US Startup Funding: No Slowdown Expected by Investors

Q2 2021 Venture Capital Market Review

As we progress through the initial weeks of the third quarter, The Exchange is conducting a retrospective analysis of the venture capital landscape during Q2 2021. Available data demonstrates a period of exceptional activity, with both global and regional benchmarks being surpassed throughout the quarter.

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Record-Breaking Investment Activity

According to data compiled by CB Insights, global venture capital investment reached $156 billion in the second quarter. This represents a substantial increase of 157% compared to the $60.9 billion invested during the same period in the previous year.

The number of unicorn companies created during Q2 exceeded all prior comparable periods. Furthermore, company valuations generally experienced an upward trend.

While the total number of funding rounds didn't consistently achieve record levels, the overall picture of Q2 venture capital activity was overwhelmingly positive. It was a particularly favorable environment for startups seeking funding.

Understanding the Market Dynamics

To gain a deeper understanding of the current situation, we consulted with investors from various geographic locations to assess their perspectives on their respective markets.

Our focus today is on the U.S. startup ecosystem, incorporating insights from Amy Cheetham of Costanoa Ventures, Marlon Nichols from MaC Venture Capital, Vanessa Larco at NEA, and Jeff Grabow, who leads venture capital efforts at EY U.S.

Drivers of Increased Investment

What factors are driving this surge in investor activity? Let's explore the key reasons behind the increased check-writing.

Is a Surge in Venture-Funded Startups Underway?

Considering the unprecedented amount of capital invested this past quarter, the fact that deal numbers didn't reach record levels prompted consideration of whether there was a shortage of startups suitable for venture funding.

A scarcity of viable investment opportunities could account for both the increasing deal sizes and the resulting valuations. With substantial capital already allocated to venture investors, a limited pool of startups aligning with the venture capital model would likely intensify competition, potentially leading to larger funding rounds and inflated valuations.

However, this isn't the situation. According to NEA’s Larco, “there is an ample supply of venture-ready startups available for funding,” and she further notes that “the rate of innovation across all sectors and geographic locations has been remarkable.”

Costanoa’s Cheetham concurred, stating, “The sheer number of high-caliber companies being launched is unprecedented,” as communicated in an email. Our analysis of this market trend suggests it should motivate the venture capital community to continue pursuing larger and more frequent fundraises; reducing ambitions isn't logical when there's an abundance of potential investments.

What, then, is fueling the current dynamism in the U.S. venture capital market? A fear of missing out (FOMO), combined with the conviction that attempting to predict market fluctuations is ill-advised.

Nichols from MaC Venture Capital shared with The Exchange that “FOMO is prevalent in the market,” and added that, given the emergence of “several compelling companies and business models this year,” it would “be imprudent to forgo a promising opportunity simply because market conditions are somewhat unstable.”

Cheetham echoed this sentiment, observing that “there’s a growing recognition within the VC community that this period of intense founding activity and funding availability is likely to persist, and delaying capital deployment will only result in having to invest at even higher prices in the future.”

The combination of FOMO and concerns about future price increases is a powerful driver, compelling investors to participate and reducing their immediate sensitivity to price.

Paradoxically, the urgency to deploy capital now to avoid higher costs later is contributing to rising prices, a dynamic similar to how consumer stockpiling in anticipation of a shortage can worsen supply issues.

“This rapid response and… FOMO [have] undeniably pushed prices upward, but no one wants to be excluded while other funds continue to generate gains and successful exits,” Cheetham clarified.

Furthermore, Larco emphasized that she doesn’t “believe investors can accurately time the market at any level, and those who attempt to do so often miss out.” Therefore, pausing deal activity is simply not a viable option.

Are we, then, poised for a prolonged boom in startup funding, extending as far as the foreseeable future? Perhaps, but with some important qualifications.

A Temporary Dip in Summer Activity

Cheetham observes that the market for seed and Series A funding has experienced a slight deceleration “in the last few weeks.” The rapid deal flow witnessed during May and June is not currently being sustained.

However, this slowdown is not anticipated to be prolonged. The Costanoa investor forecasts a resurgence in activity coinciding with the return of students to school.

The fundamental conditions supporting substantial capital availability for venture capitalists are expected to remain stable. Grabow clarified via email that “significant amounts of capital” are still accessible, fueled by a sustained period of low interest rates.

Furthermore, the positive impact of the COVID-19 pandemic on certain startups continues to be observed. Nichols notes that businesses which benefited from the pandemic are still exhibiting rapid growth, while those previously hindered are now regaining traction.

This ongoing growth should maintain robust expansion rates, enabling more startups to achieve the revenue levels necessary for venture capital consideration.

These factors collectively suggest a potentially even more competitive market in the near future. Nichols believes that “things are only going to get more aggressive.” Cheetham shares this view, stating that continued low interest rates and a risk-tolerant public market will likely drive further acceleration in startup funding.

The substantial capital recently raised by venture capital firms also contributes to this dynamic. Cheetham points out that “so many VC funds have raised significant funding in the last 12 months that the pressure to deploy isn’t going away.”

Despite the current favorable conditions, the startup investment landscape is not immune to disruption. Cheetham offers an early warning indicator, suggesting that any market shift will likely be first apparent in late-stage startup investments.

This is attributed to the higher risk profile often associated with late-stage funding. She explains that “There have been so many high-priced rounds into companies with minimal revenue post-Series B,” raising concerns about potential failures to meet investor expectations.

More broadly, Cheetham suggests the possibility of “orphaned companies or companies raising down rounds” should a flight to quality occur in public markets, impacting private market valuations.

It’s important to remember that Series A and B rounds have sometimes been secured by startups with limited revenue history. Therefore, despite current investor optimism, substantial risk remains, requiring sustained revenue growth and consistent valuations.

If these conditions persist, venture capitalists employing aggressive investment strategies could realize significant returns. Currently, the startup market is operating at full capacity. The duration of this momentum remains to be seen.