It wasn’t supposed to happen like that.
When Byron Deeter and colleagues at Bessemer Venture Partners first met the co-founders of Box.net, they were impressed by the team and the market opportunity for the then seed-stage cloud storage company. But the firm’s partners couldn’t shake off concerns about the revenue model. So they opted to pass on the Series A and look at participating in a later round.
However, the opportunity to invest at a modest markup never arose. Instead, the company, now known as Box, had grown so rapidly that its valuation shot up from less than $60 million to more than $500 million in the span of less than two years. Moreover, VCs were so excited about the company’s prospects for further growth that Box was turning away term sheets. Bessemer eventually managed to get into an expansion round, but it didn’t come cheap.
“We’re a low ego place. We went back in there and begged our way back in,” Deeter says.
Although the 2011 round was for one of the highest valuations at which Bessemer has ever made an initial investment, partners still saw terrific odds for a venture-scale return. So far, paper returns look good, with subsequent financings valuing Box at above $1 billion, a more than 50% markup from the firm’s entry point.
Welcome to the era of accelerated acceleration.
While venture capitalists have always sought out fast-growing companies, the current generation of high-achieving startups is setting new records in two categories. First, they’re acquiring users at an unprecedented clip. Second, they’re seeing valuations rise faster and higher than ever before.
That supercharged growth is changing the risk-reward dynamic for VCs, doling out enormous return multiples for savvy (and lucky) early investors and forcing later-stage investors to buy in at the kinds of valuations formerly reserved for portfolio company exits.
To illustrate just how many startups are generating tremendous valuations with private investors, we’ve come up with a list of those that have seen the biggest and fastest jump in valuation from initial to follow-on rounds in the past four years.
The list, based on a mix of publicly disclosed data, media reports and research firm estimates, is topped by some well-known names, including Box, mobile-enabled car service Uber, and self-deleting messaging app Snapchat. Dominant sectors include consumer Internet, cloud computing and enterprise software.
Following, we look at how VCs are adapting to the hyper-growth environment across stages.
For early investors, the fast pace of value creation provides affirmation of their strategy, yet it also motivates them to reconsider the standard venture model of waiting for a portfolio company to sell or go public or sell before cashing out.
Later-stage VCs, meanwhile, are adjusting their cost expectations upward, investing at valuations more commonly seen among public companies than venture-backed startups.
As for exits, there’s a worry among investors across stages that today’s fast climbers could see their momentum fade just as speedily. To date, that has not translated in a rush to exit, as later-stage investors find a ready supply of even later-stage investors.
Valuation Gap Widens
While rapidly escalating valuations may be a cause of concern to much of the venture industry, there’s one group that’s not worried.
Early-stage investors with one or more runaway hits are feeling pretty content. Even if everything else in their portfolio is a flop, a single lofty outcome can return all of limited partners’ invested capital, and then some. Moreover, there’s plenty of evidence that well-chosen early-stage portfolios can churn out multiple monster returns.
“The structural forces and trends really favor our model of venture investment,” says David Blumberg of Blumberg Capital, a San Francisco-based early-stage firm that scored a 52x return in August from a partial sale of its stake in Hootsuite, a provider of software for tracking social media campaigns.
One trend helping early-stage VCs is the lower capital requirements for Internet and software startups. Vancouver-based Hootsuite, for instance, raised less than $3 million in a seed round that Blumberg co-led in 2010, in which the firm invested less than $1 million. The company required relatively little capital to scale, Blumberg says, as it attracted users with a free application and made money selling premium versions. That approach kept marketing costs down, as Hootsuite managed to amass millions of users without a traditional late-stage round.
Although the company sold a significant stake in a $165 million August financing (led by Insight Venture Partners), that was principally a secondary transaction to cash out existing investors and management rather than fund company operations, Blumberg says.
“The structural forces and trends really favor our model of venture investment.”
David Blumberg
Blumberg Capital
Hootsuite isn’t an outlier in terms of growth either. Blumberg says his firm has other ultra high-growth companies in its portfolio, including Nutanix, a virtual computing platform provider, and Credorax, an online payment processor. Blumberg says that for Fund III, which has held a partial close, at least two out of 10 companies have 4x markups in valuation within four to eight months of the firm’s investment.
In fact, a number of firms with a strategy of making large, early investments in Internet startups with business models based on freemium services are posting exemplary returns. Union Square Ventures, an early backer in Twitter, Tumblr and Zynga, manages several of the best-performing funds in the venture industry. Spark Capital, a co-investor in Twitter and Tumbler and backer of eyeglass retailer Warby Parker, is also a top performer, as is FirstMark Capital, which provided the first institutional money for Pinterest.
FirstMark’s 2005 fund returned an impressive 3.22x investment multiple, according to the Oklahoma Police Pension & Retirement System. Union Square Ventures’ 2004 fund had an IRR of 69.5%, according to The Massachusetts Pension Reserves Investment Management Board.
Most of Silicon Valley’s most established venture firms have also benefited from early-stage bets in fast climbers. Benchmark Capital, for instance, was the first institutional backer for Snapchat, which has secured a valuation exceeding $800 million less than two years after launching. Sequoia Capital and Greylock Partners were early investors in Airbnb. And Accel Partners provided initial funding for tablet game maker Supercell, which partners described as the fastest-growing company in terms of revenue growth and profit that they have ever seen.
It’s not even necessary to make a lot of money to attract an enormous valuation. It’s often enough merely to threaten an incumbent who has a lot to lose. That’s the broadly accepted storyline behind Facebook’s purchase of Instagram in 2012. Though Instagram was only two years out of the starting gate and not making money, it was wildly popular enough for Facebook to pay a billion dollars to buy the company.
Super-Performers Are Worth the Price
The ultra-fast growth trajectory of many newly launched startups raises a question for investors. If early-stage is so lucrative, why would anyone want to invest later at higher valuations?
Late-stage VCs have plenty of answers. For one thing, looking at dollar returns and not just percentages, later-stage investors have an edge because they can put more capital to work. That’s particularly the case in the era of the capital-efficient startup, as cloud computing, open source software and freemium business models enable companies to go from concept to revenue generation on a small early-stage round. The later stage offers the only opportunity to put significant capital in a deal.
Source: REUTERS/Beck Diefenbach
Ron Conway, founder of SV Angel, says he is finding reason to invest in later-stage deals.
Additionally, it’s easier to identify a startup as a winner after it has shown traction. Of course, every venture capitalist would like to be the kind who spots the potential in a young Mark Zuckerberg and his dorm-room startup. But better to bet late on a winner than pass up the opportunity entirely.
“We love to find them as early as we can, but we don’t always find them at the Series A or B stage. So we have a cross-stage strategy intentionally,” says Bessemer’s Deeter, who says that partners will only invest later if a deal still has potential for venture-scale returns. That means they must see a very straightforward path to “comfortable 5X returns,” with potential for 10x and above.
Deeter says he’s seeing (and investing in) quite a few companies that are proving out their business model at a fairly early-stage and raising big later-stage rounds.
Bessemer investments in that mode include LinkedIn and Yelp. Another portfolio company that fits that category, is video ad network Adap.tv, which announced in August it will sell to AOL for more than $400 million. Bessemer led a late-stage round for the company in 2011.
Even angel investors are finding compelling reasons to play in the late stage arena. Case in point: Ron Conway, arguably the best-known angel investor in Silicon Valley, disclosed early this year that his firm, SV Angel, raised $30 million to purchase shares of Pinterest. The company’s reported valuation at the time was about $2.5 billion, clearly not the stuff of seed-stage term sheets.
Conway, a longtime fan of the company, writes that the model is one of the best-positioned to benefit from the growth of social commerce, as it “lets users curate what amounts to their own digital product catalogs.”
“It’s no secret that Snapchat has yet to turn on its monetization engine. Despite this fact, the financing was intensely competitive, one of the most competitive financings we have been a part of in years.”
Dennis Phelps
General Partner
Institutional Venture Partners
Notably, the fastest climbers from a valuation standpoint include both pre-revenue companies and startups generating substantial sales. In the former category are Twitter, Pinterest and Snapchat, all of which reached valuations near or exceeding $1 billion dollars without significant revenue. The latter group, meanwhile, includes Supercell, Uber and smart thermostat maker Nest Labs.
Typically, the most desirable companies for later-stage venture have $20 million to $100 million in annual revenues. But there are exceptions, says Dennis Phelps, general partner at Institutional Venture Partners, which led a $60 million round for Snapchat this summer.
As with Twitter, another of IVP’s late-stage investments, Snapchat benefits from network effects, Phelps says. That is, it becomes increasingly valuable to users as more of their friends sign up.
Venice, Calif.-based Snapchat also benefited from the network effect with its last financing, as founders were flooded with term sheets from venture capitalists.
“It’s no secret that Snapchat has yet to turn on its monetization engine,” Phelps wrote after its last round. “Despite this fact, the financing was intensely competitive, one of the most competitive financings we have been a part of in years.”
Fast Climbers, Slow Exits
To date, there’s limited evidence to suggest that investing in Internet companies with minimal revenues and massive valuations is a strategy that works out well for venture capitalists.
Certainly, many of the most lucrative venture exits have come from companies, such as Yahoo and Amazon.com, which went public before turning a profit. But even the more risk-tolerant Internet and software stock buyers look for significant revenue. That’s particularly the case today, with Internet and SaaS companies waiting to reach $50 million or more in sales before going public.
VCs seem to have better luck selling fast climbers to acquirers. As Facebook’s Instagram purchase illustrates, acquirers will pay handsomely for a startup that could threaten their business were it to remain independent. Or, in the case of Yahoo’s $1.1 billion purchase of Tumblr this spring, a large-cap company with an established revenue stream may see value in a property with a fast-growing user base.
New research, however, supports the theory that Internet and technology investors focused on high-growth companies that already have revenues and good margins can outperform their peers. That was the general findings from data published in August by private equity adviser Cambridge Associates, which found that that growth equity investors posted average returns that were significantly higher than venture capital firms over three-, five- and 10-year periods.
While the numbers included deals across industries, technology and digital media sectors were the heaviest influencers, accounting for about half of the growth-stage investments.
Joanna Glasner can be reached at joanna.glasner@thomsonreuters.com. She tweets at @jglasner.
