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The Shiny Startup

November 25, 2021

In economics and psychology, there is this idea that for some goods, if you increase the price you increase, not decrease, demand. This goes against much of microeconomics, specifically that which is underpinned by a "Homo Economicus" (rationality) assumption. But it works. The most likely reason is that people use price as a heuristic for quality, and assume that higher price = better quality. Another separate reason, which I don't think is as relevant for the following line of reasoning, is that some purchases are a status flex, and you only get that effect if the purchase is too pricy for most people. This can be true for things like watches, sports cars, or champagne bottles at a nightclub. Shiny, expensive things are cool and people want to pay for them.

I think some psychology is at play in startup valuations as well. When investors participate in early-stage rounds, they to a large extent invest in the team, a mantra constantly echoed by VCs. And the best teams don't sell themselves cheap. No half-decent VC has ever said, "I don't really believe strongly in this team or what they're doing, but they're pricing the round cheaply, so we're investing." Pricing your round way below market is very likely to turn into a bad situation for the founders because VCs start wondering if this is really a top 10% startup. You're probably just making your investment case less attractive.

There is another side to this, which is that in early-stage investing, the valuation of the company in itself, fundamentally, disregarding any psychological factor - the "true" value of the company - depends on the valuation in the early-stage financing rounds. There is a feedback loop. The valuation impacts the true value of the company, which impacts the valuation, which impacts the true value...

The fundamental value of a startup depends on the probability of that startup succeeding. That probability is in its turn dependent on a) the company having enough capital to properly execute their plans and b) founders having as much equity as possible. If founders have sufficient equity, they feel that the business is largely in their hands, even after future dilution. This keeps founders motivated, and you need motivated people running the business to build a company. Put differently, by setting the valuation ask high enough, you increase the probability of success.

I see this sometimes with VCs-turn-founders. These founders know how VCs work; they've been there themselves. When these guys go to VCs, they in my experience price their high or borderline ludicrous. They know that the startups who close funding are the ones that create an aura of being a "hot" startup and you don't do that by pricing it cheap. And that aura of being "hot" will set the startup on the right course also after the round has closed. Sometimes, they don't succeed with their rounds. Even then, they probably won't sell themselves cheaply. Instead, they back off, try to build some more and come back asking for a high price again later.