Welcome to 2021, a year that could extend 2020’s startup market disruptions and excesses — or change patterns that previously performed well for early-stage tech companies and their investors.
The Exchange explores startups, markets and money. Read it every morning on Extra Crunch, or get The Exchange newsletter every Saturday.
As we turn the page, I have a number of questions worth raising as we muck into 2021.
Each relates to a 2020 change that is expected to persist, by either the general market or those bullish on startups. I want to know what would need to change to shake up what became the new normal last year. After all, it’s precisely when it feels like nothing could shake up a downturn (or a boom) that things often do.
Today, let’s discuss seed deals, venture investing cadence, the resulting valuation pressures from rapid-fire bets, current IPO expectations and what happens to software sales when remote work begins to fade.
1. How long can seed deal-making stay hot?
As 2020 came to a close, Natasha Mascarenhas and I reported on seed investing’s strong year and its especially strong second half. How long can that pace keep up?
Nearly all our questions today deal with the endurance of certain conditions, namely: how long the market can keep parts of startup land red-hot.
When it comes to seed deal-making, Q1 and Q2 2020 saw similar levels of investment in the United States. But Q3 proved explosive, with money invested into domestic seed deals rising from around $1.5 to $1.6 billion during the first two quarters to $2.2 billion in the July-September period.
Q4 numbers are yet to fully come in, but it’s clear that private investors were incredibly bullish on early-stage startups in the second half of 2020. How long can that keep up? I think the answer is for a while yet, as investors have shown scant enthusiasm for slowing down their dealmaking cadence.
While cadence remains hot generally, seed deals should stay heated as the number of investors who are willing to invest early has increased.
Which brings us to our second question:
2. How long can investors keep writing such quick checks?
A theme that cropped up in the second half of 2020 was the pace at which investors were conducting venture capital deals. This was for a few reasons. To start, venture capitalists have raised larger funds in recent years, meaning that they need larger returns to make the math work out. This led to many investors putting money to work in younger and younger companies, hoping to get in early on a big win. That setup led to more deal competition and faster deal-making.
How? Two things. Investors who were already on a startup’s cap table — already part-owners, in other words — led preemptive rounds, in part to get ahead of other investors who might want to poach the succeeding deal. Other investors, knowing this, seemed to do the same math and move even faster, and earlier, to get around the defense.
So how long can the trend keep up? Given that many big VC firms raised in 2020, many startups picked up some tailwinds from the COVID-19 economy and exits have been strong, forever? Until something stops things? Think of it as Newton’s First Law of startup investing.
What could be the sudden impact to shake up the current set of conditions boosting the pace at which seed and later deals occur? An asteroid strike is probably too extreme, but inertia is one hell of a drug and markets love to stay happy.
Moving along, all the competition to get money to work in hot startups now has had another effect than the mere speed of deal-making; it has also pushed prices higher.
3. How long can startup valuations be based so heavily on far-future growth?
Let’s work backward. Public software companies, public electric vehicle companies and other public companies that were once startups had a great 2020 in terms of their market valuations. Stocks went up, and so too did the value of many public tech companies.
This meant that late-stage startups got ready and went public. Those IPOs often did very well. So, prices for other companies a bit earlier-stage also did well. We saw this in the pace of unicorn creation toward the end of 2020.
But what about earlier startups? They also got pretty expensive, anecdotal evidence and data tells us. Recall that we noted seed investing was strong in 2020? Seed rounds also got bigger, implying more expensive deals last year. So we can get our heads around startup prices in general rising last year.
So what? Investors, when they pay more for a startup than they otherwise might have in less-frothy conditions, are simply making a bigger bet on future growth, and less of a wager on the startup’s performance to date. This gets somewhat absurd when startups can snag a 100x ARR multiple or similar in an early round; in those cases, investors are betting nearly entirely on future growth compared to current metrics.
Valuations will remain hot as long as deal-making remains super active, which means that we’ll likely see the two rise and fall in tandem. But I reckon that price could fall some ahead of cadence if we saw some startups that managed huge valuations off small revenues stumble publicly. That could impact early-stage valuations while leaving more mature startups more tied to the value of public comps to some degree.
But, again, we’re considering change based off of future hypotheticals. That’s uncertain terrain and implies that the status quo could have room to run.
4. Can the 2021 IPO market live up to expectations?
This is a simple question. Currently many companies are prepping debuts. Whether it’s a delayed IPO like Roblox, a potentially exciting entrance from Coinbase, or just a horde of SaaS companies that will do fine but generate less press, many companies want to get out in 2021.
These IPOs are expected. But what if they don’t come? That would require some sort of system shock. Perhaps a public market crash of 15% or more. Or President Trump managing to steal the election; that would shake things up.
But, a bit like VC deal-making and startup prices, inertia seems to be the main thing at play. Why would IPOs slip if the underlying conditions that led to a strong 2020 persist in 2021?
5. What happens to startup growth rates when the world returns to normal?
Bad things. Underlying all of our above thoughts is the presumption that startup health remains generally strong. But a key question for 2021 is what happens to software growth rates when remote work fades and we all slowly crawl back into public places.
Bulls will tell you that nothing will revert when it comes to spend; software that was bought will stay purchased, implying that churn won’t rise too much. And the same folks expect that software revenue growth won’t slow materially.
Perhaps! But if churn does get nasty in Q3 and Q4 of this year, that could undercut everything: The thesis that software is immortal and enduring. That could reduce valuations, extend deal-making time and more.
We’ll see. 2020 taught us that nothing is to be counted before it happens. Let’s see how many of the above concerns wind up being bass-ackward by Q3.