Calculation of past VC excesses looms as market forces valuation restarts

PitchBook tracks and writes about all kinds of data points in the venture industry, from the capital raised by companies to the fundraising activity of venture capital funds. But perhaps no data set generates as much interest from our readers as startup valuations throughout the life cycle of the company and within different sectors.

To outsiders, start-up valuations can seem like a mystery. And while many investors will tell you that valuing a company is both an art and a science, they will usually be able to explain why a particular valuation is reasonable and fair.

But in recent weeks, many venture capitalists, especially those investing in late-stage companies, say they no longer know how to measure the value of companies in private markets.

Thomasz Tunguz
(Courtesy of Redpoint Ventures)

“When you have so much volatility in the public markets, you don’t know what the price is. [of a company] It will be in a week. It’s hard to understand,” said Tomasz Tunguz, managing director of Redpoint Ventures, who also writes a blog focused on SaaS metrics and valuations.

The S&P 500 recently plunged into bear market territory, global supply constraints that emerged during the pandemic are still wreaking havoc, the Russian invasion of Ukraine drags on, and the Federal Reserve has declared it will aggressively raise interest rates to rein in prices. highest inflation levels since the 1980s

Amid all that volatility and uncertainty, however, one thing is clear: If a startup raised capital in the last year, its valuation is now likely to be much lower than it was in its last funding round.

For example, median valuations of public software companies have fallen from 12 times future earnings to 5 times or less since their peak last fall, representing a decline of nearly 60%, according to estimates by the publication Future by Andreessen Horowitz. Other sectors have also seen valuations fall.

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Given that startups are growing faster than their public counterparts and competition for access to these companies was greater than ever during the pandemic, investors were willing to pay often exorbitant prices for participation in these businesses.

“Valuations went from 10x forward ARR to 20x forward ARR, and then we went to 50x forward ARR and then 100x and then 400x for the biggest companies,” Tunguz said, referring to the evolution of the valuation multiples assigned to annualized revenues. “There was definitely a feeling of ‘how high can we go?’ “

But now investors and founders have to deal with their recent excesses. If relevant public companies are down 60%, there’s a good chance that startup valuations have fallen that much, according to the a16z article.

At this point, we don’t know where valuations will land. Stock volatility has to subside for venture capitalists and founders to accept resetting market prices.

Since financings take up to six weeks to close, some of the ones we’re looking at now were negotiated and signed in March.

For now, trading has slowed and rumors of term sheets being withdrawn or renegotiated amid the recent stock market correction are making the rounds in Silicon Valley.

Tunguz estimates that software stocks could fall a further 50% to 60% and remain above historical valuation levels. In addition to rising interest rates, headwinds for the tech sector include cuts in software spending and the possibility that balance sheet assets sold by the Fed as part of quantitative tightening will be relatively attractive compared to equities.

Trying to get a funding round during a period of market turbulence can be very difficult. That’s why most VCs advise startups to prioritize reducing capital burn over revenue growth.

Tunguz said venture capital-backed companies that have yet to achieve rapid sales growth and are in danger of running out of cash in less than a year may have to raise a round of exiting investors or be forced to lay off employees. or make other cost cuts. Some may even be forced to sell the business. He estimates that about a third of startups will find themselves in this situation now.

Startups with years of cash on their balance sheets or rapid revenue growth, on the other hand, are in a much better position to survive and eventually attract new investment at relatively favorable valuations.

While some venture capitalists compare the current sentiment in Silicon Valley to the days of the dot-com bust, most investors I spoke with don’t think this downturn is as bad for tech companies as it was earlier in the decade. from 2000.

“I don’t think you’re going to see an extinction event, a meteor hitting the dinosaurs like we saw in the dot-com era. I just think you’re going to see the growth rates of a lot of companies slow down materially, and there’s going to be a greater focus on efficiency.” Tunguz said.

Although nobody knows how long the current pothole will last. It could be six months or a few years.

“Will we see other significant growth after that, and will technologies thrive again? Absolutely!” Tunguz said.

Featured Image by Sesame/Getty Images

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