On February 19, 2020, the NASDAQ reached its all-time high of 9,838. Three months later, the public equity market had bounced back close to peak levels despite mind-boggling US unemployment claims of over 38 million people and sharply negative GDP growth. What will all this mean for the startup economy?
It’s clear that the venture capital market is undergoing a dramatic reset, having entered the dreaded “freefall” phase of its cycle after the longest “acceleration” phase of the modern era. But where is the bottom, what will it look like and how long will we be there? We decided to look to history for some clues and expanded the time horizon of our "V21 Analysis" of early-stage financing dynamics all the way back to 2000. Also known by its publication title, “Seed is the New A”, this research has shown inexorable trends of larger deals at higher valuations in more mature companies at each “letter” of the financing “alphabet” over the past decade. The expanded study now captures a complete 20-year venture market cycle, which includes 2 very different crashes and the longest boom we’ve ever seen.
I had the privilege of working alongside the great Arthur Patterson, one of the founders of Accel, for nearly 15 years. After the Dot-Com Crash (DCC), Arthur shared with us his four-phase framework for understanding the venture capital market cycle. This framework has since been adapted and expanded upon by several others, including Brooks Zug of HarbourVest. The chart below maps the last 20 year’s onto Arthur’s framework.
Our V21 data reveals the impact of the cycle on the “headline” indicators of financing size and valuation. In the DCC, Series A’s fell 40% in size and 53% in valuation. The Series B, typically more volatile, fell 62% in size and 72% in valuation. After a period of bottoming and tentative mini-recovery, disaster struck again in the form of the Great Financial Crisis (GFC). This time financing sizes fell only 4% for the Series A and 14% for the Series B. Valuations were hit harder, falling 27% for the Series A and B in a single year.
A Quick Trip Around the Cycle
Let’s take a closer look at the 2000-2020 cycle and examine its four phases in greater detail.
Year 2000 was the peak of a 17-year market cycle that began back in 1983. The NASDAQ broke 5,000 for the first time (5,049, up from 325 in 1990). US venture fundraising broke $100 billion for the first time ($101 billion, up from $2 billion in 1991).
Dot-Com mania and the broadband boom carried the markets well beyond any notion of fundamentals. Startups went public with single-digit-millions in revenue and no operating history or defensibility. Many of them promoted concepts that would eventually be significant 15 to 20 years later. Others never made any sense at all.
2000- 2004: Freefall
When the cycle turned, it did so with a vengeance. The NASDAQ fell 77% from its 2000 peak to 1,114 in 2002. During that same period US venture fund commitments fell 96% from $101 billion to only $3.5 billion in 2002. Numerous shocks after the initial burst of the bubble exacerbated the downward spiral, including 9/11, the invasion of Iraq and the SARS outbreak.
The impact on the early stage financing market (as measured in our V21 analysis) was severe. The size of the median Series A fell 40% in 3 years, and its pre-money valuation fell 53% in 4 years. “Jumbo” Series A’s (greater than $20 million in size) became scarce, their number falling 77% from 13 in 2000 to only 3 in 2004.
Series B financings were hit even harder. The median Series B financing’s size fell 62% in 4 years, while its pre-money valuation fell 72% in 3 years.
The venture market’s downturn was exceptionally long in duration. Series A and B financing sizes didn’t hit bottom until 2004, and in the case of the Series A continued to slowly decline all the way through the GFC. Series A valuations continued to fall through 2006. This extended downturn was also reflected in US venture fund commitments and the NASDAQ itself, neither of which began to recover until 2005. All these indicators lagged the broader economy, which had returned to robust GDP growth in 2003.
At the time there was an active discussion of a “flight to quality”. Burned by the speculative bets of the late 90’s, investors looked for higher ground. Some focused on PIPE’s, trying to take advantage of the dislocation in the public markets; others looked for more established private companies to invest in. The median age of companies closing a Series A grew from 0.5 years in 2000 to 1.4 years in 2003, while the median age of companies closing a Series B grew from 1.3 years in 2000 to 2.9 years in 2004. The percentage of companies closing a Series B that were generating revenue also shot up precipitously, from only 39% in 2000 to 63% in 2001.
2005 – 2008: Bottoming
The bottoming phase of this cycle actually includes a mini-recovery from 2005 thru 2007, and one wonders if it might have continued if not for the havoc of the GFC. In October 2007 the NASDAQ hit a high of 2,859, up 156% from 2002. A number of venture-backed companies went public in 2006 and 2007 and performed well in the after-market. US venture fund commitments once again exceeded $30 billion (still a small fraction of their 2000 levels).
V21 early stage financings reflected this modest uptick. The size of the median Series A actually fell from 2005 thru 2008, but median Series A pre-money valuations increased 38% from $7.0 million in 2006 to $9.7 million in 2008. The number of “jumbo” Series A’s (greated than $20 million in size) bounced back to the pre-crash level of 13 in 2008. Median Series B size grew 21% from $10.0 million in 2004 to $12.1 million in 2006, a level it approximately maintained thru 2008.
Investors also got a bit of their risk appetite back: median age of companies closing a Series A fell to 0.9 years in 2005 (down from 1.4 years in 2003); the same figure for companies closing a Series B fell from 2.9 years in 2004 to 2.2 years in 2006.
Just when it seemed the stage might be set for a true market firming, disaster struck again in the form of the GFC. The fall of 2008 saw the collapse of Lehman Brothers, the conservatorship of Fannie Mae and Freddie Mac, and the AIG bailout. Central banks swung into action injecting capital into tottering financial institutions and stimulus funds into the economy.
By March of 2009, stock market indices around the world had experienced declines ranging from 40% to 75%. US venture fund commitments fell to $16 billion in 2009, and venture investment fell precipitously.
The early stage financing market was hit yet again. Median Series A financing size fell only 4% from 2008 to 2009, largely because it was till dragging along the bottom ($5.0 million in 2008, $4.8 million in 2009). However, Series A pre-money valuations fell 27% that year, to $7.1 million, essentially returning to the post-DCC low. Median Series B size fell 14%, from $12.0 million back to $10.0 million (same figure as the 2004 post-crash low), and median Series B pre-money valuation fell 27%, from $30.5 million to $22.3 million. The venture market had given back all of the moderate gains of the 2005-2008 mini-recovery and was back at rock bottom.
The “flight to quality” was also back, most clearly evidenced by a spike in the “capital raised prior to” both Series A and Series B financings. This figure rose sharply for both Series A and Series B companies in 2009 after the GFC, just as it had in 2002 after the DCC.
2010 to 2013: Firming
The GFC crash brought venture markets back to the DCC troughs. But this time there would be no extended bottoming period. Recovery started in 2010 and would continue unabated for the next ten years.
Venture fund commitments rebounded from their 2010 low of $13.3 billion but failed to break the $30 billion-ish levels of 2005 to 2007, much less the $101 billion of 2000. GDP growth resumed in 2010, totaling 2.6% for the year, and the NASDAQ saw a 17% gain – the first of many strong years to come.
The early stage venture market also began its steady ascent in 2010, initiating a 4-year period of stabilization and moderate growth that our framework calls “firming”. Median Series A financing size rose from $4.8M in 2009 (the lowest level in the entire 20-year cycle) to $6.0M in 2013. The number of Series A’s greater than $20 million increased from 9 in 2009 to 12 in 2013. Series A pre-money valuations grew more quickly, from $7.1 million in 2009 to $14.6 million in 2013. Meanwhile the size of Series B’s increased from $10.0 million in 2009 (again the lowest level of the entire cycle) to $15.0 million in 2013, while Series B valuations rose from $22.3 million to $42.1 million.
In stark contrast to its prolonged bottoming after the DCC, the venture market had bounced back after only a single year (or year and a half) of contraction. While the ensuing growth was modest, it was steady, and set the stage for the headier times ahead.
2014 to 2019: Acceleration
Picking a date for when “firming” turns to “acceleration” is a subtle art, and arguments can be made for several choices between 2013 and 2016. The economy as a whole hit its stride in 2014: 5 of the next 6 years would see GDP growth of greater than 2%. Meanwhile the NASDAQ nearly tripled from the beginning of 2013 through the end of 2019.
For this venture-focused commentary we went with 2014. This is the year that US venture fund commitments soared back over $30 billion, and a key bellwether indicator of the V21 Analysis, the size of the Series A, started to go ballistic. In 2013 the median Series A was still $6.0 million, the same level as 2004. In 2014 it rose 40%, and eventually peaked at $12.4 million in 2019, a 106% increase over the 6 years. The number of “Jumbo” Series A’s greater than $20 million in size leapt from 12 to 28 during this period, a 133% increase. Median Series A pre-money valuations increased 105%, from $14.6 million in 2013 to $30.0 million in 2019.
The Series B underwent similar growth in the same period. Median size rose 88% from $15.0 million to $28.3 million, while median pre-money valuation rose 113% from $42.1 million to $90.0 million.
These years also saw the dramatic increase in company maturity at time of financing that we have commented on in prior V21 studies. Beginning around 2014, the median age of companies as well as the percentage generating revenue at the time their financing closed started to rise meteorically. As an example, the percentage of companies closing a Series A that were generating revenue at the time more than tripled in just 4 years.
Baked into the acceleration phase is a modest pullback in 2016, which saw a reduction in early stage financing sizes and valuations. But even more rapid growth followed in the last 3 years of the cycle, 2017 thru 2019. By the time we roared into the 2020’s, the venture market had sustained the longest boom in its history.
A Tale of Two Crashes
Looking back at the two crashes (the DCC and GFC), we see some marked differences in their impact on early stage financings. The DCC resulted in steeper drops, which lasted longer and ended with a more tepid recovery. The GFC brought more moderate declines, which were over in a year, and ushered in a phenomenal boom. After the DCC, the tech sector lagged the broader economic recovery. After the GFC, the tech sector led the recovery. Why the divergence?
One explanation lies in the preconditions of the two crashes. The DCC corrected the excesses of a classic asset bubble in the technology sector, in which highly speculative companies were ascribed valuations well beyond their fundamentals, a phenomenon driven primarily by capital market psychology. The GFC had very little to do with the technology sector, which was performing well on a fundamental basis and spawning truly meaningful companies that would go on to transform the economy (e.g. Facebook, Google, Netflix, Salesforce, Workday, Vmware, Amazon Web Services et al). These were real companies, not overhyped schemes, and they would help transform the economy and accelerate its recovery.
A second factor has to do with the restorative nature of the bottoming phase. It is during this period that the excesses of the prior peak are swept away, in what is often a long and painful process. Meanwhile, new companies that are formed and grow up during lean times have tremendous efficiency and operating leverage wired into their DNA. When the environment improves, these strong companies are poised to capitalize and scale. In most market cycles it has typically taken 2 to 3 years of freefall plus 3 to 4 years of bottoming in order to fully eradicate the holdovers from the prior peak and clear the field for the next generation born for the new reality.
By the time the GFC hit, bottoming had already done its restorative work and the venture market was on stable ground, even exhibiting signs of firming in 2006 and 2007. The GFC was a speed bump for the venture market, not a correction. The companies were real, their models were strong, and their customers were ready. By the time the panic was over, an unusually strong and mature cohort of tech companies (public and private) was poised to lead the charge to new highs. It seems likely that the delays in market firming caused by the GFC contributes to the length and pace of the boom that followed.
The Next Turn of the Wheel
Looking ahead, its tempting to adopt the “glass half full” outlook and forecast a post-GFC-style one-year downturn followed by a return to sustained growth in the venture market. There are reasons to believe in this scenario, the most powerful of which is the strength of the companies themselves. The enterprise is being digitally transformed, and the economy digitally terraformed. The pandemic crisis, while a setback for sure, will on balance serve to accelerate these trends and strengthen the tech sector and venture market. This view argues for a 2010-like rapid return to good times.
There is another view, however. This one focuses on the venture market cycle and recognizes the unprecedented length and scale of the preceding acceleration. It has always taken a few years to get past the hangover of such binges. How long will it take this time to drive the puffed-up companies, tourist entrepreneurs, carpet-bagger investors and quixotic buyers out of the system? A post-DCC-style purge has been necessary in the past to clear the way for the next wave of growth.
There is some healthy tension between the two views, and both have merit this time around. We have a fundamentally sound and energized tech sector; but have just exited a longer-than-usual venture market acceleration phase; and are headed for a deeper-than-usual recession. How will it all net out?
My own view is the following: the powerful fundamentals of the digital economy will lead us to the next recovery, with the tech sector emerging stronger than ever. However, we are entering a recession of unprecedented velocity and magnitude, which will linger longer than many are predicting, with lots of uncertainty as to what the new reality will look like. Even a robust digital cohort will struggle against these headwinds. Net / net: tough sledding for a couple years, longer than any of us would like; followed by an even more expansive set of opportunities, more sweeping than any of us have seen before. The next turn of the wheel will belong to entrepreneurs of true vision and grit. The road will be hard, but those that persist will find a journey of great satisfaction and exceptional impact.
Appendix: Data Tables and Sources