Understanding Venture Capital Trends in Software Startups

Several prominent venture capital firms have recently dedicated significant effort to analyzing data and mapping the landscape of venture investing. Fortunately, these firms have been generous with their time and data, allowing for a clearer understanding of the current market for rapidly expanding software startups.

Last week, The Exchange examined data provided by Battery Ventures, which sought to explain the valuation increases observed in software companies over the past few years. The core finding was that the expansion of multiples – the re-evaluation of software companies at a higher price for each revenue dollar – can be partially attributed to categorizing companies based on their growth rates.

Once this segmentation is completed, it becomes apparent that the software startups experiencing the most rapid growth are also benefiting from the greatest price appreciation.

Growth Rates and Valuation De-risking

As a Battery Ventures investor articulated, higher growth rates mitigate the risk associated with valuation multiples.

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This reasoning is logically sound and could be explored further in a subsequent article. However, today we will focus on new data from Bessemer, a VC firm well-known to Exchange readers through its frequently referenced cloud index.

Bessemer’s 2021 cloud report complements the analysis conducted with Battery’s data. It allows us to expand on the argument that strong growth rates reduce risk associated with multiples.

Durable Growth Rates in the Cloud

The new report suggests that growth rates among cloud companies – encompassing modern software and SaaS businesses – are likely to be more sustained than previously anticipated.

This builds upon the initial premise: If growth rates lessen the risk of increasing multiples, it logically follows that companies with higher growth rates should be valued more favorably than their slower-growing counterparts.

However, this doesn’t fully explain the overall increase in multiples or justify why they might be considered sane. More durable growth rates, however, offer a potential explanation.

The rationale is simple: the longer a company maintains its growth rate year after year, the larger its future size will become. While modern software companies often experience a slowdown in growth over time, they rarely encounter negative growth rates.

More consistent growth today translates to increased cash flow in the future. Consequently, valuations rise, and the fastest-growing companies benefit from the downside protection inherent in rapid expansion.

Is this clear? If not, further clarification will be provided with supporting charts.

An Explanation for Elevated Software Company Valuations

A primary driver behind the high valuations observed in both startup and publicly traded software companies is investor willingness to pay premium prices. The pursuit of capital yield has led investors to favor growth opportunities within the software sector for some time. This trend was notably amplified during the global economic disruption experienced last summer.

Software rapidly transitioned from a potential growth investment to a secure haven for capital preservation, as its essential role in maintaining global operations became apparent. Essential software services continued to be paid for, ensuring stability.

One might anticipate that the valuation increases witnessed as other stocks declined would eventually normalize. However, software valuations have largely remained robust. This observation leads us to consider future implications.

The following chart, sourced from the Bessemer report (and used with their consent), will be explained in detail:

According to Bessemer partner Mary D’Onofrio, a key author of the report and a member of the growth team, the x-axis represents the growth rate of public software companies in the previous year, while the y-axis indicates their current year’s management expectations. The correlation coefficient of 0.8x signifies a strong relationship.

Specifically, approximately 80% of revenue growth observed in public cloud companies is typically sustained from one year to the next.

This consistent growth retention rate resulted in several forecasting errors by industry analysts, which Bessemer highlighted:

These charts illustrate how analysts have consistently underestimated the growth trajectories of numerous cloud and SaaS companies.

In essence, valuations are elevated because software company growth is expected to be more enduring than previously anticipated. This extended growth horizon increases the present value of their future cash flows, even if those projections were initially conservative. Does this reasoning resonate?

This perspective is rooted in the concept of expansive and deep software markets. The Exchange has previously explored this idea, though from a different angle. As the software market continues to broaden, companies have increased opportunities and time to expand from early stages through to becoming publicly traded.

This translates to a greater potential for generating substantial, high-margin revenues and consistent cash flow. That is the core hypothesis.

Additional factors influence software valuations. The accelerating pace of digital transformation could provide a sustained boost to software revenue growth beyond pre-pandemic expectations. However, some valuation corrections may occur as investors become more discerning in differentiating between top-performing and less successful companies.

However, I want to emphasize a different point. Consider the following chart, which presents the same data as our first, but focuses on a cohort of 100 private software companies tracked annually by Bessemer:

The 0.7 value indicates that private software companies are expected to retain approximately 70% of their growth year-over-year, a lower rate than their public cloud counterparts. Why this discrepancy? Why do smaller, private firms exhibit less growth retention? After all, they are expanding from a smaller revenue base!

D’Onofrio explained to The Exchange that the lower growth retention among private companies is logical, as not all firms within the Cloud 100 are suitable for an IPO. Conversely, all public cloud companies meet that standard. Therefore, while the Bessemer report demonstrates rising average growth rates across Cloud 100 cohorts, they don’t maintain that growth at the same rate.

This is illustrated by the following chart, showcasing rising average growth rates over time:

This contrasts sharply with the following data:

Observe the significant expansion in private software valuations after 2018, coupled with the accelerated rise in average growth. A considerable gap exists between these trends!

Therefore, the overarching theory suggests that current software valuations may be justifiable, particularly among public software companies due to their ability to sustain long-term growth. Private software companies, lacking the same level of retention, may be benefiting from a valuation surge they haven’t fully earned.

This is a preliminary exploration, but it raises the question of whether this dynamic is indeed occurring.

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