Is this a VC bubble, or just the new normal?

Huge deals, little diligence and hyper-fast follow-on rounds have become commonplace. For now.

Bubbles

Things are looking awful frothy, aren't they?

Photo: Drew Beamer/Unsplash

The VC industry is "frothy," "overheated" or "bonkers," investors say. Whether this is the new normal or unhealthy signs of an overheated market depends on your point of view — and how well your portfolio is doing.

There are signs that VC has changed all around. In recent months, deal sizes and valuations have spiked in hot deals; due diligence on startups has evaporated as investors compete to get into hot deals first; venture firms are investing much more than they normally do; there are hyper-fast follow-on rounds; and more non-traditional investors are backing early-stage startups.

In one recent example, low-code startup Retool, which helps companies quickly and cheaply build internal software tools, attracted top-tier investors who bid for a round that ended up valuing the quickly-growing company at close to $1 billion. Sequoia Capital won the deal, leading the Series B. Despite its fast growth and high valuation, Retool's annualized revenue run rate at the time of funding in October was between $5 million to $10 million, according to those familiar with the deal. (It has since jumped higher, one source said.)

That sort of sky-high revenue multiple is not uncommon for companies that are seeing strong growth and happen to fit into a particular theme that venture investors are chasing.

This shift started as far back as 2018, when tech's dominance in the market became clearer, some investors say, but has ramped up in the past six months or so. Some point to particular enthusiasm about a post-pandemic economy and perhaps a wave of relief-induced investment once the pandemic actually boosted many startup sectors, such as enterprise, ecommerce and gaming.

Whatever the original motivation, the surge of investment is being made possible by cash that's flooding into the venture industry, a trend driven by low interest rates, exuberance over unusually strong exits last year in companies such as enterprise software firm Snowflake and high valuations for late-stage companies, such as gaming company Roblox.

"Capital is flooding into the VC market because of high returns in VC," Zach Coelius, founder at Coelius Capital, said. "That leads to more investors splashing money around and driving up prices and investing in companies that shouldn't be invested in."

New macroeconomic conditions — as well as startups growing faster and generating higher revenues than ever before — are behind this, said Chirag Chotalia, partner at Threshold Ventures. Previous "category-defining companies" used to typically exit at $1 billion to $5 billion, but now those outcomes are $10 billion to $30 billion or higher, he said.

"We think about it as the new normal," Chotalia said. "The biggest revelation for me is the size of the outcomes really supports the quote-unquote frothiness in the cycle. In many ways, what was irrational a couple years ago is now much more rational today because of what we're seeing on the exit side."

Even if the stock market drops, these new startups still have strong fundamentals, he thinks. "The magnitude of the exits is not driven so much by the stock market but by the revenue scale and the growth rate of these companies. I don't see it nearly as cyclical as past cycles," Chotalia said. "Valuations may come down, but not these growth rates. Multiples might be questionable for some portion of companies, but revenues are here to stay, as are the growth rates."

'No time to dilly-dally'

With the fierce competition for top deals, the rigor of due diligence is declining. Startup deals used to entail days of calls and research at the seed round and weeks at Series A or later. Now seed deals can now be done in hours, and Series As within days.

"Diligence cycles have become much more compressed," Coelius said. "You don't have time to dilly-dally anymore. It's 24- to 48-hour decision cycles. You have to have done your diligence beforehand."

Investors have gone beyond "preemptive" deals where they seek to invest in a company before it searches for funding. One new strategy: VC firms might send a term sheet to a startup even before a "get-to-know-you" meeting; some even hire diligence firms to do this work for them.

"Now it's turned to firms coming in saying, 'I've done all my work; here's a term sheet,'" said Matt Murphy, partner at Menlo Ventures. "It's a way to force something on people before they're even ready."

"Everyone is saying 'I can't miss the next Snowflake at A or B or C,'" said Semil Shah, founder at Haystack. "It's not just fear of missing out: It's now fear of missing that company that could be a $100 billion company. That fear is sharpened."

What was irrational a couple years ago is now much more rational.

Another aspect that's ratcheting up is the speed of follow-on rounds. Some hot companies are raising a new round in two to three months after a previous one. "It used to be like, 'Damn, I missed it, I'll check in in six to 12 months,'" Murphy said. "Now what everyone is doing is moving to a dynamic of: 'I missed it. It doesn't matter, I'll put a term sheet in two to three months later.'"

Nontraditional startup investors, particularly in early-stage deals, could also lead to startups getting funded before they're ready. In a recent example, a venture investor pointed to the unusual case of a banking advisory firm leading a deal for an early-stage startup at the Series A. This is a step beyond investment banks leading deals, which has already been common.

The frenzy is especially focused on the hottest deals among top entrepreneurs or companies, Coelius said. It's a maxim among venture capitalists that each year there are 15 to 20 startups that will be massively successful, and those are the only companies that matter in driving investors' returns.

But this filters down to lower-quality deals. For example, companies that are not snapped up by top investors are then backed by newer investors who are trying to break into the industry. And they may be even less diligent than established firms, Coelius said.

"The risk is always: Mediocre companies raise at high valuations," said Mamoon Hamid, partner at Kleiner Perkins. "If historically you wrote $10 million checks, now you're losing $20 million [when a startup fails]. It's going to happen. But people don't think that way. They think, 'what's the upside,' not the downside."

The Icarus effect

Valuations are so high at the moment that one new firm, Apeira Capital, is seeking to create synthetic vehicles to essentially short overvalued startups. There are a plethora of companies that may be fundamentally good companies but are just overvalued due to the way that venture capitalists value and invest in them, Apeira founder Natalie Hwang said.

And despite the flood of cash going into the market, capital is not being distributed evenly, said Deena Shakir, partner at Lux Capital. The proportion of funding that went to female-founded startups in 2020 dropped to 2.3% from 2.8% in 2019, according to Crunchbase.

Venture firms investing much more than they typically do could come back to bite them. One limited partner who requested anonymity said some firms that typically make one to two deals per quarter are now making upwards of seven to nine. If it's true that there are only 15 to 20 truly winning startups in a given year, that pace could push investment returns down.

"It just can't end well," the investor said. "It almost feels like we're looking at an entire cohort [of investors] that's going to have substandard returns."

For limited partners, this could lead to trouble when it comes to exits. "There's no price diversity," said Chris Douvos, founder at fund-of-funds Ahoy Capital. "You're just playing the momentum. It's a buy high, sell higher mentality. My concern is, as a whole, the entire industry has conditioned itself to need those kinds of exits for success."

Many investors today don't think about — or weren't around during — the last real downturn, he added. "Pricing things for perfection and glossing over weaknesses won't hurt you in a one-way market," Douvos said. "But if there's ever a hiccup, you'll have the Icarus effect where the higher you fly, the further you'll fall."

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