#11. Inefficient price setting
January 10, 2022
Venture capital is not efficient.
VC-backed start-ups (at least the good ones) are notorious for being ruthlessly efficient. Shoe-string budgets, low salaries, an unending grind. All to build something incredibly valuable. Start-up chief officers are the ultimate capital allocators. Every cent spent goes to building significant value for employees and investors.
Among VC funds, the 2018 vintage (those whose funds started in 2018) are already showing 2.5x mark up. Within those 2.5x portfolios, some start-ups are returning 0x (“give me $1m and I’ll burn it”) while other start-ups are likely up 10x (“give me $1m and I’ll turn it into $10m”). For those top performing start-ups, that’s pretty fantastic. By the time these VC funds close in 6-7 years, the top start-ups in those funds can turn that $1m into $100m or more. That’s a pretty efficient use of money.
So the private equity market is efficient, right? Actually, no. Why? Static price setting. The way start-up prices (i.e., valuations) are set is via a “lead” investor - somebody who’s willing to propose a valuation, lead the diligence, and be most involved with the company. By and large, once a valuation is set for the round, it does not move. Lots of fundraising headlines today advertise “oversubscribed rounds” with pomp and applause. An oversubscribed round is one in which more investors wanted to invest than there was space for (“we’re so popular!”). Another name for oversubscribed rounds? Underpriced rounds. If a valuation is set low and is particularly enticing for investors, lots of investors will want in. In a normal liquid market, that would raise the price of the asset until supply equals demand. But that doesn’t happen with start-ups. The price of the round doesn’t go up. The start-up is stuck with the pre-negotiated price for their equity.
To me, this is where Distributed Autonomous Organizations (DAOs), darling of the web3 world, become very powerful. As more investors want ownership tokens in a DAO (roughly equivalent to equity in a start-up), the price of those tokens goes up. In that sense, DAO tokens operate in much more of a free market than start-up equity. More demand for the supply, price goes up. Less, it goes down. The venture capital industry, as wonderful as it is at funding innovation, is unfortunately pretty horrible as a price-setting machine. DAOs are one way to shift more power back to the ultimate capital allocators: the builders.
