11. March 2025
Startup Valuation Conundrum: The Flawed Logic Behind Market-Based Multiples
The Dilemma of Venture Capital Pricing: Why Market-Based Multiples Are Not the Answer to Greatness
In the world of venture capital, the pursuit of outliers is a constant quest. However, the reality on the ground is that startups are often priced using market-based multiples, with comparable companies serving as the benchmark for valuation. This approach creates a paradox, where founders and investors engage in a game of cherry-picking data to justify terms that favor one party or the other.
Founders are pressured into selecting comparable companies that demonstrate the value proposition of their startup, leading to an over-reliance on market data to support their valuation claims, often at the expense of negotiating fair terms. Meanwhile, investors manipulate comparables to suit their desired price, which can result in overvaluing startups and creating fragility in their portfolios.
The consequences of this approach were evident in 2022, when venture capital firms faced criticism from their own investors for not accurately valuing their portfolios following a market crash. With prices at rock bottom and the market frozen, the reliance on comparable multiples became a liability. Founders who raised funds during this period struggled to secure favorable terms, as investors used cost of capital as an excuse to negotiate lower valuations.
The risks of this approach are not new, but they have become increasingly apparent over time. Only those who have witnessed multiple market cycles can truly appreciate the impact of pricing on venture capital investments. Financial literacy is essential for investors to avoid making costly mistakes.
So, what’s the alternative? How do founders and investors align on terms when there is no common ground in the form of market-based multiples? The answer lies in understanding the value proposition of each startup, rather than just pricing them based on comparables.
Consider the examples of SpaceX, Anduril, or Uber – companies that offered novel concepts and required independent conviction from investors. In these cases, founders had to be examined in a vacuum, without the context of an existing industry or market. This allowed investors to build their own conviction around the growth potential, moats, margins, and exit strategy of each startup.
By focusing on the drivers of value, rather than relying on market consensus, investors can identify true gems that have the potential to disrupt entire industries. The best venture capital firms do not rely on market-based multiples to fuel their investment decisions. Instead, they seek out companies with a clear vision of the future and a strong growth trajectory.
These are the companies that require option calls, rather than generic SaaS businesses that are simply trying to ride the coattails of previous successes. If you’re in the venture business, ask yourself: what type of companies are you looking for? Are you seeking option calls on a dozen generic SaaS businesses, hoping one will work out, or do you want to hunt for masterpieces that have the potential to disrupt entire industries?
The answer to this question reveals whether you’re investing in consensus themes or true greatness. Consensus themes have a history of failing venture capital firms and rarely producing generational winners.
In boom times, it can be tempting to rely on market-based pricing as a crutch. However, this approach is inherently flawed, as startups are illiquid for about a decade and the market can slam shut within a year. This creates a risk of overpaying for companies that may subsequently lose value.
To navigate this complex landscape, venture capital firms need to adopt a more nuanced approach to valuation. By focusing on the drivers of value and understanding the growth potential of each startup, investors can identify true gems that have the potential to disrupt entire industries.
As Dan Gray, head of insights at Equidam, notes, “The best investors do not rely on market consensus. They build their own conviction around the companies they invest in, and this allows them to make more informed decisions.” By taking a more holistic approach to valuation, venture capital firms can avoid the pitfalls of relying on market-based multiples and increase their chances of identifying greatness.
In reality, the pursuit of outliers is not just about finding undervalued gems; it’s also about understanding the value proposition of each startup. By focusing on drivers of value and building conviction around each company, investors can navigate the complex landscape of venture capital pricing with greater confidence. The best startups aren’t just priced; they are valued based on their potential to disrupt entire industries.
The venture capital industry has a long history of valuing companies using market-based multiples. However, this approach has its drawbacks. Founders and investors often engage in a game of cherry-picking data to justify terms that favor one party or the other. The reliance on comparable companies can also create fragility in portfolios, as market conditions change.
In recent years, there have been several high-profile cases where venture capital firms have failed to accurately value their portfolios following a market crash. For example, in 2022, several venture capital firms faced criticism from their own investors for not accurately valuing their portfolios following the COVID-19 pandemic. This highlights the need for a more nuanced approach to valuation.
The best way to overcome these challenges is to focus on the drivers of value and understand the growth potential of each startup. By taking a more holistic approach to valuation, venture capital firms can increase their chances of identifying greatness and avoid the pitfalls of relying on market-based multiples.
Ultimately, the pursuit of outliers is not just about finding undervalued gems; it’s also about understanding the value proposition of each startup. By focusing on drivers of value and building conviction around each company, investors can navigate the complex landscape of venture capital pricing with greater confidence. The best startups aren’t just priced; they are valued based on their potential to disrupt entire industries.