For the past few months, a relatively rare event has become nearly commonplace: startups that have doubled or even tripled their value in the private market within a brief period, sometimes in less than a year.
Just a few examples: In August, the Israeli startup Gong.io, which uses artificial intelligence to analyze sales conversations, announced a $200 million funding round that gave the company a valuation of $2.2 billion (all figures are post-money), triple that of December 2019. In September it was the turn of Snyk, an open-source security platform. The firm signed a funding agreement that valued the company at $2.6 billion – just eight months after its last round, at a valuation of $1 billion. In October, the accounting software provider Tipalti raised an additional $150 million at a valuation exceeding $2 billion. Chen Amit, Tipalti’s CEO and co-founder, said afterward that the company had actually planned to issue debt, before realizing that the market’s momentum allowed them to raise capital under much better conditions. The funding round was completed at record pace, in only four days. In November, SentinelOne become the most valuable private cybersecurity software company in Israel, after tripling its company value since February.
All these companies are enjoying the rapid digital transformation caused by the coronavirus pandemic, and are growing at a phenomenal pace. While they don’t say it explicitly, they illustrate a quite clear narrative – the high rates of growth and big opportunities in their industries have led investors to give them a relatively high valuation. But at the same time another phenomenon is occurring: The revenue multiples for shares in the stock markets have risen – and influenced those in private equity markets too. The question remains: How much of this jump in valuations can be attributed to the success of the startup, and how much is the result of the rise in share prices in the public market?
Building castles in the sky
Some players in the venture capital industry admit that the stock markets often create optimism that harms the private sector. Liron Azrielant, managing partner at Meron Capital, is one of them. “The fierce competition created as a result of the large amounts of ready money in the market, along with the euphoria around everything concerning technology firms in the public market, is expressed in crazy valuations that venture capital investors are willing to give companies in the private market,” she says. “In addition, our investors, the limited partners who put the money in our funds so we’ll create returns for them, are willing today to accept lower returns on their investment due to the lack of alternatives in an environment of zero interest rates.”
Azrielant says this accounts in part for the demand from venture capital investors for companies such as WeWork in real estate, Uber in taxis, Bird in shared electric scooters or Blue Apron in meal-kit delivery services. “These are companies that are physical in their essence, and they have the ‘unit economics’ [profit per customer] of a pretzel cart,” she says. “In other words, the first customer brings the company the same profit as the second, the third and the fourth customer. This is different from the situation in software, which you develop once and sell a million copies. The great demand for innovative products has caused investors to define many things that are not exactly startups as [startups].”
‘The stock market is not the economy, and if anyone profits from it they’re the one-percenters who have liquid capital and big money to bet on it and to make a quick killing’
The good times on the Nasdaq Stock Market cannot continue forever, and the proof is the disconnect between the technology companies and traditional industry, warns Azrielant. “In the end you have to follow up on the customer of the customer, and there you run into people who can’t pay their bills. They can’t buy iPhones, so there’s is a limit to how high Microsoft, IBM and tech companies that provide services to Apple can rise. The stock market is not the economy, and if anyone profits from it they’re the one-percenters who have liquid capital and big money to bet on it and to make a quick killing. It’s impossible to fuel corporate growth that is disconnected from that of consumers. We are building castles in the sky.”
Maybe everyone will sit at home and make money on stock-trading apps such as Robinhood?
“There really is an argument that all the trading on the stock market, which was once reserved for skilled traders, is now fueled by platforms such as Robinhood. I assume it increases the level of speculation and amplifies the volatility that is affected by news headlines. It’s hard for me to truly estimate the level of this influence. On one hand, experienced traders are also the ones who gave WeWork a value of $20 billion, so who says they are any better at what they do?”
Omry Ben David, a general partner at the Viola Ventures venture capital fund, thinks we are in a type of bubble that was created in part by the U.S. government using election economics and creating mechanisms to keep the markets high – relief programs for business owners, increased unemployment benefits, printing money and buying up tradable corporate assets. Ben David says he believes the greatest risk – which is not being priced in – is what Azrielant is talking about: unemployment that leads to a drop in private consumption and then to lower corporate revenues, which creates even more unemployment, in a never-ending downward spiral. “We could have a broad economic crisis here, but the market is not pricing in a crisis that is even close to what we had in 2009,” he adds.
Azrielant has an interesting argument, according to which the price to earnings ratio of a publicly traded tech company is an indication of the minimum price a privately held company is worth. When P/E ratios rise sharply, VC investors’ willingness to assign higher valuations to relatively young firms they see as acquisition targets rises along with it, she explains. “If Amazon is trading at a P/E ratio of 90 and it buys a company for $90 million, it’s enough for it to increase its profit by $1 million as a result of synergy for the market to reward it with a $90 million increase in valuation that pays for the cost of the acquisition,” Azrielant says.
Ben David, in contrast, believes the high prices in the stock market have little effect on the young startups: “Their valuations aren’t built on earnings multiples, as those of publicly traded companies are, because sometimes [young startups] don’t have any revenue. The valuation given to a startup is determined by the competition for the deal, which depends on the team, the market in which the company operates, its technology and what differentiates it from its competitors.”
“In companies that are just starting out, it is customary for the dilution of the founders’ shares in a funding round to be 20%-30% of the company. A company needs to raise enough money for 18-24 months of operations, and will bring the company to numbers that will allow it to raise the next round. That’s why the valuation that’s given in the end will depend on the competition and on the attractiveness of the deal, but also on the amount needed to reach the next funding stage,” Ben David says.
“Mature startups in areas such as online commerce, cloud infrastructure, cybersecurity, digitization and tools for remote work are really benefiting from organic growth and increased demand, but at the same time high multiples in the capital markets also serve as an indicator for the appropriate multiple for private companies, with a certain discount because this is a smaller scale and the shares are not liquid,” adds Ben David.
What will happen when growth slows because of the partial return to the office?
“The market values growth, but there is also a different direction that it went in a few years ago, and it was called the ‘Rule of 40,’ a measure of the company’s health. The idea is that the rate of [revenue] growth plus the profitability margin should exceed 40%. Young companies grow quickly and overtake this rule, but it’s not sustainable. When they mature, they need to balance growth and profitability. They cannot continue to finance new customers and show growth. Older companies, whose growth has slowed, need to improve their performance and their profit margins in order to meet the standard. In mature companies, you really need to change the approach and switch to healthier evaluation models,” Ben David says.
The size of the opportunity
The venture capital industry has received broad coverage in the financial media, even though its size is actually modest in comparison to other financial institutions. In 2018, all U.S. VC funds combined invested $100 billion. The great interest in the industry can be explained by the fact that the companies it supports have an oversize influence: About 40% of the publicly traded companies since 1974 began as privately held companies financed by venture capital funds. The five largest companies in the world in terms of market cap – Apple, Microsoft, Facebook, Google and Amazon – all grew in the private sector with investments from these funds.
There is one line that separates a startup that is relevant to venture capital from a regular business. A startup is measured by its ability to grow rapidly and to sustain that growth over time, and by its potential to create enormous revenue by selling goods or services. While regular businesses borrow from banks and rely on their ability to create revenue exceeding their expenses from the beginning, startups turn to VC funds, which are willing to invest in firms that lose money for a long time. The funds assume that the large risk will pay off and provide them with especially high returns in an exit – the sale of the company or a public share issue. In return for the money, the startup’s founders grant investors a major stake in the company and relinquish full control of decision-making.
As a result, what investors in startups are evaluating is the size of the opportunity. But it is very hard to do this. In his book “The Secrets of Sand Hill Road: Venture Capital and How to Get It,” Scott Kupor, the managing partner of the Silicon Valley VC firm Andreessen Horowitz, illustrates the challenges of estimating the size of the market using the story of Lyft and Uber. When their founders first tried to raise seed money, the investors examined the companies through the prism of the taxi market and asked what share of it they expected to control. The taxi industry in San Francisco at the time had $100 million a year in revenues. At the end of 2019, the combined revenue of Lyft and Uber from San Francisco alone was $1.5 billion.
Lyft’s founders claim that people make a lot of preliminary assumptions before they use a taxi – about its availability, safety and the convenience of stopping a cab in the middle of the street, or by waiting on the phone for the dispatcher. In a world in which everything is done by cellphone and every driver can serve as a cab driver – at least before certain countries imposed restrictions on so-called ride-sharing services – the availability of taxis grew, as did the market for them.
Betting on one horse
The size of the opportunity is the decisive consideration in the valuation of a company in its early days. But investors assume that while there are many people with good ideas and many companies and entrepreneurs who will try to bring them to fruition, they only need to bet on a single winning horse. Yodfat Harel Buchris, a managing director of the Tel Aviv-based Blumberg Capital who manages the fund’s activities in Israel, says that Blumberg evaluates about 2,500 companies a year and invests in eight to 12 of them globally, including three to five in Israel. She personally meets with some 450 companies a year, a bit less than half the number that sends her presentations each year.
“Valuations at the seed stage are not affected by the stock markets,” she says. Instead, they are affected by the quality of the founders and the employees and their backgrounds. For example, are they serial entrepreneurs, their military service – in technological or combat units; and whether the company is involved in areas with high technological complexity such as artificial intelligence, cybersecurity and data – which are now receiving higher valuations, mostly in light of the crisis – which has created interest in them, says Harel Buchris. For example, they may come from the online commerce sector, which has been rejuvenated, but those who are benefiting from it are the well-known, large firms with a reputation – and not the startups. Valuations in the digital health sector are also rising now because finally potential customers are giving them attention, such as clinics, hospitals, insurance companies and the public, she says.
“Farther down the road, the more the company grows and advances, the person who sets the value of the companies is the new investor who comes in, and we are joining the investment at these valuations if we find they have economic viability and they are right for the development of the company. At this stage the public markets, in which the numbers are open to the public, allows us to track trends and examine if it is worthwhile,” she adds.
“We mostly examine companies that can be potential purchases for our portfolio companies. We analyze their development budget out of the entire budget to receive an indication whether they prefer to develop their products internally or to buy outside technologies. We look at their history of mergers and acquisitions to understand the scope and whether the growth horizon of the company is through acquisitions. Of course, we are not always right, sometimes those companies that didn’t buy technology that was developed by an outside body for a long time will actually look now at a time of crisis like an opportunity and will begin to buy companies at the growth stage, which will provide them with a major advantage in the market in which they operate,” Harel Buchris says.
The values of growing startups are affected by the public markets, and those of the young startups are not affected by the growing startups?
“There is a sort of downward chain to the companies in the first stage of fundraising, but it is insignificant and not representative.”
If Fiverr had its IPO today
The Israeli Qumra Capital fund focuses on growth investments – investments in relatively mature Israeli startups with annual revenue of $10 million- $20 million that need additional funding to move to the next level. The fund entered the growth investments market in 2014, when such investments were still relatively foreign to the Israeli market. In the past 18 months Qumra brought two Israeli companies, Fiverr and JFrog, to success on Wall Street. Boaz Dinte, the managing general partner at Qumra, explains that the fund invests at the stages when there is a clear connection between what is happening in the public markets and in the private market.
According to Dinte, the valuations in the growth rounds are in line with what investment bankers do when they take a company to an initial public offering. “We find five to 10 publicly traded companies – some in the same sector, some with a similar business model, smaller ones and larger ones. We assign each company a weight in the analysis – because the more similar I am to a specific firm, the more likely I am to act in a similar way. We look at the growth of the company and those same companies, the gross profit, the earnings multiple – this is an entire doctrine of how you choose the comparisons. We are trying to do what the bankers will do two or four years after our investment, and sometimes we even consult with the bankers.”
‘If there are fires all over California and the insurance company collapses, the investors will say: “If that’s what happens to an insurance company in a fire, I don’t want to take the risk.”‘
“When companies in the same industry issue stock, we can compare our companies to the results in their prospectus too, which shows the situation two or three years back, before the company went public. I compare it to the spending on development and the marketing expenses to understand if the company I am considering investing in has a financial model that is strong, weak or similar to the company that went public,” Dinte says.
Fiverr held its IPO based on a valuation of $650 million. How does its IPO look today?
“In the case of Fiverr, it was very hard to find a parallel. The closest in investment banking terms was Upwork, which in the quarter that Fiverr had its IPO warned that it would not meet its forecasts. Fiverr can explain why it’s different, but the moment someone identifies a company as comparable and it doesn’t meet its sales targets, the tendency is to think there’s a problem in the market. The view is always that of the market, if there are fires all over California and the insurance company collapses, the investors will say: ‘If that’s what happens to an insurance company in a fire, I don’t want to take the risk.’”
The investors believe
To understand the rising tide in capital markets and the optimism of the private markets, we can take a look at JFrog, which provides tools and platforms for software and application development to companies. The firm prepared for an IPO in early 2020, but the investment bankers froze when the coronavirus pandemic erupted. Stock markets tanked and even privately held companies contracted. Dinte says the bankers told JFrog that 2020 was a “dead year” and that they should set their IPO sights on 2021.
But the trend quickly reversed and shares of JFrog, already attractive to investors, rocketed in secondary rounds, when existing shareholders sold off shares. According to the company’s prospectus, in March 2020 the share price was $15, in June $24, in mid-September JFrog reported a range of $39-$41 after its roadshow and the IPO price was $44 a share. In the three months since, the share price has increased 57% for a market cap of $6.3 billion – triple the valuation when it was preparing for the IPO in early 2020.
JFrog is considered a strong, growing company, with phenomenal customer retention rates and a positive cash flow for the past five years. But it is trading at a very high price to earnings ratio, of 45. Dinte says there’s room for a correction in the market: “But I admit that I’ve been saying this for a long time and it hasn’t happened yet.”
“There are very high multiples that we haven’t seen in the past – the market is sensitive and anxious, stocks are dropping by 10% without having announced anything, just because Pfizer announced that it has a vaccine. Companies are getting multiples of 40 and 50 based on their sales forecasts for next year, and this shows the faith investors have that they will grow in a phenomenal way.
“Some really do have insane growth and a real business, but if they grow in an impressive but not amazing way – their [stock] prices will fall. It is very challenging to manage a company in these times,” Dinte concludes.