Skyrocketing Valuations: Is Security Startup Funding About To Head Back Down To Earth?

In recent months, security startups have basked in the glow of a seemingly endless flow of venture capital funding. But, some security experts think that expanding bubble of funding might be coming to an end, as they see venture capital companies starting to become more hesitant with where they are placing their bets.

In the past, venture capital companies have been willing to pour in money based on growth rates alone, never asking questions about profitability and sustainability, said Orion Hindawi, co-founder and CTO of endpoint security startup Tanium. But over the past six months there has been a drastic shift in tone, he said, with venture capitalists approaching Tanium proactively for its most recent round of funding in September for the primary reason that it was profitable.

Other companies haven't been as lucky, Hindawi said, saying that he gets at least a call a day from frantic startup founders looking to land funding but who aren't, and potentially won't, because of their lack of profitability and a weak business model.

[Related: Security Startup Boom: Solution Providers Place (And Hedge) Their Bets]

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"At the end of the day, there will be a point where the song in musical chairs stops, and many of the companies you find around us in security aren't going to find a chair," Hindawi said. "[The startups] can't sustain the burn because they don't have a real business."

The challenge for many of those frantic startups is that, despite touting triple-digit growth rates, they are spending too much money and don't have a long-term business plan, Hindawi said. That fact, combined with fewer security startups making the move to an IPO, makes for a completely unsustainable market status quo, he said.

"That is what a bubble looks like," Hindawi said. "When you really look at it, there comes a point where there just isn't more money to give these companies. ... Money doesn't grow on trees, but that's the equivalent of what the VCs have been doing for a while ... and I think they're running out of trees."

In just the past few months, security startups as a whole have seen billions of dollars poured into their businesses. Hindawi's Tanium landed $120 million this September, adding to the $52 million it raised just last March. Zscaler and Crowdstrike each landed $100 million. Palantir won $450 million. AlienVault, Checkmarx and Cylance each landed well over $40 million. That is just to name a few.

"The volume of deals is just crazy," said Art Coviello, former executive chairman at RSA and current venture partner at Rally Ventures. "There's just lots and lots of startups, and competition for the quality of deals is quite fierce."

However, while many of the deals he sees cross his desk at the early stage investment firm are "too pricey," Coviello said he doesn't expect investments will come to a screeching halt as the need for security is greater than ever.

"I have to believe that the sheer volume of deals and the sheer overlap in terms of what's being brought to market that we're in the process of creating that bubble," Coviello said. "Having said that, the need and demand for security technology is so great and the problem is ever-expanding that there's a good reason for people to be investing in security companies right now."

Dan Wilson, executive vice president, partner strategy at Optiv Security, agreed, saying that there's a lot more "meat behind the security market" than in other market bubbles that have burst in the past. While there will likely need to be an adjustment in the astronomical valuations startups are landing today, Wilson said the intense need for security means the market won't be going away completely any time soon.

"We're just at the beginning of the perfect storm with device proliferation and the Internet of Things," Wilson said. "The fact that security concerns are expanding exponentially at the same time means that there's a lot of different partners that are coming in ... but I don't see a big crash coming because it's not as if the demand isn't there to meet that supply."

That incredible demand for security might be exactly what saves the security industry from experiencing a bubble burst at all, despite the rapid growth in the market and skyrocketing valuations, said Brett Hansen, executive director of end user computing software, mobility solutions, at Dell.

"We're probably just getting to a point where we should be, which is investing in security as a primary part of business," Hansen said. "It's not a bubble per se, it's more of a natural state that we need to be in given the importance of protecting data across all the different businesses and our lives."

However, that demand doesn't take the pressure off security vendors to execute, said Ron Myers, vice president, worldwide channels, at Palo Alto Networks. In fact, the stakes are higher than ever for both established vendors and startups alike to meet their financial and technical goals, he said.

"I think all tides are rising and we've got a significant runway [in front of us] for a while, but you have to execute. You can't miss a financial metric or you're going to get hurt," Myers said.

Meeting those performance metrics will ultimately be the difference between those that make it to market with momentum and those who flounder, said Devin Archer, Americas channel director at ForeScout.

"I think it'll be interesting watching all of these upstarts coming in and some will make it and some won't. Then there's folks like us who are pretty proven in the market and growing fast and we'll continue to plow forward," Archer said.

The solution, Rally Ventures' Coviello said, is that investors and partners alike will have to get savvier about security and place their bets more knowledgeably if they want to be a winner.

However, that process of consolidation or weeding out less-successful startups isn't necessarily a bad thing, Tanium’s Hindawi said. In fact, it would be a win for both partners and customers, he said, as it makes it easier for them to know where to place their bets on the market.

"I think all of this is very good for our industry," Hindawi said. "A lot of people see the bubble popping as a bad thing. In the short term it's not very fun, but in the long term customers and partners get better products. I think our industry is more than due for all of this."