There was a quite a jolt on Friday from the news that Slack, a company whose eponymous enterprise communications platform was first publicly launched this year, raised $120 million in new venture funding from KPCB and Google Ventures.
Even more eye-popping was the valuation: $1.12 billion. Although Slack pivoted from an earlier incarnation as a games company called Tiny Speck, such a growth in valuation in just the first 8 months of a new product’s existence is almost completely unheard of in the annals of venture capital. This is even more true in the lethargic enterprise space, where there is significantly more friction in adoption and sales than in the consumer market.
What might look like a frothy bubble though, is in fact a much more fundamental change in the way venture capitalists perceive investments. These fundraising accelerations are here to stay, and represent a far more nuanced view of startup performance than we have ever seen before from VCs.
VCs have always known that the big returns are made from the largest exits. What the industry has slowly accepted over the past decade is that the biggest winners win by staggering amounts compared to their competitors. What used to be perceived as a 5x or 10x gap in valuation between the winner and a runner-up is now more widely seen as between 100x or even possibly 1000x. For every 100 startups that exit above $100 million, only one of them will reach into the billions of dollars of capital. Facebook’s chief competition during its rise was from companies like MySpace, which are almost non-existent today.
The person who most popularized this notion of investing was Marc Andreessen (who ironically also happens to be one of the earlier investors in Slack), as well as Peter Thiel, whose experience with Facebook’s growth encouraged his investment thesis for Founders Fund. The essential point is that if there are only a handful of startups a year where the vast majority of the returns go, then the only sensible investment strategy is to get into those startups and ignore the middling winners.
This philosophy leads to the current investment strategy that I call fundraising acceleration. If price sensitivity on these top winners makes little sense, then we should be willing to project ahead of a company’s growth and buy early. We might value the equity of a company 12 months early, meaning that we would invest as if they had already secured the growth of the coming year. Maybe we are even willing to accelerate our price by 24 or 36 months.
This absolute laser focus on the winners has led to the current data revolution in venture investing, where firms hire teams to scour the web for signs of startups breaking out, all in the hope of catching the next winner before any other firm realizes what is happening.
We can see this new approach right in Slack’s own numbers. The company told TechCrunch that it is currently generating sales above $1 million per month, or (and I know VC math is complicated) about $12 million per year in run rate. Since the company is valued at $1.12B, that means that its revenue multiple is about 93x. In general, SAAS companies have run rates around 8–12x on the public markets, and possibly a bit higher multiple in private rounds.
To put it another way, if Slack had the same annual revenues as LinkedIn at $1.5 billion in 2013, it would be valued at almost $140 billion and become one of the most valuable technology companies in the world.
Compare this to Yammer, which was founded in mid–2008 and sold to Microsoft just a little under four years later. It raised $142 million in venture capital according to Crunchbase, and sold to Microsoft for $1.2 billion. That means that in less than a year, Slack has raised more money and has a higher valuation than its immediate market predecessor.
Some might call this a bubble, but Slack is literally the embodiment of the fundraising acceleration thesis. The company’s sales growth is incredible – achieving a $12 million run rate in the first year of the company’s product launch is among the fastest growth rates seen for a SAAS startup.
Given the investors in the syndicate, it is clear that many have started to take this fundraising acceleration to heart. However, as the competition for these identified early winners becomes more keen, the valuations of these companies skyrocket. All of these investors are sophisticated and can see the same data, and when growth metrics are this good, everyone wants to get a piece.
This is great news for some founders. Founders with high growth companies can now command a growth premium that gives them more resources earlier in the company’s life than before, without losing as much equity. That means startups that can find growth extremely early are able to build even more advantages over their competitors.
The flip side of course is that founders who struggle to find growth early on may find raising funds even harder than before. Can you get 100 million users in the consumer world within three years? For enterprise startups, can you get $10 million in yearly revenue within the first 24 months of launching a company? As VCs seek the top 10 winners and recalibrate their expectations to the growth of companies like Slack or Snapchat in the consumer market, the bar is rising quite quickly. A few percentage points difference in growth can radically change the outcome of a fundraise process.
And even for those startups that do hit that peak level of growth, there are still the very challenging scaling issues of building a business. Slack may be led by Stewart Butterfield, a highly-experienced entrepreneur, but he still has to recruit in an incredibly competitive labor market. With the company’s valuation so high already, he no longer has the promise of massive equity paydays to easily entice prospective new employees. How quickly can hiring scale with user growth?
Those challenges for founders are nothing compared to the real challenge for VCs, who must show a return on these accelerated deals. As valuations grow, the multiples on investment that VCs can earn on the biggest winners is rapidly declining. If that happens consistently and VCs can also identify the winners with enough accuracy, much of the returns in the industry could be flushed out through competition.
And we are still early for judging the accuracies of these large bets. While data has certainly improved the quality of VC decision-making over the last few years, we still have a few years to go before we can really see the results of this new investment thesis.
Fundraising acceleration is the new modus operandi for top VC firms in Silicon Valley. So far, it has been carefully executed, generally targeting startups with strong growth potential. It’s not a bubble, and it is certainly not crazy. For founders who can take advantage of that early focus on success, the sky is the limit.