Venture capitalists tend to be an efficient bunch. But if there was a ranking of most efficient VCs, Tomasz Tunguz, a Redpoint Ventures managing director who made an early bet on Looker that this year sold to Google for $2.6 billion, would be toward the top of that list.
Tunguz is not only an active early-stage investor, he is also helping to raise five kids between the ages of two and eight and is well-known for his SaaS-focused data-driven blog.
Analyzing start-up metrics against the backdrop of public markets and macroeconomic conditions is one of Tunguz’ big passions and he gladly shares his insights with the world.
In one of his recent posts, Tunguz compared relative valuations of high-growth software public companies with high-growth private companies over the past four years. In 2017 and 2018, a median “later-stage” SaaS start-up growing at 50 percent or more a year raised capital at a higher projected annual recurring revenue multiple than the trading multiple of public companies, his analysis shows.
But this trend reversed last year. “Starting in 2019 and continuing in 2020, the public markets value these companies with better multiples,” Tunguz wrote in his blog. “It means raising capital in the public markets is now less expensive than in the private markets.”
Tunguz’ conclusion is that as long as this trend holds, we will see more late-stage start-ups choosing to raise capital on public markets, through IPOs, direct listings or SPACs.
Venture Capital Journal recently spoke with Tunguz, who talked while simultaneously making lunch for his five kids, about reasons public markets may be willing to pay more for high-growth companies and how this bodes for earlier-stage investors.
An edited transcript of the conversation follows:
There are reports that some fast-growing early-stage SaaS start-ups are raising capital at up to 100 times annualized revenues. What segment of the cloud software market is seeing that type of investor demand?
I would say the most competitive segment of the software market are start-ups with half a million dollars to $5 million in annualized revenue and about 15 to 40 employees. Investors are attracted to these companies because while they are early bets with high return potential, some of their key risks have already been mitigated and it is possible to forecast revenue growth.
Why do you think investors are willing to pay a premium for some companies at this stage of development?
You have a convergence of different investors bidding for early-stage companies. There are not only traditional VCs, but now we are also seeing hedge funds competing for these deals. Hedge funds often use early bets as lead generation vehicles. They can take a loss on an early bet, as long as it gives them an opportunity to invest a significantly larger amount into the company at later rounds.
But valuations are also a function of the company’s growth forecast and a time horizon an investor is willing to hold it.
In your recent blog, you present data which show that public investors are now willing to pay more for high-growth SaaS companies than private investors do. What do you think are some of the reasons for this?
I think there are several dynamics at play here.
Lower cost of capital has pushed stock values up. Also, with the number of public companies is down by 50 percent over the last two decades, there are fewer investment opportunities for public investors. Lastly, with interest rates near zero, high-growth technology companies look attractive on a risk-adjusted basis.
There is a bit of dry powder in private markets. Why are we not seeing private start-up valuations appreciate as much as public stocks?
In private markets, there are not as many investors to bid up the price. A typical VC deal has about half a dozen investors who might have access to the management team and the ability to compete and win. The number of investors in the stock market is obviously much larger.
Do you think SaaS valuations are overheating?
About only 20 percent of all potential software and infrastructure spend has been moved to the cloud. If you assume a terminal SaaS penetration of about 60 percent, this means this market has the potential to eventually triple. This is a long-term outlook.
But in the short term, investors in private markets are taking on a lot of risk at current valuations. Can multiples fall in half? It is possible. We saw it in 2016.