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By Dan Gray

On Aug. 20, 2011, Marc Andreessen published the definitive manifesto for a generation of technologists and investors, with “Why Software Is Eating the World.” It kicked off an era of immense enthusiasm for software startups, coinciding with a period of historically low interest rates.

The pace of investment accelerated over the next decade, and without sifting too finely through recent history we can reflect back on a quote from Andreessen’s essay:

“Too much of the debate is still around financial valuation, as opposed to the underlying intrinsic value of the best of Silicon Valley’s new companies.”

Andreessen’s sentiment lines up with reality: At that time, the risk and potential associated with high-growth software companies were not well understood or adequately reflected in the financial models used to compute valuation.

Forward-thinking people in venture found this frustrating, and practices began to diverge — drifting toward simpler financial models and crude comparison tools like revenue multiples.

The sheer momentum of software investment over the following years encouraged the growth of private capital inflows, allowing startups to stay private for longer. Valuation was seen as an arbitrary milestone on the road to IPO as investors ratcheted up the price and exit expectations to produce ever more impressive (paper) returns.

Somewhere during this period of easy money and endless growth, investors stopped thinking seriously about valuation. All that mattered were comps based on trends in similar transactions. A startup would be awarded a market-based multiple based on its growth rate, revenue and — where investors were unusually diligent — their margins.

Eventually, even smart investors started saying things like “only market-passing valuations matter,” as a way of dismissing sincere attempts to understand and rationalize private company value.

We had entered an overcapitalized environment where financial discipline was no longer valued, and those muscles were starting to atrophy.

The importance of a common vocabulary

Most investors have since forgotten what valuation is supposed to represent, as the nomenclature of venture capital has failed to keep pace with the growth. Consequently, you can ask a dozen of the sharpest investors what they think of valuation, and get a dozen different answers.

The danger is that investors end up overthinking valuation, conflating it with pricing and seeking a convoluted consensus through averages that have no real place in an asset class focused on outliers.

That approach also misrepresents the simple fact that the price of a nonfungible asset is agreed between the two sides of a transaction, not a universal truth.

(Pricing based on comparison can make sense as a fund strategy for mature companies or in a more concentrated sector like B2B SaaS, but that falls apart quickly when you look elsewhere.)

A definition of startup valuation

Fundamentally, without getting bogged down in methodology, valuation is a framework through which investors can better understand a startup by analyzing qualitative and quantitative factors which reflect risk and potential. It enables a more complete and comprehensive understanding of that particular company, the business model and the implied scale of returns.

We can clarify this further by establishing two things that startup valuation isn’t.

Valuation is not pricing. If your estimation of value is based purely on market momentum, similar transactions, investor demand and competition, then we end up with a mindless procyclical environment like 2021.

Valuation is not fund math. Having a binary investment decision based on a given price and a target ownership percentage does not imply a valuation, it just implies a threshold of tolerance.

So the complicated answer is that valuation is actually a component of pricing, along with market conditions and fund math.

Price — determined by a combination of valuation, market analysis and fund math — is ultimately the number that gets the deal done and is the topic you hear investors talking about most frequently, regardless of how they refer to it.

Dan Gray is an adviser supporting impact entrepreneurs in emerging markets, and is the head of marketing at Equidam, a platform for startup valuation.

Illustration: Dom Guzman