Venture Capital & IPOs: A Necessary Connection

Venture Capital Funding and the Impending IPO Wave

This week, The Exchange is examining the Chinese venture capital landscape, though securing on-the-record commentary has proven somewhat challenging. Further insights will be shared later in the week.

Venture Capital Indigestion

Alongside our analysis of the Chinese and Indian startup ecosystems, we’re addressing a significant trend: venture capital indigestion. It remains difficult to fully grasp the sheer volume of capital injected into startups this year.

Global venture capital fundraising has reached unprecedented levels, with numerous countries reporting record-breaking results. Data from CB Insights indicates that Q3 2021 witnessed more than double the investment dollars compared to Q3 2020, spread across a significantly larger number of deals.

This influx of capital is directly contributing to a proliferation of unicorns globally. Consequently, the total value of unexited private companies requiring eventual liquidity is increasing. With some major U.S. tech companies curtailing acquisitions due to antitrust scrutiny, a substantial increase in IPOs is anticipated to accommodate a surge of unicorn debuts.

This potential demand for IPOs is growing each quarter, and at an accelerating rate. The rate of change is positive, indicating a rapidly expanding need for public offerings.

The Exchange has previously highlighted the growing backlog of unicorns, but recent data underscores that venture capital firms are investing with the expectation of an exit wave that will surpass previous IPO cycles in both intensity and duration.

Consider the following chart from CB Insights’ Q3 data, illustrating the pace of capital deployment into the global startup market:

The Rise of Unicorns

The surge in fundraising isn’t merely reflected in impressive statistics. Startups worldwide are securing record funding amounts in recent quarters.

Approximately 60% of all global venture capital dollars are now being invested in rounds of $100 million or more. This funding activity has resulted in three consecutive quarters of 100 or more new unicorns being created.

Each unicorn represents a valuation of at least $1 billion, meaning a minimum of $100 billion in unexited unicorn valuation is being added each quarter. While some unicorns do exit, many more increase in value through subsequent funding rounds, further expanding the total venture capital exposure to eventual unicorn exits.

The speed at which new unicorns are emerging is unprecedented in the last three quarters. This signifies that the accumulation of unicorns ahead of potential exits is accelerating.

Examining unicorn births from the same data set:

This trend presents a potential challenge.

Historically, there has never been a period with more unicorn creations than exits, especially at this rate. A pessimistic outlook suggests that some unicorns may struggle to exit at their desired valuations.

A more optimistic view posits that the rising number of unexited unicorns hasn’t significantly impacted the broader startup market. However, this perspective relies on the continued stability of revenue multiples that have made technology companies so attractive to investors.

Growth vs. Profitability

In a recent conversation with a software company CEO who has raised over $100 million in capital, I inquired about the venture capital focus on growth versus profitability. She indicated that her VCs remain primarily focused on growth.

This aligns with current market conditions. Consider the following:

• The average revenue multiple for public software companies is 21.5x, according to the Bessemer Cloud Index.
• Startups can anticipate generating approximately $20 in value for every $1 of recurring revenue.
• This allows for investment at less efficient rates while still achieving substantial returns.
• Consequently, both investment and spending are increasing.

As long as market conditions remain favorable, this dynamic is sustainable. The high value of startup revenues makes investing in them a sound business strategy, and overpaying is difficult given current multiples. Therefore, the unicorn backlog continues to grow at an increasing pace.

Eventually, the economic cycle will slow and revert to a more conservative state. This is inevitable. If the current trend persists until that point, many unicorns could miss an opportune exit window. This concern is amplified by the diminished activity in the SPAC market, offering little alternative for liquidity.

Ironically, it might be beneficial for many $1 billion+ valued startups to go public now and focus on growth without the pressure of future liquidity and pricing concerns. However, with the continued appeal of private capital and easy access to funding, the incentive to choose long-term growth over immediate liquidity remains strong.