A K-shaped VC Market: Is The Era Of 10-20x Revenue Multiples Here To Stay?

By Olav Ostin

Historically, recessions have been discussed in terms of a V-shape—a sharp decline in output followed rapidly by an equally rapid recovery—or a U-shape, where a longer slowdown occurs before a steep uplift, or variations thereof (think Sir Martin Sorrell’s bathtub-shaped prediction from 2001).

This time, as the world surveys the economic wreckage of the pandemic, there is talk of another type of recovery: a K-shape. It’s a two-tier recovery, where a fall for almost everyone is followed by a continued decline for some but a remarkable bounce back for others.

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In 2021, the group still in decline will likely include old economy businesses and those in travel, hospitality and events. With yet more lockdowns this winter, any hopes of a short-term reprieve in the form of a swift return to normal have been delayed until a wide rollout of vaccines.

Those businesses not just recovering but growing with alacrity are the new economy operators like Zoom, Snowflake, Shopify and Amazon, which have both a direct solution to the challenges created by the pandemic—whether it’s simple-to-use digital collaboration, data platforms or everything you could possibly want dispatched to your doorstep—and the business model to deliver it remotely.

Companies likely to be in the top part of the K include those in e-commerce, digital health, cybersecurity, edtech, digital entertainment and many cloud software businesses.

That’s been evident in the soaring stock prices and valuations of companies in these sectors in public markets, but the same K-shape applies within the world of venture capital, too, with its own nuances.

Public market recovery versus the VC market

At the top of the K in venture capital are those businesses that are driving forward with tremendous growth—at a minimum 50 percent annual revenue growth, but often much, much faster—and products typically built in the cloud, in many cases with recurring revenue models.

Lower down, in that bottom leg, the situation differs slightly from the public market’s K-shape: in our VC/tech startup version, there is hopefully still growth, just at a much lower rate – perhaps 10 percent to 20 percent or thereabouts. For a business hovering around the 10 percent growth mark, it will take much longer to get to the big outcomes VCs are after. So while it may still be worth getting involved in such a company, there will be other factors at play.

The result is that we see historically high valuation multiples of 10 to 20 times revenue and more for the fast-growing, cloud-based businesses, in contrast to multiples of perhaps one to five times revenue for the rest, giving us our K-shaped VC landscape.

What’s driving high valuations?

At the risk of stating the obvious, many technology companies have shown a clear resilience in the face of the pandemic, unlike other traditional businesses that require in-person interactions.

Many of those companies have been able to continue their normal operations with minimal adjustment. Arguably, that resilience alone, now more widely accepted than pre-pandemic, makes these companies more valuable. However, as traditional businesses struggled, customers—whether consumers, businesses or governments—moved to these digital counterparts in even greater numbers and at greater speed. That movement dramatically increased the pace of growth for those technology companies in the right sectors. 

Recall Adobe’s June report that said COVID-19 had accelerated e-commerce growth by between four and six years, or Microsoft’s CEO Satya Nadella, who said in April that the company had seen two years’ worth of digital transformations in just two months. Or just look at Zoom, which the other day reported 367 percent revenue growth in Q3, at which no one even blinked.

It is true that for a long time, the majority of VC investment has gone to tech-led businesses. However, many technology companies that might have been interesting to VCs before the pandemic now are struggling to attract investment. That’s because either the sector they operate in or their customer base is closely tied to those old economy sectors mentioned above, so their growth is suffering whether or not they have built “disruptive” technology. Examples could be those startups selling software to airlines when the planes aren’t flying, or those using innovative ways to distribute event tickets to consumers when the events aren’t happening.

What’s ahead

In the long run, we expect many new exciting companies will be created to solve new issues that have arisen from the pandemic. But right now, the pool of attractive high-growth companies for early-stage, growth-obsessed VCs to invest in has arguably shrunk a little, effectively reducing the universe of investible companies.

On the demand side, however, those companies benefitting from the pandemic are in some cases seeing a huge acceleration of growth driven by an even more urgent need from their customers, or a lack of alternatives. That growth makes those in this smaller pool even more attractive to investors. Take Hopin, the online events platform, that went from four employees to a $2 billion valuation in less than a year.

Meanwhile, despite the initial pause in investment seen early in the year as VCs briefly turned inward to review their portfolios for the impact of the pandemic, Atomico’s recent State of European Tech report shows that 2020 was on track to be a record year for the amount of capital invested into European tech.

Another sign of the increasing amount of cash available for European tech is the rising number of U.S. VCs setting up European offices, with Bessemer and Sequoia as the most recent examples, as well as U.S. firms spending more time hunting for opportunities outside of their normal stomping grounds. All these factors mean the competition among VCs to invest in the most exciting companies is more intense than ever.

Take a step up in the investment chain, and even more capital is being allocated to technology in general, given the sector’s resilience and outperformance so far this year. Taking one more step up, we see monetary stimulus from central banks in all major markets has cut the cost of capital, too.

So overall, there’s an even larger wall of money pointed at tech assets, with a smaller supply of investable assets—at least in the near-term—and those assets remaining are potentially even more attractive due to even faster growth. Given all this, it becomes clear why valuations in our sector have jumped for the most attractive companies.

Are these valuations here to stay? Well, that’s a question for another article.

— Olav Ostin is managing partner at TempoCap, a London-based firm that invests in transformational technology businesses across Europe.

Illustration: Dom Guzman