The age old adage of nothing is certain but uncertainty rings more true now than ever before. Particularly, when talking about startup valuations. That is, tech startup valuations.
Tech startups are arguably the most risky and volatile sector of early-stage investing because much of their perceived success rides on future potential. Fundraising happens at a valuation that the company is projected to hit in a few years' time vs. where it is today. Founders are given credit for results that have not yet materials in order to obtain capital to make them a reality.
We are experiencing a repricing of software revenue multiples. Gone are the days of 50x revenue raises (with a few exceptions). Some may argue that now is a bad time to pursue a startup idea; however, this might be the time where you can separate the cream from the crop. Companies that are able to endure and withstand this downturn with minimal casualties (i.e., massive layoffs, down rounds, customer attrition, large dips in profitability) during this time are those with strong leadership, product-market fit, and ultimately a defensible business model.
SaaS (software-as-a-service) businesses are often valued on a multiple of their revenue-typically NTM (next 12 months). High growth businesses are often losing money as they heavily invest in growth, therefore EBITDA multiples are often reserved for more mature, slower growth businesses. High growth companies have suffered the most.
The average NTM Revenue multiple for the top 5 companies has dipped from ~40.0x as of January 2021 to 12.3x as of September 2022. When looking at the correlation of NTM revenue growth to NTM valuations, R^2 is 0.49. What this tells us is that for some businesses high growth does indicate higher valuations but not for all.
The froth is long gone. However, don't be fooled into thinking VC's are now solely focused on profitability. Profitability has never been the name of the game in VC. And it ultimately can't. VC's invest in breakthrough innovations and forward thinking technology with the bet that 1 out of those 10 will result in a lucrative exit. Seed stage companies do not have enough history for investors to estimate unit economics (Lifetime Customer Value / Cost to Acquire Customer).
Technology startups have been heavily impacted by the interest rate hikes and recessionary fears. Higher interest rates mean higher discount rate which in turn reduces the present value of future cash flows when valuing via the Discounted Cash Flow method.
Sheel Mohnot, a San Francisco-based venture capitalist focused on early-stage startups, noted in a conversation with Vice that his team is now focused on Companies with a clear path to profitability and sustainable growth: "The math on what you invest in has to change...There's some businesses for which this new world doesn't really work."
The low interest rate environment to date fueled a growth-at-all-cost mentality. Financial discipline was nowhere to be seen. American Affairs published a journal on America's broken startup landscape and VC ecosystem. The journal cited the increase in VC investment into startups as one of the reasons for diminishing returns as " larg¬er proportion of this funding has necessarily gone to weaker opportunities, and thus the average profitability of these investments has de¬clined". It also cited the lack of truly revolutionary technology as another reason for declining startup success: "The internet, which was a breakthrough technology thirty years ago, has matured. As a result, many of today's start-up unicorns are comparatively low-tech... this lack of revolutionary technology has made it hard for uni¬corns to create value at a scale necessary to be profitable."
Many arguments can be made as to why tech startups are being impacted in the way that they are. It is near impossible to pinpoint any one particular reason. Investors who are able to get closer to it are ones that will fare the best while others will flounder. Now is the time to place our bets and put our intuition to the test.