Why AI startups are issuing the same equity at different valuations

As competition among AI startups intensifies, founders and venture capital firms are increasingly using new valuation structures to create the impression of market leadership.

Until recently, the hottest companies would raise several funding rounds in rapid succession, each at a higher valuation than the one before. But because nonstop fundraising can pull founders away from actually building their products, lead investors have started using a different pricing model that essentially combines what might once have been two distinct fundraising cycles into a single round.

One recent example of this approach was Aaru’s Series A. The synthetic-customer research startup raised a funding round led by Redpoint, which, according to The Wall Street Journal, invested a large share of its capital at a $450 million valuation. Redpoint then put in a smaller amount at a $1 billion valuation, while other venture firms joined the round at the same $1 billion price, according to our reporting.

That structure allows highly sought-after startups like Aaru to describe themselves as unicorns — meaning they are valued at more than $1 billion — even though a meaningful share of their equity was actually sold at a lower valuation.

“It is a sign that the market is incredibly competitive for venture capital firms to win deals,” said Jason Shuman, a general partner at Primary Ventures. “If the headline number is huge, it’s also an incredible strategy to scare away other VCs from backing the number two and number three players.”

In effect, the outsized “headline” valuation helps project the image of a market winner, even if the lead investor’s blended purchase price was materially lower.

Several investors said that, until recently, they had never seen a deal in which the lead investor split its capital across two separate valuation levels within the same round.

Wesley Chan, co-founder and managing partner at FPV Ventures, sees this pricing strategy as a sign of bubble-style behaviour. “You can’t sell the same product at two different prices. Only airlines can get away with this,” he said.

In many instances, founders are willing to give a discount to elite venture firms because having those firms involved sends a strong signal to the market, making it easier to attract talent and raise capital again in the future.

But because these rounds are often oversubscribed, startups have found a way to accommodate the extra interest. Instead of rejecting investors who want in, they let them participate immediately, but at a much higher valuation. Those investors are often willing to accept the premium because it may be the only available path onto a highly desirable cap table.

Another startup that reportedly used preferential pricing for its lead investor is Serval, an AI-powered IT help desk company, according to The Wall Street Journal. While Sequoia’s lowest entry point was at a $400 million valuation, Serval announced in December that its $75 million Series B valued the company at $1 billion.

Although a high “headline” valuation can help a startup recruit employees and impress corporate customers who may see it as having a stronger market position than rivals, the tactic also carries significant risks.

Even if the company’s true blended valuation is below $1 billion, it will still be expected to raise its next round at a price above the headline price. If it fails to do that, the result would be a painful down round, Shuman said.

These companies may be in strong demand right now, but they could still run into unexpected problems that make it very difficult to justify such lofty valuations. In a down round, founders and employees wind up owning a smaller percentage of the company, and it can also damage confidence among partners, customers, future investors, and prospective hires.

Jack Selby, managing director at Thiel Capital and managing partner at Copper Sky, cautioned founders against chasing extreme valuations, citing the painful market correction in 2022 as a warning. “If you put yourself on this high-wire act, it’s very easy to fall off,” he said.