market rates for the average SF Bay startup are probably around $5-6M cap on note (forget equity rounds), with jumps to $8-$12M for those coming out of Ycombinator. These are for startups with little or no traction. Market rates for startups with traction at seed can head towards $8-$10M.

If you’re moonshotting for 10,000x at a $10M valuation, you’ll never make it. That’s a >$100B exit valuation for the company, which is at the black swan category for companies like Facebook and Alibaba: outliers by a *wide* margin.

Speaking of black swans, in Sam’s post Black Swan Seed Rounds, he states:

Great companies often look like bad ideas at the beginning—at a minimum, if it looks great, the seed round is likely to be overpriced, and there are likely to be a lot of other people starting similar companies. But even when I attempt to adjust for price, the hot-round investments still have underperformed.

I asked a few other investors about their experiences, and most are roughly similar. Most of the really big hits never had TechCrunch writing about their super competitive seed round everyone was trying to get in.

Interesting that a 10,000x comment comes from someone who also wrote the above…?

Many thanks to Tom Egan, Edward Coady, and John Lanahan for reading/commenting/contributing to this post.

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