5 Questions About the 2021 Startup Market

We've entered 2021, a year that has the potential to either continue the disruptions and unusual conditions seen in the 2020 startup landscape, or to alter the successful strategies previously employed by emerging tech businesses and those who fund them.

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Now that a new year has begun, several important questions arise as we analyze the current situation in 2021.

These questions center around changes from 2020 that are anticipated to continue, as predicted by both the broader market and those optimistic about startups. I'm interested in identifying what shifts would be necessary to disrupt the established patterns of the previous year. History demonstrates that significant changes often occur when a decline (or a period of growth) seems unshakeable.

Today, we will examine seed funding rounds, the pace of venture capital investments, the resulting impact on valuations due to quick investment decisions, current expectations for initial public offerings, and the potential effects on software sales as remote work arrangements become less prevalent.

1. How long can seed deal-making stay hot?

Toward the end of 2020, Natasha Mascarenhas and I covered the robust performance of seed investing, particularly its impressive growth during the latter six months of the year. The central question now is whether this momentum can be sustained.

The majority of inquiries we are currently addressing concern the longevity of specific market conditions, specifically how long certain segments of the startup ecosystem will continue to experience rapid growth.

Investment levels in seed funding during the first and second quarters of 2020 were comparable within the United States. However, the third quarter witnessed a significant surge, with capital deployed into domestic seed deals increasing from approximately $1.5 to $1.6 billion in the initial two quarters to $2.2 billion between July and September.

Complete data for the fourth quarter is still being compiled, but it is evident that private investors demonstrated considerable optimism regarding early-stage startups in the second half of 2020. It is my belief that this trend will continue for some time, as investors have displayed little inclination to reduce the frequency of their investments.

The overall pace of investment remains strong, and seed deals are expected to remain active due to the growing number of investors interested in participating in early-stage funding rounds.

This leads us to our next consideration:

2. How long can investors keep writing such quick checks?

A prominent observation during the latter portion of 2020 was the rapid rate at which venture capital investments were being completed. Several factors contributed to this acceleration. Initially, venture capital firms have been securing larger funds recently, necessitating greater returns to achieve favorable financial outcomes. Consequently, numerous investors began allocating capital to companies at earlier stages of development, aiming to identify and invest in potentially high-growth businesses from the outset. This situation fostered increased competition among investors and expedited the investment process.

This acceleration occurred through a couple of key mechanisms. Investors already holding equity in a startup – existing stakeholders – frequently spearheaded preemptive funding rounds, partly to prevent other investors from securing future investment opportunities. Recognizing this trend, other investors appeared to adopt a similar approach, moving even more quickly and investing at even earlier stages to circumvent these defensive strategies.

Therefore, how sustainable is this pattern? Considering that many major venture capital firms completed fundraising in 2020, numerous startups benefited from economic conditions related to COVID-19, and exit activity has been robust, could this continue indefinitely? Or will it persist only until factors emerge to disrupt the current environment? It’s helpful to consider this through the lens of Newton’s First Law as it applies to startup investment.

What sort of event could abruptly alter the existing conditions that are driving the accelerated pace of seed and subsequent investment rounds? While a catastrophic event is unlikely, the power of momentum is significant, and markets generally prefer stability.

Furthermore, the intense competition to deploy capital into promising startups in the present environment has had a consequence beyond simply the speed of transactions; it has also resulted in increased valuations.

3. How long can startup valuations be based so heavily on far-future growth?

To understand the current situation, let's consider the performance of established companies. Publicly traded software firms, electric vehicle manufacturers, and other businesses that began as startups experienced significant increases in their market value during 2020. Rising stock prices contributed to the overall growth observed within the public technology sector.

Consequently, numerous late-stage startups prepared for and successfully completed initial public offerings (IPOs). These IPOs generally performed exceptionally well, which in turn positively influenced the valuations of companies at slightly earlier stages of development. This trend was evident in the increased rate of unicorn companies emerging towards the close of 2020.

However, the impact extended to even younger startups. Available information and data suggest that their valuations also increased considerably. As previously mentioned, seed funding was robust in 2020, and seed rounds themselves grew larger, indicating more costly investment deals during that period. Therefore, we can observe a general increase in startup prices throughout the past year.

What does this signify? Investors who pay a premium for a startup, particularly in favorable market conditions, are essentially placing a greater emphasis on potential future growth and a lesser emphasis on the company’s current performance. This dynamic can become quite pronounced when startups achieve valuation multiples of 100x their Annual Recurring Revenue (ARR) or similar figures in early funding rounds; in such instances, investors are almost exclusively betting on future expansion rather than present-day metrics.

Startup valuations are likely to stay elevated as long as investment activity remains high, suggesting a correlation between the two. However, a decline in valuations could occur if startups that secured substantial valuations based on limited revenue were to experience public setbacks. This could affect valuations for early-stage companies, while more established startups might remain more closely aligned with the valuations of comparable public companies.

It’s important to remember that these considerations are based on potential future events, which introduces a degree of uncertainty. This suggests that the current situation could persist for some time.

4. Can the 2021 IPO market live up to expectations?

The question of whether the initial public offering landscape will fulfill projections is straightforward. A significant number of businesses are currently preparing to launch on the stock market. This includes anticipated debuts such as Roblox, a potentially noteworthy listing from Coinbase, and a large group of software-as-a-service companies expected to perform adequately, though perhaps without extensive media coverage. Many organizations are aiming to go public in 2021.

These public offerings are widely anticipated. However, what would happen if they were to be postponed or cancelled? This would likely necessitate a substantial disruption to the financial system. A significant decline in the public markets, such as a drop of 15% or greater, could be a contributing factor. Alternatively, an unexpected outcome in the presidential election could also create considerable instability.

Similar to venture capital investments and startup valuations, the prevailing trend appears to be continued momentum. Given that the favorable conditions that drove a robust 2020 remain in place, there seems to be little reason to anticipate a slowdown in IPO activity during 2021.

5. What happens to startup growth rates when the world returns to normal?

The situation could become unfavorable. All of the considerations mentioned previously are based on the assumption that the overall condition of startups will continue to be generally positive. However, a crucial question for 2021 centers on how software expansion rates will be affected as remote work diminishes and people gradually resume activities in public settings.

Optimists suggest that spending patterns won't change; software already acquired will remain in use, suggesting customer cancellations won't significantly increase. These same individuals also anticipate that software revenue growth will not substantially decrease.

It’s possible. However, if customer cancellations become problematic in the third and fourth quarters of this year, it could invalidate many current assumptions. This includes the belief that software is a consistently reliable and long-lasting investment. Such a scenario could lead to lower valuations and longer sales cycles.

Time will tell. The events of 2020 demonstrated that predictions should be viewed with caution. We will assess how many of these concerns prove to be inaccurate by the third quarter.