Larger funding rounds earlier in the lifecycle of private tech companies

There has been a surge of mega growth stage financing rounds globally, especially in the Internet, mobile and SaaS spaces. Venture capital funding in 2014 was up over 60% year over year across major markets globally. Average VC deal sizes have grown by over 50% on average over the past five years.

Why?

It is certainly true that funding for private tech companies is going through a phase of exuberance and globally there is significantly more risk capital available than in the last several years. There are many reasons for this. Business cycles are complex, and this can be the topic of an entire book. In this blog post, we’ll focus on the other side – why raising more money earlier in the life cycle could be a good idea for certain companies once critical mass is achieved.

Here are some good reasons to invest larger amounts of capital than before into companies where the basic model (product market fit, business model) is proven and market opportunity is perceived to be large:

  1. Scale as competitive barrier. A large number of growth stage companies (especially in segments such as Marketplaces, SaaS) are being built upon previous layers of platform innovation/adoption e.g. ubiquitous smartphone + social are key enablers for unicorns such as Uber, AirBnB. A vast majority of growth stage companies today are not built around defensible breakthrough technology. The main competitive barriers for most models are execution speed, scale and network effects. In this situation, once product/market fit and business model are proven, it often makes sense to grow as fast as possible, globally
  2. Competitive strategy.In many cases, raising a very large financing round is a way to send a strong signal to of competitors’ existing and potential investors, thereby limiting the rise of competition and creating a more dominant place in the market
  3. Attention is getting more expensive. It is getting increasingly expensive to acquire customers, especially consumers, given intense crowding of services vying for finite amount of attention on app stores, search engines and social platforms
  4. Larger digital user bases. There are ~3 Billion internet users in the world now, compared to 800M a decade back. The growth in India over this period has been even more pronounced. Consumers and Enterprises are much more engaged and are using digital platforms for a much wider variety of tasks than they were a decade or even five years back. Much of the growth capital raised is often spent by companies on customer (and supply) acquisition. It takes more money to acquire a meaningful fraction of this much larger user base
  5. Opportunity is global.There was a time when companies were built in one country, and then considered global expansion after getting to significant scale over several years. This created opportunities for business model arbitrage across geographies. Companies such as eBay ended up acquiring several companies with similar models across the globe. However, category-leading companies and their investors have realized that this leaves opportunity on the table for others (which could additionally be future threats), and in many cases it makes sense to enter multiple markets much sooner in the company’s lifecycle
  6. Lower startup costs, evolving venture model.The traditional venture capital model was born and evolved largely to fit the requirements of funding breakthrough technological innovation. E.g. a company developing a new hardware chip or a breakthrough search engine. Startup costs were high. Each progressive round of early stage financing helped the company alleviate a different form of risk one after the other: technology risk, productization/manufacturing risk, product/market risk, business model risk, scaling risk. Many of today’s high growth tech businesses do not have significant technological or manufacturing risk, and the cost to prove product/market fit and business model has reduced very significantly over the years. Companies can reach the “ready to deploy large amounts of capital” stage much faster, but so can their competitors. Given this dynamic, once the product/market fit is proven and the market is deemed to be large, it often makes sense to capitalize category leading companies more heavily and focus on acquiring customers as fast as possible

What all this means is that in many cases it makes sense to deploy more capital into companies earlier on than it did five or ten years back. However, how fast these funding levels should grow, what this means for valuations and whether investors in certain sectors/geographies are currently underestimating risk is another question.

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Why do global stock markets appear so overvalued?

Are global stock markets spectacularly overvalued compared to their longer term trends?

One basic way to compare stock market valuations over time periods is to look at the market’s P/E ratio. This metric can be quite volatile due to short term variations in both price and earnings. A more stable metric is  the ratio of price to earnings that are averaged over a few years. This post on SeekingAlpha does a nice job of analyzing P/E ratios calculated using trailing 10 year average earnings. The chart below is quite interesting:

Credit: Doug Short / SeekingAlpha

The current market’s P/E ratio of 21.7 is significantly above the long term mean of about 15. So is the current market significantly overvalued?

Look carefully at the period after 1980 on the bottom chart. It appears that over the last 30 years, the market has systematically risen above its long term mean P/E ratios, and has stayed there – in spite of the two mega crashes of 2001 and 2008! Why should that be the case?

When looking at market valuations and P/E ratios over such a long term, a few other things come into the picture. Here are at least three reasons which could lead to secular changes in ‘normal’ P/E for the market:

1) Sustained period of strong growth expectation. This is the obvious one. However, it’s unlikely that the US market is factoring this in at the current point.

2) Risk free interest rate. The lower the interest rates are, the lower the denominator (discount rate) that the market factors into the valuation of each component, hence leading to higher overall P/E. Future interest rate expectation is disproportionately impacted by current interest rates, so the market would typically have a higher P/E when interest rates are very low – like now. Interest rates in the Western world have consistently fallen over the last 30 years. This coincides with the trend of higher P/E ratios over the same period.

3) The third confounding factor is the overall demand/supply for equities in the market. It would be interesting to see how the evolution of market P/Es correlate with wider equity/mutual fund ownership among the general population. Empirically, the advent of the ‘information age’ has made it much easier for small retail investors to own equities and mutual funds. Additionally, in the US, government-driven focus on 401K (retirement savings) plans has also increased equity market participation.  Both of these trends have significantly driven up overall demand for equities. Such a sustained increase in general demand would also lead to higher market P/E ratios over the long term.

I think the above factors could have led to a long-lasting shift in the market’s “normal” P/E ratio.  Wonder if there is a good way to assess market valuations in light of these additional factors?

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