by Don Butler on July 19, 2011
If you look to the past as a guide to the future, or if you believe in the cycles of history, then I think you have two years. Two years to get enough funding to last for some time beyond then. Or, two years to get either bought or go public if you’re far enough along with your company. What gives us the confidence to make this prediction? It’s what we’re seeing in the market and what we’ve seen by going back and looking at the tech cycle as a potential guide to where we are today.
It started for me with the taco truck…
What’s so special about the taco truck above? It’s a taco truck offering free tacos to the employees of one of our portfolio companies. Sponsored by a real estate firm. For those of us that were working with startups in the late 90s, I remember these kinds of freebies. It hasn’t reached anything like the excesses that emerged towards the end of the tech bubble – I still haven’t seen any over-the-top launch parties yet – but it’s still caused us to wonder where we are in the tech industry cycle.
Our sense is that we’re back to what in effect feels like 1998, and have at least two years of good times for entrepreneurs ahead. To go beyond the anecdotal evidence and our own hunch, however, we wanted to see if the data on the public and private markets supported our general sense of where things were – it does.
To begin with, the number of U.S. startups receiving financing on a quarterly basis is on par with what we saw in 1998 as well as when the startup ecosystem was expanding in the 2006/7 timeframe.
U.S. Startups Receiving Financing, 1991-2011
Source: Thomson Reuters (2Q11 figures incomplete)
The increasing number of startups getting financed has coincided with an increase again in the amount of funding going into the venture funds themselves. Once again, we see that we’re back on par with both the 1998 and 2006/7 levels.
U.S. VC Fundraising, 1991-2011
Source: Thomson Reuters (2Q11 figures incomplete)
The increase in funding of U.S. venture funds comes at a time when we’ve seen the number of venture-backed companies going public starting to increase as well. And here again we find the current environment looking similar to both 1998 as well as 2006/7.
VC backed IPOs – Volume and Post Offer Median Valuation
Source: Thomson Reuters
So the current environment looks a lot like how it looked in both ’98 and ‘06/07; why does it feel more like the former than the latter time to us? It’s a combination of what we see in the early stage venture business as well as in the public markets. Valuations have been trending upwards, and the public market – which provides a clear signal to so many participants in the food chain – appear willing to take risks again. The public markets now appear to have a tolerance for risk and a willingness to buy into companies that might not have been able to go public just a few years ago. While the volume of VC-backed IPOs is on par with what we saw in 1998 as well as in 2006/7, the companies these days tend to be earlier in the path towards profitability and look on that measure more like they did in ’98 than in the late 2000s.
To get a sense for this, look at the three tables below – these show the top 10 IPOs by market cap for the first half of each of 1997, 2007, and 2011. The largest IPOs of 1998 were typically smaller companies (by market cap) that had yet to turn profitable.
By 2007, the largest IPOs were now typically companies with two to three times larger market capitalizations that were already profitable.
Finally, as we look at today’s IPOs, the companies that have been the largest IPOs by post offer market capitalization have even larger capitalizations and yet are once again typically not yet profitable.
What this tells us is that while the companies going public today are much larger companies than in 1998, we’re back to seeing large market capitalizations assigned to companies that are still on the way towards profitability but not yet there. Yes, the companies are definitely different and better this time – they’re larger, built on much more solid foundations, and have been around for longer periods of time – but that doesn’t change the fact that we’re back to the majority of companies going public being ones that are not yet profitable.
There are of course a number of other differences between the market in 1998 and today’s market: unemployment is sky-high compared to back then, the economy hasn’t recovered to nearly the same levels of growth as was the case then, and so on. But our experience tells us that we’re looking at another two or so years of expansion in the early stage tech environment. To us, we’re expecting some of the same factors (both for the good and for the bad) to re-emerge for entrepreneurs: easier access to funding (but also increased competitiveness as more companies targeting the same markets get funding), increased salaries for talent (and increased employee turnover as more key employees are sought by competitors), and so forth. What’s concerned me is that we’ve already heard some of the larger VCs talking about “pushing out” as many long-held portfolio companies onto the public markets as possible. Let’s hope that the public markets keep looking for quality over quantity – otherwise we risk seeing the IPO window close once again and seeing the entire financing ecosystem for start-ups slow down.