Mega-funds can justify paying "stupid prices" at the seed stage because they aren't underwriting a seed-stage return. Instead, they are buying an option on the next, much larger round where they'll deploy real capital. This allows them to outbid smaller funds who need to generate returns from the initial investment itself.

Deals like Naveen Rao's $1B raise at a $5B pre-money valuation seem to break venture math. However, investors justify this by stipulating that proven founders in hard infrastructure markets compress key risks, making market size, not execution, the primary remaining question.

The memo details how investors rationalize enormous funding rounds for pre-product startups. By focusing on a colossal potential outcome (e.g., a $1 trillion valuation) and assuming even a minuscule probability (e.g., 0.1%), the calculated expected value can justify the investment, compelling participation despite the overwhelming odds of failure.

YC distinguishes startups from regular businesses based on their potential for exponential growth, aiming for billion-dollar valuations. Profitability alone defines a business, but not necessarily a startup—a key concept for aspiring founders.

Unlike Private Equity or public markets, venture is maximally forgiving of high entry valuations. The potential for exponential growth (high variance) means a breakout success can still generate massive returns, even if the initial price was wrong, explaining the industry's tolerance for seemingly irrational valuations.

A Series A company's valuation isn't based on current financials. Instead, it reflects the purchase of an 'out-of-the-money call option'—a bet that the company could become immensely valuable. The goal is for this option to eventually expire 'in the money,' generating venture returns.

The standard VC heuristic—that each investment must potentially return the entire fund—is strained by hyper-valuations. For a company raising at ~$200M, a typical fund needs a 60x return, meaning a $12 billion exit is the minimum for the investment to be a success, not a grand slam.

AI companies raise subsequent rounds so quickly that little is de-risked between seed and Series B, yet valuations skyrocket. This dynamic forces large funds, which traditionally wait for traction, to compete at the earliest inception stage to secure a stake before prices become untenable for the risk involved.

Venture capitalists may value a solid $15M revenue company at zero. Their model is not built on backing good businesses, but on funding 'upside options'—companies with the potential for explosive, outlier growth, even if they are currently unprofitable.