Many people forget that former Federal Reserve Chairman Alan Greenspan coined the phrase “irrational exuberance” in 1996. “How do we know when irrational exuberance has unduly escalated asset values?” he wondered at the time.
In recent months, investors have repeatedly asked themselves this poignant question. When my Flybridge partners and I were preparing for this week’s annual investor meeting, we took a step back to consider how to strike a balance between the market’s obvious exuberance and our firm belief that the exuberance is based on sound, fundamental reasons. Rational Exuberance was coined by us as the best way to describe where we are right now. Yes, valuations have risen, and as we build our portfolios, we VCs are all paying a higher price. Nonetheless, we, like other industry leaders, are realising that the scale of market opportunities for our best companies has proven to be much larger than anticipated. Although our entry price is 30–50% higher, we are investing in companies with a 3–5x higher exit potential. That’s a trade we will take over and over again. Allow me to explain why we — and many others — arrived at this conclusion.

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Rational Exuberance?

In recent years, valuations, particularly in the public markets, have reached new highs. In the nineteen months since the COVID-19 crisis in March 2020, the NASDAQ, for example, has increased 105 percent. Those valuations have trickled down from the public markets to the later stages of the private market, where capital is pouring in at record levels.

As a result, the rise in startup valuations — particularly later stage startups — is dramatic. The chart below, drawn from Pitchbook’s latest data set, shows the sharp increase in the last two years. Later stage financing valuations have grown so sharply and on such a large scale that the magnitude of the change in valuations at Flybridge’s stage — the seed stage, labelled here the Angel stage by Pitchbook — is imperceptible.

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But everyone in our small corner of the early-stage market has also seen substantial valuation increases. When we analysed our seed-stage deals across three recent cohorts — 2017–2018, 2018–2019, and 2020–2021 — we saw that despite being located outside the ridiculously competitive Silicon Valley (our offices are in NYC and Boston), our post-money entry valuations have grown 56 percent and 33 percent , respectively (see chart below) (see chart below).

Interestingly, each of these cohorts raised more capital. The average seed round size for our portfolio companies in 2016–2017 was $1.7M while it grew to $2.6M in our 2018–2019 cohort and then $3.3M in our 2020–2021 cohort. Entrepreneurs are taking advantage of the higher prices to raise more capital in the seed round and thus make more progress before raising their series As — leading to dramatically larger series As at dramatically higher valuations. Crunchbase recently reported that the average Series A round has increased from $6M to $18M.

Come on Get Higher!

Why are valuations rising across the board across all segments?

The obvious answers are Economics 101 (thanks, Alan) and well covered in the daily newspapers: capital is chasing yield in a low interest rate environment, more capital drives up prices (simple supply and demand) and at the same time, when later stage and public investors do their future value math for growth companies, low-interest rates result in higher future value calculations — thereby valuing growth even more.

The less obvious answers are what we are seeing on the ground as we work with our companies day-to-day. First, technology innovation is affecting and disrupting the entire $23 trillion US GDP. We used to focus on a little small corner of the market called the IT industry. Today, every company is a technology company, and every industry — from healthcare to financial services to retail to real estate — is being disrupted.

Second, with a nod to Thomas Friedman, the world has gotten flatter. Global smartphones have now reached over 80 percent of the world’s population up from 25 percent just six years ago, increasing the potential market for all of our companies. And, finally, as we study technology adoption patterns, we are seeing a fundamental shift to more rapid, earlier adoption of new products and services.

I have written in more detail about this phenomenon that we are seeing of faster technology adoption, framing the situation in the context of Geoffrey Moore’s canonical book from 30 years ago, Crossing the Chasm. In short, every business on the planet is realising that they need to be an early adopter and embrace new technologies or they will be disrupted — think Blockbuster and Barnes & Noble. And every consumer has been trained to rapidly embrace new apps that make their lives easier and richer. As a result, the pace of technology adoption has quickened and the potential market size that startups can address in their early years — even if their product isn’t perfect and their organisation is still nascent — has dramatically expanded. That’s why a young infrastructure company like our portfolio company MongoDB can count over half of the Fortune 500 as their customers at the time of their IPO a number of years ago.

All of this is leading to our conclusion that market sizes are proving far, far larger than we had ever imagined — surpassing our most optimistic forecasts and prognostication.

Faster Than a Speeding Bullet

We can see these trends play out across the entire tech ecosystem. For example, by looking at the revenue growth rates that the Big Five tech companies reported last quarter. Each of these companies, worth over $1 trillion, is supposedly operating mature businesses at scale, and yet they are still reporting growth rates in the 20–60 percent range — as if they were VC-backed startups.

Speaking of VC-backed startups, Bessemer’s recent report on the top 100 private cloud companies was also astonishing. Their analysis showed that on average, the revenue growth rates for these large private companies — as an entire cohort — have risen to 90 percent year over year while the top quartile is growing 110 percent . Again, these are large-scale companies defying the “law of large numbers”.

Recreating the Entire GDP of China…in 5 Years

As noted, these powerful forces driving accelerating revenue growth as a result of very favourable underlying market conditions and rapid adoption curves have led to unprecedented increases in valuation. We wanted to quantify this and so looked at the handful of Big Tech companies mentioned earlier along with the top 100 next most valuable tech companies and compared their change in market capitalizations from five years ago to today.

Even we were astonished to see the result. That cohort of companies has grown from $5 trillion to $20 trillion — an increase of $15 trillion. That is a staggering amount of value creation in tech in the last five years. To put that figure in perspective, $15 trillion is equivalent to the entire GDP of China.

Further, in our analysis of the top 100 most valuable companies, we noticed that 27 of these companies are newly public — that is, they were still private companies five years ago, invisible to the public markets and operating solely in the VC market.

Speaking of the VC market, these forces and favourable conditions have also led to the substantial growth in the number of unicorns (i.e., companies who have private valuations > $1 billion). Specifically, the number of unicorns has grown from 39 in 2013 to 842 today, a cohort worth nearly $3 trillion. Add that to the public growth and you have $18 trillion of market value creation in tech in the last five years.