Jon: Marketing and strategy MBA. Okay, Welcome to the Venture Capital podcast or a VentureCapital.fm. If you want to see or learn about all of our places, you can hear about us. Instagram, Spotify, Apple. And today we're doing a Q&A. We did we did a LinkedIn post. So we said, Peter Harris and I are recording our next group of venture capital podcasts.
Jon: Is there anything you'd like us to cover? And there were two main themes that kind of came, and the first one is represented by Michael Gray. He said this might be a private conversation, but I've been shocked by how many companies get investment with no profit in sight and why so many VCs accept the high valuations when they have never made a profit and won't for many years.
Jon: I feel like that those who get the investment must be really good salespeople at what they are doing. And why does this happen so often? What are your thoughts?
Peter: Well, I mean, this isn't like a new question.
Jon: This is existed for decades.
Peter: Yeah. And I think it's a fundamental misunderstanding of like the kinds of companies that venture capitalists invest in and.
Jon: Why they invest in that.
Peter: And why they invest in them. because the reality is 97% of companies do not raise venture money. They shouldn't raise venture money. They should be profitable. And so you could argue 97% of entrepreneurs look at this, and rightly so, and they're like, why the heck would an investor give this like, crazy idea? I'm profitable, blah, blah, blah money.
Peter: Right. It doesn't make any sense. And of course, then it's like, well, duh, of course they lost their money. Right? That was obvious.
Jon: I think the first time I heard this story was probably back in 2007. John Richard's local investor talk about a company named Monitor got acquired. It was public. They said throughout their entire tenure, 5 to 10 year existence, they'd never had a profitable quarter. And the the definition or the understanding I got at that point was that the assumption was, is if they stop doing marketing, if they stop doing sales and have these aggressive spins to just dominate the market, there would be this wave of cash flow that would make up for it.
Jon: And so what they're really going for is this aggressive, potentially this aggressive land grab, because a lot of these these the spaces that you that you invest in it is if you see that you've said again and again is you want to see a monopoly. And I think a lot of these monopolistic powers happen when you're the first or second and maybe a distant third.
Jon: And then for everyone else, it's hard to carve out a living. So what these investors are looking at is, you know, is can we see a long term positive ROI, I think is the first thing. And or can we get to a monopolistic position? Yeah. And who gets there first?
Peter: Yeah, no, I think I think that's right. I think the other thing is that it's not that VCs don't care about profitability. We do care about profitability. In fact, I would argue in some ways I care more about profitability than your average investor that's investing in the like 97% of companies. The difference is I'm not looking for profits today.
Peter: I and I'm not looking for like mediocre profits tomorrow. I'm looking for gigantic world changing, dominating profits in the medium term. Right Next week kind of thing. And when I say next week, I mean it could be ten years out. It could actually be 20 years out. Right. What matters is, is that the company, to your point, can become a monopoly and then in a monopolistic position, can generate outsized profits relative to other companies in the space.
Peter: And those profits can be distributed to investors. That's what ultimately makes big companies. And so if you look I mean, the classic examples here, right, are like Google. Google wasn't making any money, didn't have any plans on how to make money. Facebook, same thing, Right?
Jon: They even know how to make money.
Peter: At the time, they didn't know how to make money. Right. It wasn't until they acquired AdSense. Like they even build their own tech ad to start making it a by somebody else to give them the ability to make money. But today, Google is by far one of the most profitable companies in the world, right? Because it's established itself as such a dominant player and the intersection of so many large markets and exhibits like crazy monopolist like power within those markets.
Peter: And so like as a VC, like, those are the profits that I want. The difference is, is that I'm taking all of those future profits that I may never see as a VC hit my balance, my bank account, and I'm discounting them all the way back to today to give me a valuation. And what and this is like the art versus the science of valuation, particularly when it comes to venture.
Peter: Is it because it's so far into the future? It's ten, it's 20 years. It's maybe in some cases like 30 years, right? You think about like, how long is Google been around? Right. So it's so far into the future that anybody that says that and tells you that they know exactly what the exact discount rate should be is crazy, right?
Peter: Like, there's no like, mathematical formula you can apply to it because there's you know, there's just so many different probabilities of what can occur. There's a VC you're just trying to like, do the best you can around forecasting. How big can that really get someday and discounting back to today at a rate that generates a big enough return to justify the risk I'm taking like gives me this valuation.
Peter: Yeah, right. And and so yeah so that to a certain extent, like doesn't matter if I pay $100 million or $1,000,000,000 or $1,000,000 valuation on Google, if Google someday is going to be worth $1,000,000,000,000, kind of doesn't matter. Right. Like, even if even if like before Google had really, like, generated a penny in revenue, I had invested $1,000,000,000 valuation I held it to today.
Peter: Right. Companies, you know, at different points in time has been worth close to $1,000,000,000,000. That's a thousand times my investment. Like, how would be phenomenal. Most VCs will never see a thousand X return on any of their investments in their entire lifetime. Right. So it kind of doesn't and it doesn't matter what the valuation is if you're in the right deals.
Peter: Right. And this is something that Andreessen Horowitz like came out and made a very big statement when they started their fund, is that like you're like, look, it doesn't matter. All that matters. You're only job as a venture capital is to get into the handful of deals every year that matter. And if you can't do that, you failed.
Peter: Right? And so yeah, we're going to pay up. And everybody was pissed about that in Silicon Valley and elsewhere. When Andreessen came in and they're like, they were throwing down like huge valuations and everyone's like, freaking out, right? Like, they're going to ruin it for all of us because, you know, the valuations are high or like, they're, they're pushing up these valuations and just they wait.
Peter: There's just you wait and see, like they're going to screw it up and they're going to, you know, have all these losses and so forth. But the thing is, is like value investing does not exist really in venture. And so being too valuation sensitive doesn't make a ton of sense. What matters is like getting into the really good deals.
Peter: But again, less than 3% of U.S. companies are venture. And of those, I would argue probably half of them should are even bankable. So it's just such a small percentage of the overall.
Jon: Yeah, Yes and no. I agree. And remember the first time I heard it being been shocked. But ever since then, every time I hear about it coming up in the news, I'm like, that news reporter doesn't know anything about this space.
Peter: Yeah, but look, they're not wrong because 97% of the time they're right. Right.
Jon: But you just knew. What was it like? Mint.com had their exit multiple revenue. I forget the number of quarter, but, like, they're just. You win, you win big, and that's what you're going for.
Peter: Yeah. I mean, Mint probably had, like, a couple hundred grand in revenue. They can match. They got to pick it up for like 76 million, which today is not like that big. But I mean, it just happened so fast and it was such a unique model. So why would a V.C. invest? I mean, we've covered a lot of the reasons why, but, you know, when they look, when I look at a deal, I'm thinking about those future profits.
Peter: And then there's the question of like, well, how do you get to those future profits? And ultimately it's because you are solving just insanely big pain point in a way that's defensible that other people can't copy you. And you have an amazing team that can execute on that. Right? And if you basically if you have those things, then VCs will get excited and they'll throw money at it with the hopes that, you know, 1000 X can cover a lot of losses for sure.
Peter: And so we don't hate to say most VC is like, you know, we don't want to lose money, but any V.C. that's like overly concerned about the money that they lose as opposed to the money that they can gain on their investments is probably not in the right game.
Jon: You're looking at the next question that's been brought up.
Jon: To the Pre-seed valuation. So Peter's not really a precede expert, you guys. Do you watch series A and above?
Peter: Yeah well occasionally dabble and seed but yeah yeah we don't we don't do a ton of pre-seed.
Jon: Okay so this is Mark Whalen, marketing and strategy MBA. He says more specifically, I'm curious to learn more about valuations at the Pre-seed stage. In some regards it seems like Pre-seed valuations are much a much different ballgame, almost like quantum physics. Things that you thought were true start to break down at scale. I think I don't have a lot of data, but I feel like right now I would be.
Jon: When the market was at its peak, it wasn't uncommon for founders who've had exits not like like Grand Slam exits, but some type of exit.
Peter: Yeah, been there, done that due.
Jon: To five x exits. They were getting valuations between eight and 10 million. Sure. I think right now that same group is probably raising a 5 to 8.7 million. And if you don't have experienced or probably in the two and a half million range.
Peter: That's pretty fair and you have to show more traction.
Jon: Correct? Yeah. So I think those are the current terms and a lot of people that were holding out for higher valuations are now taking these these numbers.
Peter: Yeah, that's fair.
Jon: I think if you're looking at people who've had exits, some of them are raising who was it? Those are the primary series A, some of them are raising it. We're like 20 to 30 X times revenue could be.
Peter: I mean, in some cases they don't have revenue because it's PRE-SEED.
Jon: But these are individuals who've had major exits. But so that would not be a seed, but that would be a later stage. Just to give you like a comparison.
Jon: Like the people I know at the top, at the top end who have a track record. Yeah, we're getting VC funding 10 to 30 million is the Hyatt. Yeah.
Peter: Look, I don't think Pre-seed valuation is that big of a black box. Got. I think generally there are standards that are relatively not like firm because they're fluid and that they change over time depending on what's happening in the market and supply and demand of cash. But but generally like there's there's the standard which you talked about right.
Peter: Was like two and a half, $3 million for first time founders for Pre-seed and then, you know, upward pushing up against ten for repeat founders, right somewhere in that range, 5 to 10. But I mean, you just have to think through like the basic math. So if I am a pre-seed fund, I manage like 25 million bucks, I'm going to make 50 bets, right?
Peter: So that's half a million dollars per bet. Then in order to return my fund on a $25 million fund, assuming that only one of those 50 ultimately succeeds. Right. Which is pretty close to what you'd expect. to return my whole fund at $25 million. Well, over time, I'm probably going to get diluted down to like 10% over time.
Peter: And so if the company ultimately is worth, you know, 250 million. So anyways, like if ultimately the company is worth 250 million bucks, that's great. Ever turned my fund. But as a seed fund, like, I'm probably going to lose a lot of my other companies if not all of them. Right? So just returning my funds, not enough. I really need to be pushing for like 3 to 5 X Fund returns, particularly because I'm investing at Pre-seed, which means I'm taking on even more risk.
Peter: And so investors are going to want an even bigger return so that means like if I own 10%, I need this company to get to $1,000,000,000, right? $100 million return. That's for my fund. I can go raise another fund off that. If it's below four X, it's almost like, well, why would I take all the risk of investing in your seed fund only to get four x or three x when I can invest in a more established series a fund and also get like three X with less risk.
Peter: Right? So like there's that going out. So to ultimately like you want to be pushing for like north of four X pretty close like five, six, etc. to really be competitive as a seed fund. So okay, so now I've got to sell the thing for $1,000,000,000 and I got to own 10% when all is said and done and I am writing a half million dollar check.
Peter: So dilution alone is probably going to cut my stake in half minimum. So now I need to own 20% of the business, but 20% of the business for the half million dollar check, that's roughly two $2.5 million pre.
Jon: Okay, there we go. We got there. Right.
Peter: Jon's like eyes glaze over math or No, but you know that that's the basic math. And look if a.
Jon: Percentage of the cap table shared a seed investor half or how much is too much before investors will be like you gave, how much away or does that matter?
Peter: I don't know. I think once you're north of like 40%, I would start to get super nervous.
Jon: When someone says, Hey, Don, 100 K for 35% of the company. As an investor for round two, you'd be red flag or no. I mean, yes, that's probably yes.
Peter: Okay. The caveat is like, I don't know, like if you absolutely slay it and.
Peter: The company is just like going gangbusters.
Jon: That could be a potential red flag.
Peter: But like you're going to value your company at 200 K.
Jon: I'm just am give you an example. Nothing. That's what I would do.
Peter: Yeah, but people do it.
Jon: I mean 100 K gets people where.
Peter: Well, I mean look I would raise 100 K at A to 200 K pre money valuation if I thought there was a very clear near-term exit to like 10 million. Okay, sure, why not. Yeah, but I wouldn't dedicate my life for the next like 10 to 15 years.
Jon: You're saying let's, let's say someone was going to give me $50,000 that you would try to go for a post-money valuation of 2.5 million or 10%.
Jon: I'm just trying give you, like rough examples. Yeah. And you wouldn't see a red flag with that.
Jon: But if someone gave me 250,000 and it had 30% in a pricey deal as a B, C, is that concerning or. No.
Peter: Not necessarily. Okay. I don't think I mean, those aggressive it would make me question like their ability to negotiate and fundraise.
Peter: Right. Which I think is an overlooked like characteristic that people don't talk about a lot. But I have found it to be more and more and more important of the entrepreneurs. I back that like they know how to fundraise. Problem is, you can't just be good at fundraising. You have to be good at fundraising and good at like operating because I've also seen situations, right?
Peter: like we work where the entrepreneur is exceptional at fundraising, but a total trainwreck when it comes to operating and managing and the whole thing kind of blows up. They raise tons and tons of money at super high valuations. They can't sustain it. And the whole thing, the whole you know, house of cards comes collapsing. so you got to, you got to have both.
Peter: But the flip side is I've also seen situations where you have an entrepreneur who is phenomenal at operating and cannot fundraise to save their lives, and they have like an actual interesting business that if that were in the hands of any other, like good like entrepreneur who knew how to fundraise like would be where 2 to 3 to 4 to 5 times the value right and that matters not just because valuation you know is like this ego trip, but because startup land is all about momentum in a lot of ways.
Peter: And so if you've got momentum, you're growing, you're hitting higher valuations. It's easier to hire, it's easier to fundraise, it's easier to land. Customers like you know, wins behind your sales, like it's easier. And so we both both really matter. Those are side hands, I mean, to go on. But the good.
Peter: A lot something I think of is what's.
Jon: Happening. Yeah. And I think our next episode will dig deeper into maybe some of the reports that Kartik came out with, Sir. But just as a general pre-seed understanding in the in the Utah market, my general minor standing is that most people are raising around 2.5 to 5 million post-money So post-money would be the pre money valuation would be the amount you raised and minus that valuation.
Jon: Yep. Would be the pre.
Peter: And the one thing I want to add is like why would you pay an entrepreneur that's been there, done that even if they haven't had like a massive homerun success. This is because like they've been there, they know things that you just can't learn other than being, you know, having gone through it. And so they're going to avoid risks and pitfalls that first time entrepreneurs are going to run into most likely or could run into.
Peter: There's just a higher degree of likelihood that they will, which means it's more risk and less likely that they'll hit that outcome that you need them to. Whereas somebody that's kind of been there before, not their first rodeo, they have enough experience and usually enough drive to because like the first one was like, yeah, it was okay, but it didn't change my life.
Peter: Next one. I want to like, change my life, right? And so there's just a lot of more things that are teed up that ultimately reduce the risk, that the company will fail or will achieve that big outcome that you're really going for. Or alternatively put, it increases the likelihood that they will.
Jon: Okay, awesome. Let's wrap up this LinkedIn Q&A session that has really good feedback. Where is it a 30 million RE money valuation? But and that's what all of us should expect. But a venture capital firm, you can like a five star reviews. That would be very helpful. Live comments on YouTube and would love to answer your thought your question.
Peter: Yeah. And if you have questions, ping me and John on LinkedIn, on YouTube, whatever.
Jon: All right. Thanks, guys.
