When we consider the overall economic situation a lot of analysts’ predictions range from a doomsday scenario to others predicting that we are near the bottom. After analyzing many sources of data from the skeptics to the optimists we have concluded that in all likelihood, the safe bet is that we will end up somewhere in the middle. However, what we are witnessing, we believe, is not a Great Recession nor a Tech bust. We do not believe we are witnessing an economic tsunami. Rather we are witnessing a hard Re-Pricing.
While there were many initial public offerings (IPOs) and SPACs in 2021 and the first half of 2022, the Wall Street Journal (WSJ) says two-thirds (66%) of the companies that went public in the U.S. are trading under their IPO prices.
The share of U.S. companies that were profitable after their IPO has been falling since a decade high of 81 percent in 2009. In 2020, this figure had dropped to only 22 percent, which may spell bad news for this form of raising capital. It is also indicating that the market is unwilling to pay the price.
This valuation misalignment was created by the Venture Capital market. With the VC industry growing so handily with such strong returns, many of the largest VC’s were getting access to an unlimited amount of capital. When you couple that with the large multiples of sales that were being seen in the public market (e.g., Tesla, Rivian), we saw a huge influx in prices. VCs were looking for ways to deploy capital and drive a larger “Book Value.” When you add increased competition for the hottest opportunities, this led to what we believe was a valuation wild west. As the public markets are repricing from the 100x sales multiples, it is only expected that the late round companies will also need to reprice.
As human beings, our brains are prediction machines, trying to constantly assess and reassess the future. In normal times we take for granted the unknown nature of the future. As Covid has taught us, the future is always uncertain. Going through a Re-Pricing period over an unknown timeline highlights this reality. However, we must still deal with real implications, and before we begin to speculate and conjecture about the future, it is essential to focus on what we know.
What we know:
- Both the Public and Private market are highly inflated
- Public tech companies prices are down as much as 50% from their highs
- At the peak, tech values were abnormally high relative to long term trends
- Broader valuations are down much less from the peak. The S&P is down 18%
- Tech Market Cap is still growing by $3T annually and will continue
- Legacy industries will be the fastest catalysts for the growing market cap and will be forced to deploy more technology post Repricing to stay competitive.
- We are going to a period that investors will be focusing on profit vs. growth
The Impact:
- VC funding has become much more challenging to raise especially stage 2-3 startups
- The price of funding, if you can get it, is going to be higher
- Early-stage valuation will significantly drop in the next 12-24 month
- For many startups to go from start to scale will take longer
- If in the past 10 years the investors screening process ratio was 300:1 now it will be 500:1, which means the investors will be even more picky in their selections.
The fears of a deep recession are there but highly speculative at this point. The Fed is fighting and tightening, but the financial state of consumers and the job market are stronger. Some say the consumer spending during the pandemic period slowed down and most consumers hold a lot more cash than previous periods of economic downturns. Wages are also continuing to rise. To understand the future, we need to keep a close eye on metrics. Does economic uncertainty decrease corporate spending? Does Quantitative tightening cause a new credit bubble similar to 2008? At this point it is too early to tell.
So the 2001 and 2008 “playbooks” are not relevant at this point. Some progressive economists say that maybe the economic models we have been using for the past 50+ years are not working and we need to invent new models, Maybe?
Remember the conservative voices and the beginning of the pandemic? “Pull back, conserve cash, etc.” Well, now it might pay off for most people.
The common sentiment is that most VCs will be overly cautious in this environment because a down round is the worst that can happen to any fund manager. To a founder, it means they will be forced to part with more of their companies out of necessity for cash. To the VC, it means writing down an asset and facing up to their investors that they overpaid.
Startup takeaways: You need to be proactive:
Early stage Seed and Series A seem to have mostly been immune to the pricing debacle. However, for the later stage companies, it means that it will take longer to raise capital for your pitch deck and your projections, the pathway to profitable revenue will need to be tighter and bullet proof, remember you are 1 out of 500 being evaluated.
You need to be proactive:
- Swallow your pride – Your startup valuation will be established by how much investors are willing to pay for it. Be willing to accept the downround and work with the investors
- Your runway is critical, and everyone needs to focus on being more capital efficient.
- Founders and CEOs should over-communicate with their investors and present a tight, efficient, and value-creating plan for the next 24 months. You lead; they follow.
- Remind yourself and others of the basic unit economics of your business.
- Spending X to generate Y in ARR worth Z
- Focus on worst case scenario – more likely many startup will be forced to move to plan B
- It will be important to focus on maximizing runway to make it through the periods of uncertainty
Angel (Early-Stage) Investors takeaways: Seize the opportunities
Although there is a need to be somewhat thoughtful to say the least, there will be great opportunities. If you are an active investor it is time to buy and be more aggressive in your investment strategy.
Look for the right opportunities:
- Use the 2.5X factor reduce any valuation by this factor
- Increase any timeline and cost by 2.5X
- Take a deeper second look at any opportunity comes your way
- Time to join a syndicate or a fund to reduce risk and increase your Investment[IQ]
- Diversify and make small investment in more companies – build your “Index”
- Go back to the fundamental of profit vs. scale
The million dollar questions; “Will we learn from this?”. Julian Robertson the founder of Tiger Management once said, I am paraphrasing; “ Greed has no brain, therefore there is no memory”. Does history have the tendency to repeat itself or ignorant people repeat history?