This Chart Shows Why VCs Are Willing To Give Hyped Startups Absurd Valuations

Why has the billion dollar valuation become trivialized in startup investing?

What started Facebook down a path where it would it reach a $150 billion valuation on secondary markets before going public at a $100 billion valuation, and then sinking to a $50 billion valuation within months?

We were talking about these questions with the CEO of a startup that has itself raised more than $100 million in this environment.

This CEO believes the answer to these questions are in the chart below, which shows how the yield on corporate debt has declined for the past 22 years:

Yield On Corporate Debt Since 1980

Photo: FRED

What makes debt attractive is that it is a low-risk, guaranteed return.  

But two trends in the past few years have combined to make venture capital funds a more attractive place to put money than corporate debt.

  • The first is that, as the chart above shows, the yield on corporate debt has declined greatly – especially relative to the 1980s, when pro investors cut their teeth.
  • The second is that the venture capitalists are now investing in startups in a way that reduces their risk while only slightly reducing upside.

Here is what VCs are doing.
They start by targeting high-profile, hyped startups that already have lots of users and have reached a point where they are not likely to simply go away. These startups are likely to at least someday be acquired for some amount of money, if not multiples of their valuation. Often, these startups come from highly-regarded “branded” incubators, such as Y Combinator.  Examples of this kind of startup include: Airbnb, Dropbox. and Evernote. After targeting these startups, these VCs approach them about investing. But the VCs don’t want normal “common stock;” they want stock with special rights. These “preferred shares” guarantee their owner that, in the event of any sale, the owner will, at the very least, get the price paid for the stock back. If the VC invested $10 million in Startup X at a $100 million or $200 million valuation, that VC will get at least $10 million back, even if Startup X only sells for $10 million.

To convince the startups to sell them this preferred stock, the VCs agree to pay more for it. The way they pay “more” is not by investing more, but by acquiring a smaller percentage of the startup with the same amount of money – by giving the startups much higher valuations.

These higher valuations mean that VCs have lower potential reward. But the special rights also make VC a less risky investment.

Combined with a decline in yield for corporate debt, that makes venture capita a more attractive sector for large pension funds and other institutional investors to put their money.

So the money has come flooding into VC. 

This, in turn, makes the competition for the few high-profile, hyped startups that much more frothy. In competition with each other, VCs become more willing to “pay more” for their preferred shares, and startup valuations get higher and higher. 

In 2007, Microsoft bought $250 million worth of preferred Facebook stock at a $15 billion valuation.

The huge valuations haven’t stopped since:

  • THE BILLION-DOLLAR CLUB: 12 Startups With Skyrocketing Valuations 
  • Evernote Has Completed A $100 Million Round At A $1 Billion Valuation Led By Meritech  
  • The (Near) Billion-Dollar Club: The 11 Most Valuable Startups In New York

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