The State of the Fundraising and Startup Market with Tomasz Tunguz, Redpoint Ventures

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To need to be invested in the next four years. And so that's going to create a booming effect within the ecosystem. That's probably the most important factor in the private market. We've got record levels of dry powder. I need some traction. You need some traction. Let's get some traction.

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I need some traction. Hi everybody. Thank you so much for being here. It's a privilege to be talking to you today. My name is Moshten Goose and my background is I started a company when I was 17. I was a product manager at Google doing large scale machine learning for ads. Then I've been a managing director at redpoint for 14 years. I write a blog and then I've worked with six unicorns from the time that they were very small to the time that they were very big. And today I am going to talk to you about fundraising in this environment, which is a radically different environment than any other 14 years that I've been in venture capital. And it's important for you, or what I want to share with you is right before I joined Redpoint, Lehman fell. I joined in May of 2008 and four months later the global financial crisis happened. And I saw what happened to startups when the fundraising market dried up. All of a sudden, term sheets were pulled, rounds were flat, the pre money valuations in those days were single digits. And then what ended up happening is we had four massive periods in the United States of quantitative easing that created 40% more US dollars than had been in existence up until that point. And then we had Covid, we had huge supply chain issues and we catalyzed this inflation. All of a sudden the Fed needed to act in the United States and the first thing they did, which is something they hadn't done in a very long time, was to raise interest rates. When rates go up, valuations of high growth technology companies fall because the vast majority of growth, vast majority of the revenue of a high growth technology company is in the future. If you look at a company that's growing 3x or 4x in a year, 10 years from now, it'll be really big, but today it's quite small. And so as rates go up, valuations fall. The other thing that happened when rates went up, the stock market fell. And when the stock market fall, people suddenly become conscious of what's going on with their portfolios. And that's much as true for individuals as it is for companies. And so as a result, companies and individuals spend less. Consequently, startups grow slower and that yields a decline in multiples. And multiples are how we value software companies. Today I'm going to be talking predominantly about software companies. When I'm talking about a multiple, I'm looking at a company and I'm projecting what its revenues are going to be for the next 12 months. And I'm multiplying it by a number. That's the multiple. And we'll be talking about those numbers and what they've looked like over the last 10 years. But when a company starts to grow slower, it gets the benefit of a much lower multiple. And so the combination, the consequence of all these different things is that you have a crash in the stock market, which is exactly what we've seen. So today, what I'm going to talk to you about is what's happening in the public markets, what's happening with founders, how do founders see it? And then what's happening in the private markets. We'll gather up all that data and at the end, I'll give you my prediction for what's going to happen, which is doubtlessly going to be wrong. So let's talk a little bit about the public markets. So this is the data from 2016 to 2022 of all the software publicly traded software companies by Quartile, the 75th quartile, are the fastest growing ones. That's the yellow line. You've got the blue line and the red line for the two other quartiles. You can see that in 2016, the sum total of the market cap of all these different companies was about 10 billion. It hit about 40 billion four years later as a result of that quantitative easing, and then collapsed by about 60% in two quarters. That's the shock that we've all been feeling. The result of this is that revenue is slowing. And the way that I think about measuring revenue is you take a look at the companies that sell the most software. Google, Amazon, Microsoft, they sell software to every buyer on the planet. So they're effectively an index of software buyers. What are these software buyers doing? They're buying less. The growth rates of these Companies fell by 21%, quarter over quarter. That's not to say that they still aren't growing fast. Amazon web services generated $20 billion in revenue last quarter. That means they're adding another $10 billion each year. That growth has slowed. But still, these are massive businesses growing really fast. And again, going back to the initial point we had the market correction, companies are spending less and as a result, public multiples are down again. These are by the quartile, so public multiples are down 60 to 70%. And you can take a look. Here's the crash, right. So what does it mean? It means that the way that we value software companies today in the public markets are effectively equivalent to the valuation levels in 2017. Those were still heady times like these. These are valuations that are still in the venture world, pretty elevated. When I joined in 2008, a typical Series A was 4% for 25 million. Today, if you go and raise capital, you're probably raising a Series 8, somewhere between 8 to 10 for 20% of the business. So we're still significantly higher than we were even before Lehman fell. But it's painful to see a 60 to 70% loss in the value of a business. So to summarize what's happening in the public markets, the Fed raises rates. Valuations of public companies fell, businesses stop spending as much, so growth slows, which means everybody's multiple collapses and we have a crash. That's what's going on in the public markets. How do founders feel about this? In May, I sent out a survey, surveyed 450 companies. These companies range from the very small to publicly traded businesses. And I asked them, what's going on inside of your business? How do you think about your ARR growth? And what do you think about the fundraising market? Most founders are anticipating a 31% decline in ARR, which is 10 percentage points higher than Amazon and Google and Microsoft. So they think they're actually going to grow slower. But they only forecast about an 11% decline in valuation. That's tough. If you look at what's happening in the public markets, there's a discontinuity there. So if we take a hypothetical startup that's at $10 million in revenue last year and it's growing at 300%. And we project its growth for two years. We think about two different scenarios about how to value it in the good old days. In Q1, 2021, that's that second column there. And then after the crash, in Q2, 2022, let's go down the first column. In the first environment, the growth rate was about 300%. The ARR two years from now is going to be about $66 million. The multiple that we would have applied to that business, given what's going on in the public markets would be 22. And so the company would be worth about 1.4 billion. It would be a unicorn. Today that very same business is going to grow about 25% less so 225% instead of 300%. Its ARR in two years time is going to be about 48 million. It's growing slower. The multiple that we apply has been corrected by 60%, 63%. So we're going to multiply it by eight. And so the value of that business is now 400 million. So just as a result of what's going on in the public markets, we've seen a billion dollars of value wiped off this company. The fundamentals of the business are probably exactly the same. It's just the market values in a completely different way. And so that creates this disconnect. There's a disconnect between what's happening in the public markets and founders expectations in the private markets. And that's why every VC I know is on a beach somewhere in Mexico or in Italy, because there is such a disconnect. I'll give you an example. There were three late stage companies that came in to pitch our partnerships. They all came in asking for 700, $800 million valuation. And the difference between what we were willing to offer them and what they were asking was measured in the hundreds of millions of dollars. Now anybody who's operating a market understands that when the bid ask spread is that large, the market doesn't work, which is why everyone's on the beach. And so what's going to happen with this disconnect? Let's take a look at what's happening in the private markets today. It'll give us some sense of what's going on. So these are seeds, Series A, series B, series C. These are the round sizes. So typically, basically the median amount of money put into companies at each of these stages. And the blue lines going across them are the trend lines, basic linear regression. And you can see that the round sizes really haven't moved. They really haven't changed. There are some fluctuations here and there, but they're basically in line. Right. The valuations across these rounds are also identical. And somebody should yell, hey, Tom, this doesn't make any sense. You just told us the public markets are down 70%. All your friends are on the beach drinking Mai tais, but the market looks healthy. There's a problem in this data. And the problem with this data is round counts are declining meaningfully. So what's going on is VCs are funding a select number of companies at similar terms to the previous valuation environment, but only a very small number. The companies who aren't doing so well or are stuck at really large valuations or having a hard time, they aren't raising. And so they're not actually reflected in this number. There's a survivorship bias. So, to summarize, this is what's going on in the private markets. The publics are down 70%. Founders expect a 10% drop. And the private markets are slowing because the delta between the bid ask spread is so enormous that the market is not functioning anymore. So what does it mean for the future? Well, one of the most important pieces of data that I can show you is there's about 300 billion in dry powder. So venture capital as an Asset class grew 10x over the last 10 years. In 2010, two years after I joined Redpoint, we were a $30 billion asset class. Venture capitalists invested about $30 billion a year. Last year, we invested 330 billion. 80% of those dollars were coming from non traditional VCs. They were coming from hedge funds, crossovers, public market investors. And that's led to this absolutely incredible rise in the amount of money that's available and money that has been invested in the ecosystem. That's also what's driven up valuations. VCs like us continue to raise capital. We've raised that capital. We need to invest it over the course of four years. It's four or five years. It's a requirement in the documents that we sign. And so consequently, there's $290 billion that's going to need to be invested in the next four years. And so that's going to create a booming effect within the ecosystem. That's probably the most important factor in the private market, we've got record levels of dry powder. The other thing that's going to give the private market a little bit of a softer landing compared to that 70% drop. From the public markets is the mark to market latency. If you're a publicly traded company, your value changes every day. If you're a Snowflake or Apple or Google, your stock price closes every day. And you know exactly what the business is worth. In the private market, that might happen every nine months, every 12 months, every 14 months, every 18 months. And the reason that's important is the four most similar recessions to the one that we're currently going in. The average duration of those recessions is about 14 months. The definition of a recession is two consecutive quarters of negative GDP growth. So by the time you figure out you're in a recession, you're about halfway through. The other really important data point to know is the stock market starts to rebound 153 days before the end of a recession. So six months into the recession, you're in a recession. You wait two months and then by that point, the stock market should start to take off because you're basically on the back side. And the stock market anticipates price movements or revenue movements six months ahead. And because of the mark to market latency, you can imagine a lot of companies would raise at one point, basically miss the dip, and then raise it another point, relatively healthy. And that's why you probably won't see as harsh of a pricing environment for most startups as you have seen in the public markets. The third reason is as a result of that data point, that 153 days, the stock market starts to rebound, we should expect higher multiples in the public markets than we have seen in the last couple quarters. And so those multiples are really important because venture capitalists like me, we put those in our investment memos and that's the way we justify valuations. And so if they go up, it's easier for me to write a check at a larger price. The last dynamic that's really going to help nullify or soften the blow for the private markets is in the public markets, there are tens of thousands or hundreds of thousands of shares traded in Google every day. They might even be in the millions. And so there are lots and lots of different transactions in the private markets. There's only one person who sets the price for a company. It's a single auction winner. If I'm competing to lead a deal in the next generation software company, if I set the price as a single actor, that's the market clearing price, that's the comp. And so I can bid 30, 40, 50% ahead in order to win a deal. And that's gonna set the comp and that's gonna create this nice booing effect. So for these four reasons, we're gonna see, I think a more muted impact in valuation correction in the private markets than we would have in the publics. Cool. All right, to summarize, so the publics are down 70%. The private data suggests that the market is steady, but it's actually a mirage. The number of the volume of venture backed companies actually raising capital is really quite small today. If I were on your board and you were asking me I need to raise capital today, what price should I expect? You should expect a 40 to a 60% decline relative to your expectations a quarter ago. And that's basically based on fundamentals. Is there any government policy that I could imagine that might change the environment for venture backed startups? The only thing is whether or not the government influences the Fed to raise or decrease rates. Because right now that's the biggest driver. And one of the sagest pieces of advice in investing is don't fight the Fed and you got the big chips act for semiconductor investment. I don't think we're going to see a lot of venture capital investment in semiconductors anytime soon. Topic for a different day. But so anyway, publics are down 70%, privates are steady, but it's a mirage. If you need to raise capital, you're probably down 50% in terms of price. I do think volumes are going to come back pretty meaningfully in early 2023. And I'm basing that just on the fact that Most recessions are 14 months. And at that point we're basically going to be at least three quarters of the way through a recession. So there's two different worldviews of the way that the future is going to go. There are the people who believe that inflation is permanent or long term. And the argument there is that we're basically in some new form of world war where the international trade is going to break down. And so that means the supply chain costs are going to continue to increase. And so as a result, inflation is going to be steady. The only times that the US Fed has ever broken inflation was to take the Fed funds rate above inflation. If we're at 6 or 7% inflation, that would mean taking the fed funds rate above 6, which the government can't afford because the debt is too big. The other scenario is that inflation is transient. Corn is down, lumber is down, energy is down because of what Russia has been doing. And in that scenario, basically the Fed hikes and then cuts that's the Goldilocks scenario. That's the view that I take. I'm an optimist as are every founder in here. And so in that scenario I think honestly like the market is going to do great at least in the back half of next year because that's because I think the fundamentals are there. But the reality is I can't tell you that's absolutely what's going to happen, but I think that's what's going to happen.

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No, I've done some silly focused on the tech stack thinking it was brilliant. Now I know that it's no way for you to.