Venture capital and private equity has always been a part of the startup ecosystem, but in 2021 we saw some noteworthy trends and developments. In this article we will take a look at some Venture Capital trends in 2021, and implications for it affects entrepreneurs and investors.
Venture capital funding has been strong over the past decade. The combination of an increase in public market valuations, technology companies’ strong performance, and accelerated digital adoption has led to robust VC fundraising. In 2021, Venture capital valuations tended to go up. One thing that should go without saying is that different companies are valued differently based on many factors including their sector, stage of growth, and founder’s reputation.
A Record Number of Venture Capital Unicorns Were Created
In 2021, the US venture capital industry generated a record number of companies valued at $1 billion or more (also known as ‘Unicorns’). This exceeded the combined total of each of the five previous years.
In last year’s Venture Capital Unicorn deals, meaning companies valued at $1 billion or more, investors invested about $70 billion, according to PitchBook data. By contrast, in each of the prior three years, the amount invested in VC Unicorns has been in the $15 to $20 billion range. What we saw in 2021 was very different than historical patterns.
Is a Decacorn the New Unicorn?
In fact, last year we found ourselves wondering whether a Decacorn–meaning a company valued at $10 billion or more–had become the Unicorn.
What really stood out to us last year is that hot money coming into the sector wasn’t always consistent in valuing companies. Simply put, not all Unicorns are created equal.
What Drove Venture Capital Valuations?
What should drive venture capital valuations is fundamentals. In particular, rapidly-growing and capital efficient companies that have excellent unit economics. The select few good companies that truly have the potential to become category creators and category winners are the ones that deserve premium valuations.
However, last year we saw that Venture Capital valuations were more driven by an influx of “hot money” coming into the space. This money came from what the Venture Capital industry often refers to as non-traditional investors. That includes hedge funds, mutual funds, corporate venture funds, and venture firms that have grown so large that they no longer conform to the fund sizes associated with the venture capital asset class.
Are High Valuations Sustainable?
Historically, an influx of non-traditional investors has not necessarily correlated with long term success of the underlying companies. In fact, it has been inversely correlated according to Bloomberg. Simply put, discipline never goes out of style.
When companies are valued on metrics other than fundamentals, it fuels speculation and excess. Such speculation and excess usually doesn’t have staying power because it is often based on the premise that prices keep going up.
What Justifies These High Valuations?
Below are three common reasons used to justify very high valuations:
Reason 1: Startups are staying private longer, which means they deserve higher valuations than what would be historically justified.
Verdict: False. This certainly was not the case in 2021. The IPO markets were robust and thanks to SPACs many early stage companies went public based on little more than robust projections. So this reason doesn’t hold water.
Reason 2: Startups are able to achieve stronger metrics than what they would have been able to historically due to cloud computing and non-dilutive funding.
Verdict: Mostly False. It is true that it is cheaper and easier to start a company. Cloud computing and a digital foundation allows startups to put a product out there very quickly and cheaply. But scaling a company takes capital and is a whole different matter. To support Unicorn valuations, startups should be showing real growth, differentiation, and sustainability metrics. These take time, effort, and capital to establish.
Reason 3: Today’s startups are addressing bigger market opportunities than ever before. Therefore it makes sense to pay forward for companies that can be massive.
Verdict: Partly True. While many startups truly have the ability to create new categories and define new ones, creating tremendous shareholder value, it is dangerous to apply a blanket statement to all startups. Generalizations are rarely effective in good investing. Judgment is critical to separate the wheat from the chaff. So this reason, while partially true, fails as a blunt generalized justification.
Public Market Cloud Company Valuations
The last two months of 2021 were tough for public market software companies. The average NTM Enterprise Value to Revenue (EV/R) multiple for Cloud and Next-Gen Systems companies in the public markets compressed by more than 30% between mid-November 2021 and January 2022. During this period, the EV/R multiple shrank from over 17x forward revenue to less 12x in January 2022. The average non-market cap weighted name is off its peak by about 40%.
We think this correction is healthy and probably overdue. After all, even after the pullback the space is still trading at more than 65% ahead of the average EV/R multiple of the last 10 years. We’re going to get a better sense for which companies have built durable growth engines versus those where demand may have been transitory or pulled forward. It still seems like the average software may drift lower based on our observations, but this might just be an occurrence of mediocre reverting back to what is expected.
How is Omega Approaching Valuations?
Omega’s investment strategy tends to favor companies that deliver growth with a clear path to profitability and positive unit economics. At the same time, Omega looks for companies that have the potential to become the dominant leader in a category that is benefitting from secular growth drivers.
While business model drivers like product-led growth, consumption-based pricing, and integrated payments continue to demand high valuations, there are fundamental themes in software that are creating compelling growth categories. Here are 3 secular growth themes:
1) Modern Data Management & Applied AI
How do you manage, make sense of, and activate the ever-growing set of data that’s available to most organizations
Instead of a static system of record, companies are investing in Intelligent Software solutions that help them better understand what drives customer behavior and to drive hyper-personalization at scale.
3) Automation and Augmentation
Enabled by low- / no-code solutions, software solutions can be set up for unprecedented automation as well to augment human judgment and common sense.
Venture Investors must be more diligent and judicious than ever before. It is a full-time job to find the best companies, invest in them at good terms, and give them advantages to win. Conviction in investing must be balanced with discipline, judgment, and a long-term orientation. We at Omega recognize that enduring value is created and earned over years of consistent execution.