A Ponzi Scheme is unfolding right in front of our eyes. Chances are nobody will wind up sharing a cell with Bernie, but it could ultimately crush the growth of the venture and startup industry.
Here’s why it happens: insider pricing rounds, when financing is led by existing investors, creates a natural conflict of interest; as many times, it’s in the insiders’ best interest to inflate the values. The inflated values allow the investors to show paper gains to their LP’s on their existing investment, which makes their LP’s happy, thereby making the GP happy. This also makes the founders happy as it’s generally easier to raise money from existing investors, and most entrepreneurs feel a higher valuation is better, something I’ll dive into in a future post.
The sham is being perpetrated by existing investors who price follow on rounds. To make things worse, since angels are so eager to invest right now, they are essentially ‘validating’ the high valuation.
Below is a realistic example of how the scheme works:
A startup raises a $500k seed round on a $2m pre-money followed by a $1m round.
The table below shows the outcomes of raising $1m on $5m pre-money valuation and a $10m pre-money valuation:
The example shows that the fund has an incentive to go with the higher valuation, as the net result of the value of the full investment is 50% higher. Further, while not shown above the value of their 1st investment is 100% higher by increasing the pre-money from $5m to $10m.
Unfortunately, this situation is happening pretty regularly right now, and in the long term will prove to be detrimental to founders, vc’s and angels.