I’m seeing tons of seed rounds at $40 million and up. Here’s why those will turn out to be bad investments….
Venture Funds Need Massive Growth
Startups raising seed rounds at $40M need to hit $1B ARR within 10 years. That is a near-impossible task.
But any less, and it’s not a great investment.
To justify investing in startups, we need to hit at least a 15% annual return. Stocks give us 10%. We need to beat that handily to make up for the risk and illiquidity.
That means that we need to hit a 4X fund in 10 years.
A typical early-stage fund might contain 35 companies. Most funds have nearly all gains come from one company.
So, we need one of those companies to grow its valuation by 280x to get our 4x fund, after accounting for 50% dilution (35 x 4 x 2).
The Difficult Math of $40 Million Seed Rounds
The average public SaaS company trades at 5.7x ARR. Let’s be generous and assume that our newly public startup trades at twice that, 12x, to account for high growth.
Our $40M seed stage company needs to grow to a valuation of $11.2 billion to give us our 280x. Unicorns aren’t enough anymore — we need decacorns.
At a 12x multiple, hitting a valuation of $11.2 billion requires $933 million ARR. If we get the average multiple of 5.7x, we need $2B in ARR.
Very few companies ever reach that much revenue.
If we had done that seed round at a more reasonable $15M valuation, we’d “only” need to hit a $4.2 billion market cap on $350 million in ARR to get our 280x (assuming a 12x revenue multiple).
Even that is very difficult. But it’s a lot more realistic.
But What If…?
“But what if it’s the next OpenAI?”
I can practically hear you saying that now.
True, if that high price seed round becomes a company worth hundreds of billions, it will be an excellent investment. But those companies are vanishingly rare.
We can’t count on hitting one of the couple best companies in an entire generation.
A more typical successful investment is a company like ServiceTitan. And while ServiceTitan is a great business, it’s no OpenAI.
What the Typical Unicorn Looks Like
ServiceTitan went public a year ago. It’s trading at an $8.5B market cap on $866M of revenue in the last year.
That’s a 10x revenue multiple — well above average.
But even for ServiceTitan, the $1B ARR milestone hasn’t come yet. And while it receives a generous multiple, it’s not high enough to make it a decacorn.
Making Exceptions
Once in a great while, we’ll see a truly extraordinary company. Founders with incredible backgrounds. Off the charts growth.
In a situation like that, we can make an exception. We can do $30, $40, or even $100 million if we really want to. Then, we can balance that out with more reasonably priced deals.
What we can’t do is pay $40 million across the board.
If we do that, our upside in the winners just isn’t enough. Our fund would have little chance of an acceptable return.
Wrap-Up
Roelof Botha recently called investing in venture “return-free risk.”
If we’re doing deals in companies with little to no revenue at $40M valuations, Botha is absolutely right. Investments like that are highly unlikely to produce the returns necessary to justify the risk.
I’m focusing on awesome founders raising at reasonable valuations.
Price isn’t everything. But it’s not nothing, either.
More on tech:
Should You Take a Low Ball Offer from a VC?
Scouting for an AI Venture Fund
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