Startup Market Today vs. 1999: Raising a Series A

Navigating a Potential Shift in the Startup Landscape

As 2021 concluded, The Exchange sought insights into the potential consequences should the current surge in startup funding subside. To gain perspective, we consulted with seasoned venture capitalist Matt Murphy to discuss this possibility.

Murphy’s career began at Sun Microsystems in the mid-1990s, and he subsequently joined Kleiner Perkins in 1999, remaining there until 2015. He then transitioned to Menlo Ventures, where he continues to work. His investment portfolio includes prominent companies such as DocuSign, Egnyte, AppDynamics, and Carta.

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Murphy’s extensive experience investing through previous downturns, including the dot-com bubble of the early 2000s and the 2008 financial crisis, made him an ideal source for this discussion. We engaged in a comprehensive conversation, covering current startup valuations, the long-term viability of today’s ventures, and evolving trends in startup success rates.

Our discussion with Murphy was broad in scope. To enhance readability, we’ve organized his responses thematically, incorporating subheadings where the conversation shifted. We’ve also streamlined our questions and made minor edits to the transcript for clarity and conciseness, clarifying certain abbreviations.

Assessing the Current Market: Fundamentals vs. Overheating

Matt Murphy: I am comfortable with existing investments showing increased valuations, as it reflects positively on performance. However, I find securing new investments more challenging, which can be frustrating.

The speed at which valuations have changed recently is remarkable, even more so than during the late 1990s. This period feels more sustainable, being more widely distributed, and consistently exceeding previous peaks.

The Landscape of Early-Stage Funding Rounds

Matt Murphy: Five years ago, a Series A round typically involved a pre-money valuation of $20 to $30 million. This rose to $40 to $50 million within a year. Currently, the standard has shifted to $70 to $90 million, with some outliers reaching $120 million, even for companies with less than $1 million in Annual Recurring Revenue (ARR).

A $1 million ARR was once considered a benchmark for Series A funding. Now, companies are securing funding with ARR between $300,000 and $500,000. This signifies an increase in valuation and investment at an earlier stage, inherently increasing risk.

Investors are accepting greater risk. The perceived difference between $1 million in ARR and $300,000-$500,000 has diminished. However, with each stage of growth, more data and experience become available regarding the company’s performance.

Companies with $300,000-$500,000 in ARR often haven’t completed a full renewal cycle. Net retention, a key metric for venture capitalists, indicates the health of the existing customer base and product satisfaction. Assessing this metric is difficult for very young companies, leading to increased risk for investors.

Risk Management in Light of Elevated Valuations

Matt Murphy: This trend explains the increasing focus of many venture firms, including ours, on seed and even earlier stages. If a seed round is valued at $20 million pre-money, and a Series A round follows six months later at $70 to $90 million pre-money, the risk reduction in that timeframe is minimal.

It may be more advantageous to invest at the seed stage, securing a larger stake for less capital, and diversifying investments, rather than pursuing expensive Series A deals. These dynamics are shaping the early-stage investment landscape.

The later-stage market is saturated with capital, making it highly competitive. Capital is readily available, prioritizing speed and initial investment commitments. However, earlier stages offer opportunities to differentiate through investor expertise, platform support, and network connections. The later stage is likely to become more challenging, an area where we do not actively participate, focusing on companies up to $10 million in ARR.

Justifying Current Valuations with Long-Term Growth

Matt Murphy: Companies are achieving faster growth rates and sustaining them for longer periods than in the past. Previously, public companies were modeled with growth rates of 25% to 30% in perpetuity. Now, companies are growing at 80% or more, even after going public, with some even accelerating growth post-IPO.

These dynamics allow investors to reassess value. Instead of using a Discounted Cash Flow (DCF) model with a 25% growth rate for ten years, a more realistic approach might be 80% for three years, 60% for three, and 40% for another three, resulting in a significantly higher terminal value.

The abundance of capital is undoubtedly driving up prices. Furthermore, a growing number of companies are proving successful, altering the traditional venture capital paradigm.

The Increasing Startup Success Rate

Matt Murphy: The success rate of startups is unprecedented. Traditionally, 50% of companies fail to return capital, with only 5% of outliers generating all the returns. Currently, the failure rate is lower than 50%, and returns are becoming more evenly distributed.

Investors are experiencing multiple companies performing well, changing the way they evaluate opportunities.

Comparing Today to Past Bubbles: 1999 and 2008

Matt Murphy: The most striking parallel to 1999 is that many successful companies are selling to other rapidly growing startups.

In 1999, the internet infrastructure was overbuilt, leading to a collapse in the telecom sector. Additionally, the advertising revenue that supported e-commerce and media companies dried up due to budget constraints.

The 2008 financial crisis prompted a widespread reassessment of the global economic landscape. Concerns about the stability of the financial system and currency devaluation led to a temporary halt in investment activity. After a year, investment resumed, but with caution.

The early 2000s were a challenging period for investment, with a recovery beginning in 2005, 2006, and 2007 before being interrupted. Determining the nature of the next shock remains uncertain.

The COVID-19 pandemic was navigated remarkably well. Approximately 80% of firms temporarily paused investing for a quarter. We were among them, preparing for potential portfolio challenges. Some companies implemented layoffs, only to rehire within six months, demonstrating resilience in the tech economy.

Key Concerns

Matt Murphy: A primary concern is the reliance on abundant capital and increased software spending. The question is whether this funding will continue indefinitely and how it will impact these companies.