Why AI startups are selling the same equity at two different prices

As the competition among AI startups intensifies, founders and venture capitalists are exploring novel valuation strategies to create an impression of market leadership. Traditionally, highly sought-after startups would conduct multiple funding rounds in rapid succession, each with increasing valuations. However, this frequent fundraising can divert founders' attention from product development. To address this, lead VCs have introduced a new pricing structure that effectively merges two funding cycles into one.

This innovative approach was recently employed by Aaru, a startup specializing in synthetic-customer research. According to The Wall Street Journal, Redpoint led Aaru's Series A round, investing a substantial portion of their capital at a $450 million valuation. Subsequently, Redpoint invested a smaller portion at a $1 billion valuation, with other VCs joining at this higher price point. TechCrunch was the first to report on Aaru's funding, including this tiered valuation mechanism.

This strategy allows promising startups like Aaru to claim "unicorn" status (a valuation exceeding $1 billion), even though a significant portion of their equity was acquired at a lower price. Jason Shuman, a general partner at Primary Ventures, explains that this is a competitive tactic by VCs to win deals and a strategy to deter competitors from backing the second and third-ranked players in the market. The substantial "headline" valuation generates an aura of market dominance, despite the lead VC's lower average purchase price. Investors indicate that this practice of splitting capital between different valuation tiers within a single round was previously uncommon.

While the high headline valuation can assist in attracting talent and corporate clients who may perceive the company as having a stronger market position, this strategy carries inherent risks. Startups are expected to secure future funding rounds at valuations higher than their headline price; otherwise, they risk a punitive down round. Although these companies are currently in high demand, future challenges could make justifying these valuations difficult. A down round can diminish employee and founder ownership percentages and erode the confidence of partners, customers, future investors, and potential hires.

Wesley Chan, co-founder and managing partner at FPV Ventures, views this valuation tactic as indicative of a market bubble, stating, "You can’t sell the same product at two different prices. Only airlines can get away with this." While VCs often offer discounts to top-tier investors as a market signal to attract talent and future capital, allowing latecomers to invest at a significantly higher price point can be a double-edged sword.

Jack Selby, managing director at Thiel Capital and founder of Copper Sky Capital, cautions founders against pursuing extreme valuations, citing the market correction in 2022 as a warning. He emphasizes the precariousness of such strategies, noting, "If you put yourself on this high-wire act, it's very easy to fall off."