$4 Billion Is The New $1 Billion In Startups

Music streaming company Spotify just raised $250 million at a $4 billion valuation.

That sounds high, but $4 billion seems to be the magic number for today's biggest startups. Recent valuations have dwarfed Tumblr and Instagram's once-massive $1 billion buyouts.

Uber received a $3 - 4 billion valuation in August when it raised a $258 million round of financing led by Google Ventures.

Pinterest raised at a $3.8 valuation in October. A few weeks ago, Snapchat was mulling over a new round at a similar valuation. Evernote hasn't raised a round in over a year, but it's likely near the $3 - 4 billion valuation range by now. Dropbox doubled the magic $4 billion figure and is raising at an $8 billion+ valuation. Today, Spotify joined the $4 billion club.

Why have valuations gotten so much higher in recent months?

First, there's a lot of private money out there, and investors need to invest in something. When late-stage VCs stumble upon a startup that's could become a category leader, they're willing to throw tons of cash at it.

Uber, for example, is the category leader in on-demand transportation and logistics. Pinterest is winning in the visual retail discovery market.

"When one of the big players emerge [in a market], then you have these big firms that need to deploy a lot of capital," says RRE investor Steve Schlafman. "A lot of these companies don't need to raise more money...the only way these companies are going to raise more money is on a much higher multiple. But I wouldn't call it irrational exuberance. These are big spaces with likely one or two winners (transportation, music, discovery, messaging)."

It's important to note that a lot of high-valuation deals give investors preferred stock, not common stock. That means their investments are much less risky. Even if it gets bought for less than its official valuation, the preferred stock still gets bought out in full - sometimes at a premium or multiple. If a startup's valuation increases, both preferred stock investors and the founders win big. Even if a startup goes to zero, preferred stock holders get their money back first - if there is any left - while a founder with common stock might lose everything.

It's also important to remember that investors don't want marginal wins. They're after home runs, so it's in their best interest to keep promising startups private and flip them later for higher returns. Investors put money in Instagram at a $500 million valuation, for example, probably didn't anticipate the company selling for a smaller, 2X multiple.

To prevent startups from getting acquired early, some investors let founders pocket cash during fundraises. Founders are able to take a few million dollars off the table and become instantly rich, just like they would if they sold the company. Eliminating the financial lure of an acquisition keeps entrepreneurs focused on building longer-term businesses.

Snapchat's co-founders, for example, reportedly pocketed $10 million each during their last round of financing. They're rumored to be taking much more than that off the next round of financing - whenever that officially closes.

Some of the valuations are the result of hype though. And sometimes aggressive valuations can backfire.

"I think later stage investors are analyzing growth rates and size and using Facebook (and other public stocks) as a comp on valuation," one industry insider says. "If Facebook stock is high, than those startups will get a high price if they continue to exceed expectations. This can be tricky though, as we saw with [recent] late stage deals ... When growth slows down, the pain is harsh and swift."

Instagram would be worth $5B+ today. It buttressed FB stock & gave it's mobile strategy legs. Insanely smart,cheap acquisition by Zuck.

- Shervin Pishevar (@shervin) November 13, 2013