The Entry Price Fallacy: Why Valuation Matters Even for Potential Unicorns

Originally a thread on X/Twitter:

The biggest fallacy in the Startup world is to believe that the entry price for a great investment is irrelevant.

While great investments generate great returns, being indifferent to price is a function of sloppy thinking.

A useful mental model that great Investors use:

A great Investor spots investments that have attractive risk/return characteristics.

They know that investing is about taking on risk and then getting paid if that risk doesn’t materialize.

They also know that when risk materializes their investment could become impaired.

Risk takes many forms including:

Technical risk: Can it be built?

Market risk: Will enough prospective customers buy your product at a profitable price?

Operational risk: Can the business scale without breaking?

Regulatory risk: Will the legality of a business be challenged?

And most investment opportunities in highly liquid and highly transparent markets are priced to reflect their risk.

Low-risk investments have low return profiles with low volatility and high-risk investments have high return profiles with high volatility.

At its core, investing is about buying ownership in a distribution of outcomes.

Each outcome has a probability of materializing and a value if it materializes.

Great Investors base their yes, no and pricing decisions on the expected value of the distribution of outcomes.

Investors seek out distributions with positive expected values (EV+) and try to avoid distributions with a negative expected value (EV-).

But what makes investing difficult is that it’s impossible to calculate the outcome distributions with true precision.

Imagine if every investment decision could be made with the precision of playing Roulette.

A roulette wheel has 38 numbers (inclusive of green 0 and 00) and the payout schedule for a direct bet on a number is 36 to 1.

This is an EV- game with a known distribution of outcomes.

If you “invest” money on a number and it hits on the next spin you get paid 36X your investment. Was this a good investment?

No. It was a bad investment with a good outcome. Conflating the two is where many Investors are sloppy.

As “N” increases this becomes more apparent.

But absent precise information, many Investors don’t try to frame the distribution of outcomes.

Instead, many early-stage Investors fall back on a “talent scout” methodology which assumes that “talented people will tackle big problems in big markets and create big outcomes”.

The assumption is that big outcomes are big enough to generate top decile returns.

And therein lies the rub.

It assumes that Founders are trained experts in outcome analysis!

This is a TERRIBLE assumption for a few reasons:

Proximity Bias

The best Founders are exceptional business builders but proximity bias is unavoidable.

There’s a massive difference in the odds they place on success and the actual odds of success.

This isn’t mostly true. This is a universal truth.

Mine is Better

Very few Founders seek out to build a slightly better version of a product in use today. They hate the incumbents and want to build 10X better experiences.

They believe “mine is better” which makes them dismissive of comp analysis based on today’s market players.

Asterisks

The market provides proof or anti-proof that a Founder is on or off track to build an amazing business.

To Investors, anti-proof is evidence of how difficult a business will be to build, but to many Founders, anti-proof is just an “asterisk” that can be fixed.

Which leads us back to the job of an Investor: To seek out investments with an EV+ distribution of outcomes. This isn’t easy.

It’s challenging for early-stage VCs to find ways to triangulate the odds of success and potential of startups that are still “figuring things out”!!!

This might start with an understanding how an industry works and the mechanics of value capture.

Then an Investor could ground “what has to be true” to create an amazing business.

From there, the perceived distribution of outcomes could drive yes, no and pricing decisions.

The truth is that pricing doesn’t matter much for “unlimited right-hand tail with decent odds of success startups”, but unfortunately not many investments fall into this bucket.

Too many VCs justify their pricing based on a tail that doesn’t exist!!!

And intuition can play an important role in the decisions made by great Investors.

But guess what intuition helps these Investors decide? It’s whether or not a startup has the potential and a fighting chance to become a generational company.

Same concept. Different methodology.

So to VCs who say “price doesn’t matter”, I ask if they’ve done the work to justify an open checkbook.

More times than not the answer that comes back is a single-click response that skims the surface of the opportunity and never gets to the bottom of the risk/return dynamics.

And with the world entering a new economic cycle, the enterprise value of high growth tech companies is down massively.

This changes the distribution of outcomes for startups and should be reflected in valuations.

But will it ripple back to the earliest stages like it should?