Why is Venture Capital Exploding Right Now?
Discussing bubbles, market expectations, and the catalyst of tech optimism in the market
Venture capital is at an all-time peak. Globally. Nationally. Across North America. Europe. Everywhere.
But why? What has happened over the last 12 months that has caused funding to flow into the private market more rapidly and intensely than it has in decades?
To answer this, we will take a step back to look at where we are today and how we got here.
The State of Venture in 2021
Today marks the first day of Q4'21, meaning that we will soon have a fresh batch of Q3 data to tell us what has happened in the venture ecosystem over the last three months.
As a refresher, let’s recall what the first half of this year has looked like.
The Explosive Story of Q1 & Q2
Q1 and Q2 were battling neck and neck to become the biggest venture quarters ever.
Global Funding Peaks
Global venture funding hit a record high in Q1'21 of $147B deployed, only to hit another record high in Q2'21 of $157B deployed.
Unicorn Count Peaks
The number of unicorns minted globally in the first half of 2021 exceeded the total number of unicorns minted in all of 2020. By ~2x.
US Funding Peaks
US venture funding has also been peaking over the last two quarters. $75B of funding was deployed in both Q1 and Q2.
That is $150B in the first half of 2021 in the US alone.
For context, $164B was the annual total of funding deployed in the US in 2020. 2021 is on track to nearly 4x that annual total to $600B. In just one year!
You might also notice that US funding is a large portion of global funding (approximately 50% of global funding in both Q1 and Q2 of 2021). However, it’s not just massive quarters coming out of the US that are driving this peak. Canada, Europe, and Israel have all had massive, record-breaking quarters as well.
Israel’s Funding Peaks
Israel hits $2.8B in funding in Q2’21, compared to $978M in Q2’20, nearly a 3x increase in funding in one year.
Europe’s Funding Peaks
Europe hits a whopping $34B of funding in Q2'21, up more than 3x from its total of $11B in Q2'20.
Canada’s Funding Peaks
Canada hits its highest ever quarter of financing, $4.1B in Q2’21, up more than 4x from its Q2'20 total of $840M.
All of these peaks beg some serious questions.
Why are things heating up so rapidly, so intensely in 2021?
Why is there so much money suddenly going into venture-backed companies?
What is driving the massive valuations we have seen across tech?
Is this spike justified, or are we in a bubble?
All good questions. Some harder to answer than others. All impossible to answer with 100% certainty. That is the beauty of betting on the future, and what makes venture so fun. No one knows for sure how it is going to look, in a quarter, two quarters, even a year — let alone 10. This uncertainty and rapid change makes this rapidly approaching future so exciting, riveting, and engaging to watch unfold (and analyze).
Let’s start answering these questions by reflecting on what we know:
Venture is at an all time peak.
What’s driving the peak?
- Bigger deals
- More deals
- More exits = more freed up capital to go back into the private markets
- More dollars being allocated to venture as an asset class = more demand for private tech deals
Factor #1: Bigger deals
The average deal size at all stages of venture capital has been steadily increasing for the last 5+ years, with a significant jump from 2020 to 2021, bringing us to our key question: what is causing deal size to increase?
Bigger valuations.
Despite company trajectories staying relatively consistent compared to 10 years ago, their corresponding valuations are increasing. In other words, revenue multiples are increasing, while company trajectories stay consistent.
Higher multiples
As a quick refresher, revenue multiples refer to the quotient of a company’s Enterprise Value/Revenue. So, if a company is worth $10M, and their revenues are $2M, their revenue multiple would be 5x. When multiples expand in a given industry, it means that it is not necessarily rapidly growing revenue that’s making a company more expensive, but higher multiples driving the high price tag.
The natural next question is: why are revenue multiples increasing?
A few reasons.
The size of the tech market has been highly underestimated. Despite the total market cap for public cloud companies hitting $2T this year ahead of schedule, we are still only at approximately 17% penetration for cloud spend, meaning the cloud/tech market is still less than 1/5th penetrated, and we have 5x more runway ahead of us.
This means that the runway ahead for these companies building for the future is at least 5x bigger than what it is today. In addition to this current untapped runway, the market continues to get bigger, meaning the 17% share penetrated is spending more, and the 82% unpenetrated is ripe for disruption.
These new valuations factor in the optimism/belief that with much of the market still untapped, we are just in the beginning of tech’s run. Thus, these new valuations are “pricing in the future” by paying up for where tech companies are today in the hopes that they will capture some of this untapped market as they grow.
Higher demand
Another reason these multiples are increasing is because the best tech companies are in such high demand. Especially considering Factor #4 driving this global peak: more dollars being allocated to venture investing → more demand and competition for these deals. As a result of the spike in demand, investors need to pay a premium for the hottest deals. As demand continues to grow, multiples may continue to expand as well.
While there’s tremendous potential for these companies, the reality is that some will fail to execute (or be slow to execute) and the premium multiples paid now for certain companies may not be justified. This is why it is becoming increasingly important in venture to be selective with the deals worth paying a premium for.
Factor #2: More deals
Key question: What is causing the number of deals to increase?
Rounds are happening closer together than they used to. We are seeing companies raising their Series A only months after closing their seed, and this trend is rippling out to later rounds as well.
This compression of the fundraising timeline has led to companies raising more rounds in a shorter amount of time, spiking the number of deals done in a given period.
Returning to Factor #4, demand is higher. This increase in demand is leading to more deals getting done. It is also leading investors to pre-empt companies before they may traditionally choose to seek funding, also causing a spike in deals funded.
This, in many ways, is healthy for the ecosystem, making it easier for founders to access funding without having to spend as much time and effort fundraising — instead they can just build. It can also be dangerous, because with so much money flowing into companies so frictionlessly, a certain portion of companies could be getting funded because of the space they’re in picking up momentum, rather than the value their company is individually creating.
Factor #3: More Exits
Exits are soaring. The number of exits in the first half of 2021 almost beat 2020’s full year total, freeing up plenty of liquid capital to be reinvested into the private markets.
Not only were there more exits, with Q2'21 representing an 8x increase in number of exits from Q2'20 and 2x from Q2'21, but the exit value remained strong. This means that these weren’t “fire sales” or rushed exits with companies being sold at lower values. These exits were standard size for what we’re used to, there were just 8x more of them. Craziness.
Key question: Why are there more exits?
Big tech needs small tech to stay relevant
With the rate of change in tech picking up, larger incumbents are realizing they need to keep up.
Bigger companies — both tech and non-tech — know they need to innovate, and one way that is far easier than doing so themselves is acquiring smaller companies who have the tech they need or want to create.
One large-scale acquisition example over the last 12 months: Salesforce acquires Slack for $28B.
Smaller-scale example: SNAP persistently acquiring smaller 3D/AR companies (Vertebrae, WaveOptics, Pixel8Earth) to expand its in-app AR efforts.
The proceeds of these acquisitions are largely going back into the pockets of the venture investors that backed these companies in the early stages. These investors now need to re-deploy much of this capital into new investments. This is leading to even more demand for private tech deals, driving up both the number of deals completed, and deal size in the private markets (they have the capital to pay up for the deals they want).
The public market wants access to the private market
The number of IPOs and SPACs done in 2021 was 5x the number done in 2020. Gross proceeds of these exits amounted to 4x the total gross proceeds in 2020, meaning the exit value was not greatly diluted by the sharp spike in volume.
There is such an appetite in the public markets for tech deals, that going out earlier and with slightly less-sexy metrics is becoming much more acceptable and better received. This is spiking SPAC/IPO count.
This public market hunger for private market deals brings us to Factor #4.
Factor #4: Public market investors are hungry for tech
The most obvious example to demonstrate the newfound attention that public market investors have been paying to venture investing is the all-mighty Tiger Global.
Tiger went from making virtually no private market investments to out-investing the top 4 biggest funds in the industry — in one year.
Tiger is just one of many hedge funds that are now playing in venture, putting pressure on venture capitalists from growth stage to seed.
Their interest reflects the excitement for early stage tech deals rippling across the market, as well as the impressive returns many venture funds have been demonstrating over the last five years.
TLDR: Everybody wants a slice of early stage tech.
Ultimately, all of these factors are linked:
Tech companies start doing super well during the pandemic
→ private tech market heats up
→ public investors start paying more attention, getting hungrier for tech
→ more money flows into venture as an asset class from traditionally public market investors (i.e. Tiger Global)
→ more demand
→ more deals are done
→ the hottest deals are priced at a huge premium (multiples increase)
→ the great deals do super well
→ their investors do super well
→ they have more $ to invest
→ they can afford to invest in more deals at higher prices
→the space remains hot
And so on and so forth.
Which leads us to our big question of the day:
Is this all a bubble?
Is this sustainable? Are these valuations justified?
Let’s take a look at where we are today compared to the 1999/2000 period, the famous tech bubble which burned many investors at the time.
While we’re seeing an analogous spike in the number of IPOs and SPACs to the ‘99/‘00 period (which is understandably alarming), it’s important to recognize that the IPO Size:Revenue ratio is much healthier today compared to ‘99/‘00. Both the median and the extreme cases are significantly less inflated today, though there has been a steady increase from 2017–2021 mimicking the rise from 1997 to 2021 (largely due to some of the aforementioned factors).
Revenue multiples are also much healthier now, with far less variability at the tail ends of the bell curve.
So, what does this tell us?
While it’s certainly possible that tech valuations may be a bit frothy right now due to heightened demand from investors new to the private markets, mega funds being deployed at much faster rates (see chart from earlier demonstrating Tiger Global’s recent activity), and extra attention paid to tech during the pandemic, this might also just be the beginning of this growth stage for tech, with investors finally understanding the runway still ahead and just how big the market can be at full penetration.
TLDR: In ‘99/’00, a sharp spike in hype, optimism, and confusion allowed companies with little to no revenue to be dramatically overpriced.
In 2021, the market is heavily rewarding companies creating real value (even if they’re early). An investment in one of these companies is a bet on the company’s ability to grow, find or maintain product-market-fit, and the future of tech being largely untapped, and enormous.
To wrap up here — no one knows the future.
No one knows exactly why we are where we are today. But a lot of signs are pointing to the fact that these valuations are here because people are finally seeing the full scope of tech’s market opportunity (it’s huge), and are flowing as much capital as possible into the companies they believe can capture it.
In short, the future is coming at us fast, and everyone wants a piece. And these days, that piece is costing all investors (public, private, early stage, late stage) a very pretty penny. But is it justified? The more we zoom out and look forward, the more the evidence is pointing to… probably.
That being said, every investor must proceed with caution and select carefully, because no matter how hot a market is, venture has always followed a power law, with most companies not succeeding, a few doing fairly well, and even fewer doing incredibly well.
The hard part is determining which ones will fall into each bucket.
We should get Q3 data in the next couple weeks which will show us which way the market is swinging. It feels like momentum has continued to build since Q2 and we may see another booming quarter when totals are tallied up.
With a new wave of exciting companies being built around Web3, the creator economy, blockchain and other rising tides, it will be interesting to see how funding ebbs and flows into these categories as they evolve as well.
It might be time for another deep dive to refresh some of these perspectives when data on the second half of 2021 hits.
In the meantime, happy Q4! Stay vigilant, curious, selective, and optimistic as you invest, ponder, and read about tech.
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