The Curse of Overvaluation: a Breakdown pt. I

Jason Yeh
February 28, 2023

A big ol’ headache is coming on for a lot of startups that were SUPER hot a year ago. Their overvaluation relative to today’s market will make things challenging. 

I want to break down the mechanics behind that migraine to educate you all. Their pain is your gain. Learning about this extreme example will help you navigate your own valuation decisions in any market conditions. But first… some background.

What happened

People love saying “follow the money” during investigative research. I hate to say it, but that’s the easiest way to explain the overvaluation crisis we’ve found ourselves in.

I don’t pretend to be an expert in economics so I’ll just briefly touch on some of the inputs to our current situation…

Cheap money (low interest rates)

In 2008, we experienced a global financial crisis. In order to fight the threat of a total meltdown depression, central banks around the world lowered interest rates to record lows to stimulate economic growth. When dropping to near 0% interest rates wasn’t enough, the US layered on “quantitative easing” (essentially the government giving banks more cash by buying the bonds that they held) in order to encourage banks to lend even more.

To say we had a flood of cheap money is a bit of an understatement. Cheap money means it was easier for businesses to borrow at lower rates to support their businesses. Consumers also had access to this cash machine which stimulated spend and propped up business of all types.

Which led to…

Explosion of VC activity and funds

With more money to go around, investors looked for ways to put this overabundance of capital to work. LPs of all types (from individuals to institutions) gave more money to VCs, with 5 straight years of record allocation into the VC asset class. That meant bigger fund sizes for existing funds and more newly minted, first-time VCs.

Easy Markups

With more capital flowing in the system, the pressure to deploy capital increases. This leads to more investments being made at a higher velocity and in many cases with a lower bar. The positive of this was more quality companies getting funding that might have received a pass in less frothy times. Either way, deals across the spectrum got done and allowed funds to show “mark ups” in their portfolio more readily than in years past. In other words, they could go to investors and say “Look at my investments. They’re doing so well! I invested at X and the portfolio is now worth 10x!!” Even though that was all on paper, it allowed funds to raise even MORE capital and feed into the cycle more…

Crypto Bull Run

As if cheap money from the government wasn’t enough, the crypto bull run between 2020-2021 shook up the ecosystem even more.

With the price of bitcoin going from $10k to $65k and other alt currencies experiencing even crazier pricing explosions, significant wealth creation happened overnight. That meant thousands of newly minted millionaires were suddenly available to angel invest and existing investors with more wealth became bolder in their investments. Everything going up and to the right meant you couldn’t miss!

Web3, Tokenization, and early liquidity

Without commenting on its staying power, I want to point out a blip in the landscape related to web3 that contributed to the overheating of the VC industry. When web3 was having its moment, many of the companies launching in the space issued tokens alongside the launch of their company. Because these tokens became tradeable quickly (sometimes within a year of issuing), investors were able to capture returns from their investments far sooner than the traditional timeline a VC would expect. This early liquidity gave investors even more reason to YOLO into deals at the height of the craziness.

So those were the inputs… but what actually happened?

Everything above fed into three elements of our overheated VC market:

  1. A glut of capital needing to be deployed
  2. Irrational exuberance for early stage investing 
  3. Extreme FOMO (gold rush mentality)

In other words, between 2020 and Q1 2022, there was more capital than quality deals available. The scarcity mixed with a dash of FOMO made competition for deals go insane. Over an 18-month period, any deal that had even the slightest bit of potential created a feeding frenzy that few active investors were able to avoid.

The simple (and dangerous) logic followed as such: since every deal skyrockets in valuation 6 months after raising, all that matters is getting into these deals. There are tons of other investors competing so winning a deal requires me to be fast and price insensitive. If investing is a feel-based exercise, then what more am I going to learn in a month that I wouldn’t already know after a week of diligence. And if the company will be worth $10B, what’s the difference between a 10M valuation vs. 100M?...

This is how we got to $100M term sheets in 1 week for seed-stage companies 🤦 

A hot investing market persists as long as investments continue to produce follow-on raises and mark-ups along with exits to the public market or M&A. The more cynical description of this is called the “Greater Fool Theory” of investing. This theory says you can make money overpaying for something as long as you can find a buyer after you who is also willing to overpay. 

This means it’s ok to invest at a $20MM pre-seed, as long as there are seed investors paying $50-100MM, and ok to invest at $100MM seed rounds when there are Series A investors coming in at $200MM.  And related, as long as LPs investing in new venture funds count these paper returns (TVPI vs. DPI) more venture funds will be raised off of this momentum leading to more dollars fueling this overheating market.

But what happens when the music stops?

Next week, I'll cover the two main challenges of overvaluation and how founders should adjust their approach to this new fundraising environment. Stay tuned!

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