Tech valuation 🚀 🌒

Anecdotes and data

Startup valuations 🚀 🌒

In 2021, there is not a day without a $X billion startup headline in the media. The frenzied pace of investing is astonishing to those detached from the startup scene. To New York Times, it seems insane. To my friends, it seems like investors are jostling to invest in the first billion-dollar slide deck.

Yet even for investors, the pace is stupefying. The recent media favorite is Clubhouse, the audio-only social app. It was valued at $1 billion even though it did not make any money, yet. But among venture investors, Retool, a low-code software platform, is generating more fuss. Consumer social apps are first measured by users as they scale to reach a critical mass of userbase that can then be monetized. But business software tools are measured by revenue from the start. Retool was valued at $1 billion with only $10M of revenue. A 100x revenue multiple, when not too long ago 10x was the norm. These exemplify how startup valuations have soared over the past decade.

It is an interesting dynamic because investors don’t like high prices, yet they continue to drive it higher. Not only will returns be lower, but it will also be more difficult to process an investment. In venture, there is a lot of selling needed to get to the point of owning company shares. There is no one-click investing like in public markets. First, investors need to sell to founders that they are the best partners. Then to their partnership that there is a lot of money to be made.

A higher valuation also means more risk. As valuations increase, so do the funding rounds, which means investing a larger portion of the fund. Investing 1% of the fund is fundamentally different from 10%. From a portfolio management view, 10% concentrates the fund too much. From a deal perspective, convincing investment partners that risk is worth it is another hurdle.

Going back to Retool, Sequoia led the $20 million series A round. According to Pitchbook, the average venture fund raised in 2020 is $235 million. The round would have been 9% of the average fund. Incorporating the practice of reserving an equal amount for future rounds, the commitment is effectively 18%. But for Sequoia, $20M is just 0.9% of the $2.15 billion it raised in 2020 for US investments.

So, in this essay, we explore why investors continue to bid up startups. Even when over 90% of them think startups are overvalued.

Supply and demand

One way to look at it is in terms of supply and demand for startups. The Bureau of Labor Statistics (BLS) tracks how many new businesses are created each year, which grew 40% to 804,000 since 2010. But this pales compared to the flow of new venture capital looking for startups, which grew by 380%. The gap may even be larger since BLS registers all types of businesses, including mom-and-pop shops, which are not suited for venture funding. Looking instead at the de-facto venture database Crunchbase, the number of startups created in 2020 is surprisingly just a fourth of the number in 2010. Even fewer startups for venture investors to chase.

Statistics reveal just the surface of the matter. The set of startups that a venture fund can invest in is much smaller than what the charts suggest. There are easily 10–20 companies building competing products, and investors can only choose one. Investors have an informal agreement with founders to not invest in competitors. Contrast this to the public stock investors who can invest in every company in a sector. Coca-Cola’s CEO does not care if you own both Coke and Pepsi shares.

Hence, you’ll often hear that venture investors are frantically chasing the best deals. What this often means is the best leadership team. Convince enough engineers to join, you can build any product. There is only one Jack Dorsey. One Elon Musk. One Bill Gates. One Jeff Bezos. One GP told me recently that while there are several exciting startups he could invest in this year, he is dropping everything to focus on investing in a stealth startup run by an enterprise software legend. He is convincing the CEO to take his money even though Sequoia and a16z have already verbally committed to writing blank cheques.

How venture capitalists value startups

I’m still mentally reconciling my Philippine childhood, where less than half of the people earn a livable wage and my current job where investors are sending millions to founders unsolicited. But I digress. There is some rationalization to the seeming madness. After all, venture investors are finance professionals.

My venture 101 professor taught several startup valuation methods, each with its nuances. But all boil down to the expected exit value. In a survey of 885 venture investors, 86% answered that expected exit is a key consideration. Half said it is the most important. So how are startup exit values calculated? On the crude end, investors look at comparable public companies. Snowflake will replace Oracle with a much better product. Therefore, Snowflake will eventually be worth over $200 billion. On the sophisticated front, investors estimate the likelihood of different exit scenarios and calculate a probability-weighted return. I’ve illustrated a simple example below, but you can find excellent examples from Bessemer’s investment memos and Ulu ventures’ decision making framework.

A few factors essentially determine the valuation equation. So let’s look dive into what data says and answer the questions:

• Did the exit rate increase? Exit rate is the probability of getting acquired or going public.
• Did exit size increase?
• Did cash-on-cash (CoC) return increase? CoC is the exit size relative to startup valuation.

Did the exit rate increase? No, it decreased by 5% points.

Y Combinator launched in 2005 with eight companies. Their latest Winter 2021 cohort had 237. That means almost 500 for 2021. YC’s policy to grow as there are many good applications feeds into the anecdote that the number of quality startups is much larger than in the past. Educational content is now accessible by anyone. Further, past entrepreneurs continue to mentor new entrepreneurs. New founders can avoid common pitfalls and grow faster. Though that is the case, the percentage of companies that exited, which is a measure of success, decreased from 20% to 15%. Though there are more startups that exit, there are even more that become inactive. Y Combinator just gets more of those that exit, with a 31% rate for its pre-2009 portfolio.

Did exit size increase? Yes, across the board.

Another anecdote that gets passed around is that exits are much bigger. It is not about getting unicorns anymore. It is about decacorns. When Aileen Lee coined the term unicorn in 2013, only 16 startups joined the club that year. In 2020, it was 223. Three unicorns were born every five days. In 2021, 77 to date. One every day. While startup valuations are “paper” in nature, they signal how big exits would be since startups would only want to get acquired or go public at higher valuations. The average IPO exit used to be below $500 million. Today it is over $2 billion. Though less pronounced, M&A exits have doubled from $150 to $300 million.

Did CoC return increase? Yes, largely because of IPOs.

What matters to venture capitalists, in the end, is the return they can get. While exit values have increased, so have startup valuations. Using a simple heuristic of the ratio of startup valuations to exit values, the higher prices seem justified. While exit rates have gone down, the potential CoC returns of IPOs have increased significantly.

Using the probability framework earlier, we can see why investors continue to pile money into venture capital. Despite valuations going to the moon, expected returns have increased.

Public market valuation 🚀 🌒

Since public markets warrant the rise in startup valuations, let’s look at publicly-traded software companies where valuations have grown the most. Bessemer constructed the EMCLOUD index composed of 61 of the best cloud software companies. It is a good proxy of the software industry. Since mid-2013, the index grew by 1,000% versus just 274% for NASDAQ and 140% for S&P 500. EMCLOUD revenue multiples quadrupled from 5x to over 20x.

But do those valuations make sense?

In 2020, only 20% of tech companies that go public were profitable, almost as low as in the dot-com bubble. Goldman Sachs created an index of unprofitable tech companies, which tripled in value from last year. It seems like the more money a tech company losses, the higher the price investors are willing to pay.

The rationalization peddled around is that software companies are now growing much faster than before. Sure, they might be losing cash, but it is for the sake of growth. That justifies the higher valuation multiples across the board. Supposedly.

Going back to fundamentals, a company’s financial value is determined by three things: cash flows, growth, and risk. So let’s dive into the data and answer whether companies in the EMCLOUD index:

• Are growing faster?
• Are burning more cash? This is calculated with free cash flow margins.
• Are less riskier?

Instead of looking at the index average, we’ll look at cohorts based on when companies went public. It reveals how companies have and haven’t changed.

Growing faster? No, it is the same.

Burning more cash? Yes, by a lot.

Less riskier? Yes. Rather, software ate the world.

Risk is difficult to quantify. No accounting rule captures it. Finance theory measures it as volatility of stock prices, but it does not grasp what we think of as risk. In some ways, we can only intuitively gauge it anecdotally.

You are probably inundated with data at this point, so I’ll spare you from charts about the rise of smartphones, broad access to the internet, and the shift to the cloud. Simply put, we became a software-first world. The question is not why software but why not. In 2012, I bought a 50mm f1.8 camera lens to get the bokeh effect I love in portrait photos. Today, I get the same effect with one click in my phone app. There is an app for (almost) anything a consumer wants. I imagine that when Marc Andreessen was writing his seminal essay a decade ago, the question that investors thought then, “Will this even work?” Today it is, “This makes total sense. Why hasn’t anyone built this yet?” Software is not a risk anymore. It ate the world.

But there is a difference between being bullish about software as an industry and a software company. Investors, both retail and institutional, are applying the same excitement to all companies, especially unprofitable ones. Am I sounding the bubble alarm? Maybe. But what I am sure of is that today’s public software companies are not growing any faster than before and are burning a lot more money.

What should I do as a venture investor? Valuations will remain elevated with more venture capital chasing fewer startups. Venture returns as an asset class might compress. That means I just have to be much (much) better at finding, picking, winning, and helping startups than others.

I bet that if I asked Marc the same question, he’d just send me the screenshot below.

Actually, he will just ignore me.

Originally published on Substack.