Short Run / Long Run

There’s always something.

Currently, early-stage investors are complaining about (yet participating in) a supposedly frothy funding environment, catalyzed by a surge of interest in software infrastructure. During the early days of the pandemic, people were preparing for the worst, but the split between the digital and real economy has spun a different story.

Pre-seed and seed investments are quickly marked up with subsequent financings happening within a matter of months. It’s easy to call bubble, but Galbraith explains the difficulties associated with that:

The euphoric episode is protected and sustained by the will of those who are involved, in order to justify the circumstances that are making them rich. And it is equally protected by the will to ignore, exorcise, or condemn those who express doubts.” — A Short History of Financial Euphoria (1990).

At first glance, the markups seem only positive for early investors. The initial investment is worth more than what you paid for it! Great. Nevertheless, I can’t help some level of paranoia, and I wanted to highlight some possible second-order effects of markups.

  • Illiquidity — Josh Wolfe, of Lux Capital, sounded the bells on this a few years ago, where he commented on the danger of late-stage liquidity preferences and ratchets on unicorns that could wipe out early-stage investors. In the 2018 paper, “Squaring Venture Capital Valuations with Reality,” the authors argue that private technology company valuations could be overstated by 50% when controlling for the worth of the individual share classes. I haven’t seen the recent data yet, but I also have a hunch we’re living a very founder-friendly environment, so the late-stage ratchets may not be as strong, which would diminish this.

  • Fight for dollars — Ultimately, ownership at exit and reserve management are major factors in outstanding venture fund performance. If other sources of capital are backing into companies at variable rates, it may be difficult for seed managers to even maintain pro-rata, much less put more dollars to work and play reserves accordingly.

  • Overcapitalization — There is a fear that if you invest too much in a business before one knows where the truth growth levers are (and it has an inherently capital-light business model), you will contribute to aimlessness. Ilya Sukhar, of Matrix Partners, presented an interesting counterargument, citing the need for significant resourcing against product development to build an enterprise-grade business in a B2B software market today.

These are all disquieting in their own ways, but to me, the real danger markups pose for early-stage investors is in acting as proxies for truth; behaving as short run noise, when long run signal matters more. Being a great early stage investor does not equate to being right 100% of the time, but blind faith in personal ability based on portfolio markups is also not the way.

There have been plenty of examples of cohorts of companies that raise lots of money, but plateau in the $500M - $1B valuation range (the no-man’s land of venture). D2C brands and fraud / risk prevention startups come to mind. Their stories and narratives of world domination suddenly change when growth inflects the wrong way.