How to make the math work for today’s sky-high startup valuations

Venture capital price discipline is out the window; venture funds are looking to make faster, earlier deals; and more unicorns were minted in the last three months than during any quarter in history. It’s a busy time for startups and their financial backers. Now weeks into July, it’s increasingly clear that 2021 is shaping up to be a record-setter for venture capital investment. And investors don’t expect the frenetic pace to slow.

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But while the dollars flowing into global startups are setting all-time records, deal volume is not tracking similar extremes. Global deal volume reached a record in the second quarter, but it just barely eked out a win over several quarters from 2018 and Q1 2021.

A flood of money invested against more modest deal flow has helped drive up startup valuations this year, along with deal sizes.

CB Insights data indicates, for example, that median Series A valuations rose to $42 million thus far in 2021. That’s far above 2020’s median Series A valuation of $33 million, also beating the previous record set in 2019 of $39 million. The same dataset indicates that Series B, C, D and E rounds also reached new highs in 2021 compared to years going back to at least 2015.

So startups are getting larger checks, earlier. Does that mean that many startups are landing investments with smaller revenues than their stage (or capital base) would normally require? Yep.

Yesterday in a public discussion of startups valued at $1 billion or more — unicorns, in our modern parlance — Boldstart Ventures’ Shomik Ghosh said something that matched what The Exchange has heard from other investors, albeit in more private conversations. The Exchange estimated that the percentage of unicorns with valuations between $1 billion and $2 billion with $100 million in revenue was small. Ghosh took note of that approximation and wrote the following:

Let me translate: Here the Boldstart investor is saying that it’s now common to invest in startups at a valuation that works out to 40 to 50 times those companies’ annual recurring revenue, or ARR. LTM stands for last 12 months, indicating in a somewhat slang fashion that we’re not discussing forward numbers.

That’s what NTM means: next 12 months. Ghosh’s statement indicates that some startups are actually able to raise capital at even higher multiples of their current revenue, enjoying pricing that can work out to 100 times their ARR for next year.

This yields some questions. For example, The Wall Street Journal’s Christopher Mims asked if low startup revenues compared to their valuations indicates that there are a great many houses of cards set to fall in time. The answer is maybe, but probably not. Let’s talk about why the math can work out for startups with minimal revenues, rich valuations and lots of cash.

Penciling out the math for today’s startup valuations

Ghosh is not the only investor discussing big prices and sometimes negligible revenues at hot startups. Other VCs have told us that Series A rounds are being done in the low hundreds of thousands of dollars of revenue, provided a strong growth rate and reason to believe that the company’s growth can persist or even accelerate.

Factors driving these rounds can vary: an active open-source community indicating a large future pool of developers to monetize; a target market that is accelerating thanks to external conditions; founders with successful histories of building large companies; fintech. You get the idea.

To put a more specific example into the mix, let’s mention Sourcegraph. The startup just raised capital from a16z at a $2.6 billion valuation. Previously, Newcomer reported that the company had reached a revenue run rate of around $10 million. That’s a present-day ARR multiple of around 260x. Now, the company may have grown since those numbers became known, limiting its multiple to some degree. But the company is still rather expensive.

A good question at this juncture: So what? Why do we care if startups are able to raise capital at prices that would have been venture nightmares in years past? Because startups take on added risk when they raise at a price that is outside historical norms. It’s not hard to come up with a list of risks startups accept when they raise lots at a rich valuation:

  • Revenue growth failing to meet expectations, leading to difficulties raising capital at an attractive price later on.
  • Creating a halo effect around their target market, leading to well-financed, me-too competition.
  • Raising too much money too young, leading to a lack of focus, lax spending discipline and hubris.

In today’s risk-on startup market, those concerns aren’t given much consideration.

For investors, the risks in investing in startups at historically abnormal prices include the following:

  • Revenue growth failing to meet expectations, leading to stagnant or falling valuation marks at the company.
  • Painful fund lock-up in an investment that isn’t performing, exacerbated due to rising round sizes.
  • Signaling risk leading to rising founder valuations expectations, possibly limiting future returns in other deals.

But while things can go wrong at richly valued startups with limited revenue histories and lots of potential, a lot can go right as well. So, let’s talk about what happens at startups when things pan out, and what happens when startups slip and find themselves moving more sideways than forward.

The bull case

In the bull case, startups that raise at a high price can put more capital on their books; this can provide years of runway. Extended runway, in turn, can provide startups with time to recover from stumbles.

If a startup growing at a 300% yearly pace raises a big check at a high price, sees its growth fall to 100%, and then recovers the next year, it can get back on track without needing to take on more capital in the interim. The startup is, therefore, able to power through a trough thanks to its cash supply.

More cash at a higher price may also allow startups to staff up quickly when they otherwise might have had to wait, perhaps access more expensive talent, and spend more on marketing and sales efforts that may help it better attack its target market ahead of the competition. Those can be positives.

In short, startups can have more time to grow into their new, higher valuations thanks to the larger rounds that helped drive up the same valuation figure. Provided at least a modicum of spending discipline, of course. That, plus access to potentially stronger human capital, can help a company that suffers a short-term hit to its growth rate get to where it needs to be later on. Or at least grow to the point where its most recent investors are effectively made whole, buttressed in part by strong public-market valuations for the sorts of revenue that startups generate.

Yes, but

Undergirding all of this, as well as VC expectations regarding the future worth of their portfolio companies, are strong public-market multiples for growing tech companies. If those slip, the game could get messy in a hurry.

Here’s why: If public-market investors decide that recurring software revenue (SaaS top line) is not worth the present-day 21.3x multiple that Bessemer’s cloud index counts, but instead worth 15x, startup valuations will also dip. Why? Because investors pay for startup equity today in hopes of a strong exit later. If anticipated exit values fall due to slipping public-market comps, investors won’t pay as much for present-day startup shares.

To avoid a down-round, startups in a lower-multiples world would thus have to generate more revenue just to stand still; they would have to grow faster. That situation undercuts the potentially positive impact that larger, more expensive rounds can have on startups. If startups have to grow more quickly to defend their valuations as a result of falling public multiples, their ability to lose some time between rounds with periods of slower-than-anticipated growth diminishes.

Risk would go up.

Today we can make super-expensive startup math work out, provided that growth rates stay generally strong and public-market multiples stay rich. If the latter dips, the former has to improve, and vice versa.

A high-wire balancing act from investors to get into the right deals but not overpay too much? Of course. But it’s called venture capital, not banking, for a reason.

Over the next 24 months or so, a lot of companies that raised aggressive rounds in the last year will have to go back to the well. At that point, we’ll get a picture of whether many deals made today are shaping up to be winners, neutral results or stinkers. But with interest rates low and stocks high, there’s more than enough money betting that everything works out.

We’ll see.