Tech Startup Valuations Skyrocket — What does a Bubble Look like?
Private company valuations jumped more dramatically last year than in any other year since the middle of the previous decade. According to PitchBook data, the median late-stage VC valuations in the US was about 20x revenue in 2021 — nearly twice as high as the year before (10.9x).
Nonetheless, founders keep raising larger and larger rounds at increasingly higher valuations. Software startups are still closing deals at valuations significantly above 100 times their annualized revenue, despite public SaaS companies trading many times below these levels.
Private company investing anno 2021
You are in a meeting with some VC investors about to pitch them your business. The investors squeezed you in for a 20 min session at noon, impatiently waiting for their 1 hour daily sushi lunch where they get to converse unicorns and trash talk performance of other VC funds.
Feeling prepared, you burst out the problem in the market and your unique solution to address it. You speak big numbers and remember to include “AI on the blockchain with 5G utilization”. Investors nod happily.
You then pull up your golden slide showing your user engagement and projected user growth. The graph is exploding out of the slide, so high is the growth. Investors nod again, thinking this is good.
Your business is pre-revenue but you built a disruption of no comparable magnitude, you tell them — and it will be easy to monetize users once you grow large enough! Margins are high! Estimated LTV/CAC is high!
Being the gentleman you are, you propose $5M for 5% at a $100M valuation. Your research indicates that it is a trillion dollar market, a big number — so there is no need to worry about the valuation now. And a low valuation will just signal that the business is “uninteresting”, you point out.
Pitch done.
The VCs deliberately debate in whispering language. “We need this deal” they mumble. “But the price is too high” one argues. “He’s an experienced guy” the senior states; “what can really go wrong here?”.
Someone is calling you. It is Sequioa Capital. They want in on your $100M. Your smile widens. You will get back to them shortly, you say.
The VCs hear your excitement and burst out a term-sheet. It is flaming hot; no preference shares, no nothing. Congrats. You now created your own bubble.
The morale of the story is that there is none, really.
Today’s market allows tech founders to get (irrational) investors buying into extreme valuations. Just take a look at the mesmerizing median (green line) valuation spike among early-stage tech startups in the US:
In the past three years the median early-stage valuation has roughly doubled. Startups however are not earning twice as much. Expectations to monetization and future earnings have never been higher, but why’s that?
First, late-stage investors are moving downstream and betting more on early-stage deals, which inflates valuations.
Second, cash is free and LPs are flocking to VC in the hope of superior returns. With more cash, VCs can afford to pay more in order not to loose a hot deal.
And finally, the anatomy of the VC investment model has been causing valuations to deviate from intrinsic values for as long as it has existed. This is the pessimistic view, at least. A bit more on that below.
The fallacy of the VC model
VCs have a high investment-to-loss ratio. The common rule of thumb in VC is that of 10 startups three or four fail completely; another three or four return the original investment; and one or two produce substantial returns. This high investment loss ratio pushes up valuations.
To see why think of the investment model as a price spiral; valuations are increasing because of more available cash and competition among investors, and a VC will therefore be paying more for their deals. The VC knows that only 10–20% of its investments will provide the needed returns, but it does not know from which deals. Alas, informational asymmetry is high and the VC bets more or less evenly across the palette.
Once the VC has made its investments, the information asymmetry decreases; the VC is now able to recognize its “winners” and “losers”. It is in the best interest of the VC to obtain the highest possible price on the equity of their loosing startups, as this will improve their book value performance in the short run and enable them to successfuly raise subsequent funds. However, the VC’s long-term performance will likely not improve with the higher valuations on their loosing startups, because, well… they are losing!
…Investors and acquires can see that the losing startup is not a strong case — they are overfunded and fail to achieve commercial targets! Yet, this is not too important for the VC who invested initially because they already priced in the fact that 80–90% of their startups fails. Hence, they doubled down on their winners in the meantime, securing themselves a nice fund performance.
Here comes the real problem — that evil venture capital price spiral. Those “losing” startups have now been invested in by other VCs, that in turn need even higher returns from their winning 10–20%. Paradoxically, the fallacy of investing aggressively in tech startups that are (oftentimes) not a good business at their current stage but that are expected to be so when they grow larger, is a self-destructing mechanism for the whole industry.
The principle of having a few deals returning the whole fund performance is what causes prices to go up to above intrinsic value.
And since this happens exponentially — i.e. the higher the valuations, the higher losses, and the higher the valuations needed to recoup those losses — valuations have increased notibly in the last couple of years.
So this really looks like a phenomea where one tech bubble is replaced by a new bobble, which is replaced by yet another bubble…
VCs do not do this intentionally, of course. It’s a self-eradicating model that will make the VC industry bust; this is the pessimistic view at least.
Eventually acquirers (PE funds, retail investors, corporates) will say stop; LPs’ will burn their fingers on their early-stage fund investments; VC firms will disappear and fewer funds will then be able to attract LPs’ capital.
Like a wildfire sweeping the old and making room for something new, I believe that the surviving VCs will have a conservative approach to investing in tech startups; favoring solid business models over unicorn potential.
So, two questions are of interest here for those that are still reading. Is there an early-stage tech startup bubble? And if there is, when would it burst?
Indicators of a tech startup bubble
A bubble means that companies are valued higher than they should be based on their intrinsic (fundamental) value.
A tech bubble is highlighted by rapid share price growth and high valuations based on standard metrics like price/earnings ratio or price/sales.
History has shown that investors deviate from fundamental value because of greed — or put more nicely, because of the “this time it is different” story.
And sure enough, there are many trillions of dollars of revenue not yet digitized, which tech startups and VC investors seek to capitalize on.
But the rate at which this happens — and can be effectively monetized — are probably highly overestimated right now. And one more thing; there is no proper risk tool for gauging risk in private company investing as optionality is thought of as an one way street only.
No VC has a clue about their true risk exposure.
Tech investors generally bet on future expectations, with their focus being on market share size rather than earnings. But the concern is whether the valuations meet the business model possibilities; a lot of capital seems to be focused on hype rather than substance in today’s market.
It’s easy to see VCs justifying their purchases by using different metrics while they often become blind to traditional investment fundamentals.
Many early-stage tech startups are burning through incredible amounts of cash. Some have a story, but no evidence, about reaching profitability. And they would like investors to believe that their losses can be erased quickly when they decide to become profitable and stop competing for market share.
But as seen in the case of Uber, Lyft and many others, this is a fairytale story. They are not able to sustainably take market share, and margins are thin.
Any macroeconomic event could in reality undermine confidence and bring everything tumbling down. Some top signs that we are in a tech bubble:
Early signs of a startup tech bubble
- Startups are overvalued
- Increasing numbers of IPOs
- Funds and investors moving out of the industry
- Unsustainable business models
Knowing if startups are overvalued is hard, but it seems that they are (charts above). Regarding IPOs, they have surged in 2021, raising $79bn in the first half year; which is already more than US IPOs raised in all of last year.
But as you can see on the left dear reader, some of the largest IPOs are not performing well, which clearly indiciates that the private market is overvalued.
Are funds and investors are moving out of the industry? There is no proof on that, in fact, more and more are coming out of the cracks. However seeing those that flee can be difficult, after all, they may not want to be heard and they are the “few” and “weird” that no one pay attention to.
And yes, business models are unsustainable — at least among a fair share of the early and late-stage tech startups attracting huge funding rounds.
Later stage signs of bubbly behavior
- People rushing into tech
- Fierce talent wars, both for startups and investors
- The arrival of the tourist investors (spray and pray investors)
- This-time-is-different story
- Companies getting funded solving problems that don’t exist
- More niche companies getting funded
According to Jeremy Grantham, the most reliable sign of a bubble in its final stages is a hysterically speculative behavior — especially by individuals. You can see this behavior in public markets with people buying NFTs and coins.
In private markets it is a bit different, but the biggest red flag is probably that investors bet on businesses that are solving problems that do not exist. Crazy.
State of play, 2022
Yes, I believe we are in a tech bubble. It may continue to be replaced by new bubbles (read: free money) in the short to medium term, but eventually valuations must come down to intrinsic values. We currently see tech valuations erode in public markets because of inflation, hence rising rates. In private markets not so much.
And yes, it is possible that intrinsic values can be met by other means than a big bursting bubble. For instance, digitization and startup monetization rates could increase faster than expected in industries such as construction or agriculture, which are two unbelievable huge sectors. Or it could be that LPs start to invest in VCs that do not bet wildly on unsustainable businesses, causing natural selection to kill those bad tech startups.
Michael Burry, played by Christian Bale in The Big Short and famous for predicting the 2008 subprime credit crash, has repeatedly being calling the current bubble the “greatest speculative bubble of all time in all things”.
And in a report by the European Securities and Markets Authority it was stated that the high debt, assets overvaluation, and growing speculation for high-risk investments could lead to a big crash in financial markets.
The trigger
While writing my concluding remarks here I simultaneously closed the book Antifragile (Taleb, 2012). To understand that you cannot predict black swans is pretty valuable, I think. And to know if you are fragile (hurt by volatility), robust (not harmed by volatility) or antifragile (benefits from volatility), should be food for thought. Generally speaking, founders are fragile, but the industry as a whole is antifragile exactly because of their fragility.
So, what to make of that? My bet would be a near mass extinction of those unsustainable business models — and the investors attached to them.
And what could be a trigger for that? I suspect rising interest rates could be a major driver, as already seen in public markets.
A rise in rates will squeeze out the cash in the industry because LPs will be drawn away from risky investments such as VC into fixed income opportunties. The real rate (adjusted for inflation) is down at -6%, so this is a definitely a plausible scenario. But it is rather foreseeable and already paid attention to by LPs, hence there will likely be no big “burst”.
Rather, it will be a long squeeze. Eventually those unsustainable business model founders will run out of cash. It will be more obvious to LPs that the investment thesis of certain VCs simply are not sustainable.
What many could hope for is private company valuations to come down in new funding rounds if tech stocks continue to trade at lower levels. I would be rather surprised if this happened. I think we need to see increasingly more heavily funded tech startups die, and with them their investors, for the industry to “wake up” and bet more cautionary in private companies.
A mix of excessive debt, near-zero interest rates, and wild speculation is a potential prelude to disaster. So, invest responsibly. Do not fall for hype.
What should resemble among investors and founders is that by chasing the highest of valuations, you put yourself in excessive risk.
When the dot-com bubble burst, private funding to technology companies dropped by over 80% and it took nearly a decade to recover.
Disclaimer: The views expressed in this article are non-political, non-commercial, and solely my own. The content here is for informational purposes only and shall not be understood or construed as financial advice.
About the Author: Joachim Schelde is an Investment Associate at Scale Capital, a danish venture fund investing €1–3M in Nordic B2B tech startups at Seed/Series A and helping them win in the US.
