Are Startup Valuations Too High? You May Not Expect the Answer from the IPO Expert

Our conversation with Professor Jay Ritter about IPOs, valuations, and more

In the venture industry, August and September are typically known as slow months. People take time off. Companies, fresh off of raising capital, are heads down building.

But this year was different. We saw a huge amount of activity – from LPs, GPs, and startups. 

Andreessen Horowitz announced a $400 million seed fund, NFX launched a $450 million seed fund, and (not to be outdone!) Greylock Partners debuted a $500 million seed fund. This capital will be flowing through the ecosystem for the next 7-10 years.

We also know our friends at Cooley show startup valuations are up. In fact, since 2015, Series A and B valuations have gone up 2-3x while Series C valuations have gone up a gobsmacking 4-5x.

Given where startup valuations are today, we had a conversation with Professor Jay R. Ritter, Eminent Scholar in the Department of Finance at the University of Florida.

Professor Ritter started his research on initial public offerings (IPOs) over 40 years ago and is among the most highly respected academics studying IPOs. 

In fact, we have personally heard several other academics talk about how much they admire his research. His work found here includes the number of companies that go public every year, their profitability, first-day and subsequent returns, industry, and more.

IPOs vs. SPACs vs. Direct Listings

Today, there are three ways for a company to go public: (i) filing an S-1 with the SEC and going through an initial public offering (IPO), (ii) being acquired by a special purchase acquisition company (SPAC), or (iii) completing a direct listing.

As a benchmark, from 2017 to 2020, there have been 148 tech IPOs.

In 2020 alone, SPACs raised a record $82 billion of capital, the most in history. But SPACs have existed for decades. Since the 1990s, SPACs have provided an alternate way of taking a company public.

The challenge today is that “there seem to be more SPACs than the number of potential merger partners,” according to Ritter. 

He continues: “Right now, there are over 400 SPACs searching for a merger partner, with many of them looking to acquire a tech company with a valuation of $1 billion or more. Put differently, there are many SPACs looking for relatively few targets.”

Interestingly, the average age of SPAC targets is slightly older than the age of companies going public via IPO. This is partially due to biotech companies that are able to IPO relatively quickly.

Direct listings do not require the creation of new shares and, instead, allow currently outstanding shares to be sold to the public. When discussing direct listings, Professor Ritter shared that “The average return after a direct listing has been good. People are not overpaying for direct listings.” 

That said, he also caveated that answer by sharing that this is a small sample set. Only 12 companies have successfully completed a direct listing. For those curious, the 12 companies are: Spotify, Watford, Slack, Asana, Palantir, Thryv, Roblox, Coinbase, SquareSpace, ZipRecruiter, Amplitude, and Warby Parker.

Startup Valuations Today

On startup valuations, Professor Ritter shared that “Valuations are high, but justifiable. They are optimistic, but not implausibly so.” There are a few reasons why.

First, the market potential is much bigger than people expected a decade ago. Apple and Microsoft have a market cap over $2 trillion, while Google and Amazon are over $1.5 trillion. Giants like Facebook, Tesla, NVIDIA, PayPal, Netflix, Adobe, and Salesforce are all easily clear of $200 billion.

Second, with interest rates low, the valuations on all assets are high. During the internet bubble in 1999-2000, 30-year Treasury Inflation-Protected Securities (TIPS) were yielding 400 basis points above the inflation rate. Today, they are yielding 20bp below the inflation rate. Thus, higher multiples in both public and private equity markets can be justified today.

“Valuations are high, but justifiable. They are optimistic, but not implausibly so.” –Professor Jay R. Ritter

At Ensemble, we see an opportunity for startup M&As above $10 billion and, in some cases, the opportunity to build a standalone business worth $100 billion – or more. 

Four years ago, we invested in Zoom Video at a $1 billion valuation. We would have never thought that our investment could be a >100x multiple. Now, the startups being funded today have a real chance of being valued at over $100 billion in the public markets.

With regards to M&A, we can also look at Facebook acquiring WhatsApp ($19B), Microsoft acquiring LinkedIn ($26B), and Salesforce acquiring Slack ($27B) as just a handful of examples.

In fact, ~70% of the top 25 largest VC exits since 2000 have occurred in the last 3 years:

And U.S. venture capital has hit a new level of liquidity:

‍‍2021 is estimated to generate ~$372 billion of exit value. It’s worth highlighting that even though investment dollars in VC have doubled in the last few years, liquidity has tripled during that same period.

Furthermore, markets are bigger than ever. In the year 2000 there were only 40 million people online with average usage about 1 hour per week. Today, there are 5 billion people online for several hours per day – each consumer now has a supercomputer in their pocket.

While startup valuations have undoubtedly increased in the past few years, market sizes and exit potential have increased even further.