The Startup Market is Taking on More and More Risk

Hello from the freezing East Coast of the United States, where I am avoiding the side effects of my COVID-19 vaccination booster injection by eating doughnuts, the third dosage of Moderna is not quite as horrible as the second but who knows what is next. Therefore, we will keep it short today in case I slip out of my computer chair and into a slumber in the middle of a keystroke. To begin, I would want to express my gratitude. This little weekend email now has well over 30,000 subscribers and a weekly open rate in the mid-to high-forties. It’s part of a wider effort I started when I returned to TechCrunch, but it was not clear when we linked the newsletter to the regular Exchange sections.

To be honest, I felt it was a coin flip whether or not it would draw a crowd. The gamble paid off, and because of your efforts, The Exchange now publishes six times weekly. That is a lot of fun. Thank you very much. Now, take a chance! We discussed a few weeks ago how dangers from the startup industry are increasingly making their way into the public markets. Because of SPACs and certain unusual public offerings, normal investors may now get their hands on more fledgling, higher-priced startup shares than before.

However, there was an implied argument within that statement that startup risk is also increasing for its private market funders. Let us have a look at what is going on here:

Startup valuations are growing because of abundant funding, limited high-yield investments, and other challenges. This is not the first time you have heard it. Startup values are also growing as more investors enter the market earlier in the process. This is not the first time you have heard it. 

However, you may be unaware of how this is a self-reinforcing problem. Given the scale of their assets, major funds can invest “earlier” than they could otherwise, taking out an option contract on a greater purchase of shares in the business in question without jeopardizing their overall return profile. This pushes later-stage capital to come in early. Because of the dollar gap, later-stage investors are less price-sensitive to early-stage values, causing valuations to grow.

Simply said, if you had $1 billion to invest and put $5 million into a Series A, it does not matter if the company is valued at $65 million pre-money or $75 million pre-money. What matters is that you invest another $50 million in the winners when they raise their next round.

However, there is more: According to The Exchange, startup values are soaring in part due to growth rates at IT businesses that are not only greater than projected, but also more durable than expected. That is to say, former startups are going public at a quicker rate than many predicted, and they are maintaining that growth rate for longer.

As a result, IT businesses may be worth more in the future than expected, allowing investors to pay more today and not worry as much as they might otherwise. Another issue to consider in terms of growing pricing, as Menlo investor Matt Murphy recently emphasized to me, is that traditional venture failure statistics are now wrong. He claims that the failure rate has decreased and that the all-important hit rate has increased.

If you consider the foregoing as its whole, you could conclude that all those insta-unicorns and six-figure rounds make sense. It is a reassuring point of view to have. After all, the ostensibly wise money is betting that increased expenses will be offset by quicker, more durable growth and fewer failures — essentially, that SaaS is difficult to kill — to provide the kind of returns necessary to make venture math square up.