As 2021 wound down, The Exchange wanted to dig into what might happen if the startup music stopped playing. So we got veteran venture capitalist Matt Murphy on the phone to talk it over.
Murphy started his career at Sun Microsystems back in the mid-90s, joining venture shop Kleiner Perkins in 1999, where he stayed until 2015. From there, the investor changed teams to Menlo Ventures, where he’s worked since. For a little bit of context, Murphy has invested in DocuSign, Egnyte, AppDynamics and Carta, among others.
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But most relevant today is his experience investing during downturns, including both the 2000-era startup contraction and the 2008 financial crisis. So, armed with a grip of questions and a recorder, we talked through a host of topics, from current startup benchmarks to the durability of today’s startups and changes to the overall startup hit rate.
Our chat with Murphy was wide-ranging. To manage its length, we’ve sectioned his answers by theme, adding subheadlines in places where the topic changed slightly. We’ve also edited our questions down sharply and made modest edits to the transcript for clarity and length, including expanding certain acronyms.
Enjoy your snow-day read!
On whether the current period is overheated or backed by fundamentals
Matt Murphy: Well, I’m very OK with the investments I’ve already made being marked up, because that makes you feel like a hero, and very traumatized by trying to get into new stuff, because that makes you feel like a chump. [Laughter]
[But yes,] the way that valuations have changed and continue to change in a relatively short period of time has been astonishing. Definitely more so than in 1999. It just feels like this has been more of a durable period. It’s more distributed, and every time you think it’s a new max, something else happens.
On the state of the market today for hot early-stage rounds
Matt Murphy: Five years ago, we felt like Series A rounds went from $20-$30 million pre-money to $40-$50 million pre-money. Then in the last 12 months, that new baseline has been set at $70-$90 million pre-money, with not too infrequent outliers at $120 million, for a relatively raw Series A with less than a million of ARR.
$1 million of ARR used to be the magic number for a SaaS company [to raise a Series A], and now it’s somewhere between $300,000 and $500,000. So valuation is up, and the point at which you make that investment [is] earlier, which means more risk.
People are definitely taking on more risk. I think what people have started to say is there’s not that much difference between $1 million of ARR and $300,000-$500,000. In some ways that’s right, but with every step of maturity you get a little bit more data and longitudinal experience with the company.
At $300,000-$500,000 in ARR, the company probably hasn’t even hit a renewal cycle yet. Venture capitalists’ favorite number is net retention, because it tells you how healthy the existing customer base is and how much people do love [the product] once they have it. How can you do that when a company is that small? So unquestionably, people have taken on more risk and we’re all being forced to do that.
On the impact of high valuations on early-stage startup risk management
Matt Murphy: It’s why you see a bunch of venture firms like ourselves pivoting more and more into seed and even earlier stages. Because if a seed round is getting done at $20 million pre-money, and within six months an A round is getting done at $70 to $90 million pre-money, how much risk has really been removed in that six-month period? I might as well just get in at the seed stage and own a bit more for less and take more shots that way, than trying to spearfish at a very expensive Series A. Those are some of the dynamics that are going on in the early stage.
The later stage is so flush with capital that it is clearly the most competitive stage. It’s where capital’s the most commoditized. It’s about speed and who’s going to write the base check and things like that. The good thing at the earlier stage is that there’s still more of an opportunity to differentiate around what you bring to the table as an individual investor and board member, as a platform, and from the cluster of companies you’re associated with. At the later stage, it’s going to be brutal and we don’t really play there. We stop at early growth, which goes up to $10 million of ARR.
How the numbers can make long-term sense
Matt Murphy: Companies are growing much faster than they used to, and much longer at higher growth rates. It used to be that you’d immediately model out a public company as going to grow at 30%, 25% in perpetuity. And now you see these companies going out and growing at 80% and more, even when they’re public. Some companies are even accelerating after they get public.
I think those dynamics are allowing people to underwrite value differently. I’m not going to have a discounted cash flow (DCF) with a 25% growth rate for 10 years. I’m going to say 80% for three years, 60% for three and maybe 40% for another three. And that just gives you that whole different terminal value.
I think the other thing is there’s just so much capital, and clearly that dynamic is driving prices up.
The other dynamic that we see is that so many companies are working out right now. As VCs we look at all the companies we passed on for valuation, and oftentimes in the past, because so few companies worked, you’d feel relieved or realize that didn’t really matter. But now you look at so many of these companies you missed because you didn’t quite stretch on price, and they raised at three times that within some period of time, or they went public at some breathtaking valuation.
On rising startup hit rate
Matt Murphy: The point is that the hit rate of companies [is unprecedented]. In traditional venture metrics, 50% of companies don’t return capital and really only 5% of outliers drive all the returns. The failure rate is lower than 50% right now, and I would bet you’re getting a more distributed set of returns and the fund.
I think now people are having multiple companies that are doing really well. So those are a bunch of things that kind of changed the way you think about it.
Comparing things to 1999, the market felt like it was narrower. There were a bunch of companies that were feeding off each other, buying ad inventory from each other, for instance, or an incredible amount of speculation on what could be. Versus here, in most of these companies, you have real revenue, you have real growth rates, real traction, real metrics. People have a mental framework for what is a good company and not.
On today compared to the 1999 startup bubble and 2008
Matt Murphy: The only parallel I can really find with 1999 is that a lot of companies that are doing extremely well are selling to other fast, high-growth startups.
In 1999, you had two things. You had an infrastructure of the internet that was overbuilt. So for all the [telecom] companies that were booming, suddenly there was no demand. So that went to shit. That was one beautiful area.
And then the other area was e-commerce, media and all these things that lived on ad revenue, which dried up because all these companies were constrained on budget.
2008 was more about, “OK, what does this mean for the world?” It was like … our financial system felt upside-down. “Are all the banks going to fall apart? Is our currency going to be devalued?”
Everyone immediately ground to a halt. And then a year later, people said: “Oh, that’s not that bad. Let’s start re-accelerating.” The early 2000s were a horrible period for investing. In 2005, 2006, 2007, you started to feel this nice uptick. Then all of a sudden, it stopped. And then it kind of had a nice buildup again after about a year. So I guess the thing that’s hard to say is, what kind of shock comes?
It’s amazing that we lived through this COVID one the way we did. There was a period, a year and a half ago, where maybe 80% of the firms just stopped investing for a quarter. We were one of those because you’re just like, “Look, we might be back in one of those periods where it’s all hands on deck to the portfolio, assume half your growth rate.” A number of companies did layoffs … only to start rehiring six months later. So, I guess that shows some resiliency in this tech economy.
Concerns
Matt Murphy: I have got several concerns, but probably one of the most prominent is that everyone’s feeding off this incredible abundance of capital and spending for software. Does that music ever slow down or stop? And how does it impact some of these companies?