Trickle down valuations

The topic du-jour amongst venture investors, limited partners and entrepreneurs alike is whether valuation declines have fully trickled down the capital stack following the ’22 tech market reset. While it is widely publicized that deal counts and round sizes are significantly down from their ‘21/’22 peaks (especially at the later stage), valuation analysis is harder to find. So, I dusted off Pitchbook and Excel….

Most analyses I’ve seen read something like the following chart with precipitous late-stage valuation declines (>50%!) dominating the scale. For early-stage entrepreneurs and investors, analysis at this scale doesn’t tell us much, nor answer the question of whether these late-stage changes have or will “trickle down”.

If instead, you index each series to its maximum, you learn a lot more. See below. Series C and D valuations are down by half or more, A&B are down but less, and seed is even still rising. However, the normalization shows something more – a clear three to four quarter lag from changes in the late-stage (C&D) to mid-stage (A&B). The question is whether this same lag will mean a peak in seed valuations about now given we are three to four quarters past the A&B peak.

In the Midwest market where we focus, we are anecdotally seeing seed price declines of ~25%. We are also seeing the re-emergence of “post-seed” opportunities after a period of several years where any company with a whiff of progress would go straight to A from seed. (Post-seed is not characterized in the Pitchbook data and might, in fact, confound the seed trend in a way that inflates Seed valuations)

While the supposition that a similar lag in peaks will occur in Seed is a nice “story”, it’s hard to buy into it without some economic basis. To find that, we can look at how the typical “markup” between round types has fared, comparing, for example, Series A pre-money medians to Seed post-money medians from 18 months prior. The trends surfaced are remarkable.

Prior to the COVID tech boom, markups from Seed-to-A and A-to-B (early-stage) ran stably around 2.5x while late-stage markups ran between 1.5 and 2x. Then they all exploded during the covid boom. Late-stage markups have since crashed, approaching 1x, (e.g. a flat round). These have overcorrected and will likely adjust back up as their denominators (post-money valuations at t-18 months) moderate. Series A-to-B has also overcorrected somewhat, indicating that Series A valuations should continue to shift down, which in turn will put pressure on Seed. In short, we think it’s coming, though we don’t expect the same level of adjustment as at the late-stage, which had a much greater runup in markup ratio than did Seed, A and B.

Notes on data: All data is from Pitchbook for the US only. Valuations are median valuations. “Markup” is between post-money medians for the earlier series at t=-18 months and pre-money medians for the later series at t=0 months.

Recession is a feature, not a bug

The theme for tech in the 2020s is that macroeconomics matter a lot, seemingly much more so than in the prior decade. This makes sense given the mainstreaming of tech and its significant composition of overall GDP as compared to a few decades ago. In this new decade,  first pandemic fear, then pandemic elation and now a potential recession is shaking tech back and forth. 

When a president says that a recession is not inevitable, we should assume he or she means they are expecting one but hoping their mightiest that it doesn’t happen. I’m pretty sure it’s coming, and here is why.

With inflation increasing – which it has nearly without stop for the last nine months –  a recession is not a bug of the Fed’s interest rate hikes; it’s a feature! That is especially true when so much inflation is tied to food and fuel, whose supplies are under duress from the Russian war and over which the Fed has no direct control. The only tool the Fed has is to reduce demand for those and other key economic inputs, e.g. labor. That means hiking interest rates enough to reduce business growth and demand… to drive layoffs… to reduce sticky wage inflation and consumer demand… and so on. Again, recession is not a bug; it’s a feature!

While it’s true that there is a very narrow possibility of a perfect soft landing without recession, that seems unlikely. Interest rates are a rough and imperfect tool, and the overall economy much more resembles an underdamped system in systems theory (see below) than a precisely controlled overdamped system. In an underdamped system, responses tend to overshoot the target.

It’s hard to tell yet how painful a recession will be, so let’s look at housing as an indicator. As a veteran of the financial crisis, I wince when I hear 30 year olds boast about their newly purchased pandemic house increasing in value at 20% a year. History has a short half life. Many retort that this time is different because the financial crisis systemically hampered supply for a decade leaving the US short of millions of homes, while at the same time, people now want more space because of work-from-home needs. Okay, fine, but:

Housing prices = f(supply, owner/occupier demand, input prices, investor demand, interest rates, unemployment, etc, etc)

Over the last two years, most of these variables have been strong tailwinds to housing prices, but some are switching direction now. Yes, supply/inventory will continue to lag, but a simple domino effect could heavily outweigh that:

High interest rates >> reduced consumer buying power >> reduced investor demand >> increased unemployment >> reduced owner/occupier demand>>and so on

In the extreme case where unemployment gets into the upper single digits, a lot of homes with inflated valuations could be foreclosed and later dumped into the market via bank auction. The resulting lower prices only circularly fuel themselves – the catalyst to price collapse during the financial crisis. Will that happen again? Probably not to the extreme, but don’t count on housing prices continuing upward. Psychologically, expectations that housing prices may flatten or drop will also reduce demand by reducing FOMO!

As an allegory for startups:

So if you’re a founder wondering why existing and potential investors are getting more rigid about valuations, think about our housing price example above as an analog.<p style=”padding-left:25px;”>Your text </p>

Startup valuations = f(supply, team experience, investor demand, interest rates, acquisition demand, etc, etc)

Supply doesn’t seem to be changing much initially, but a weaker labor market will eventually free up more and more experienced founding teams. Meanwhile investor demand is down partially because interest rates are up. Explicitly, increasing interest rates have reduced public multiples for valuation comps and made capital harder to raise for VCs, or at least there are expectations that they will. Finally, acquirers also have a higher cost of capital, less valuable stock (currency) and expectations of a recession. They are less likely to buy or buy for high prices.

While much of this sea change is already quantitatively measurable, especially valuation multiples, don’t forget the psychological component. The trends above show that investors have good reasons to believe that prices will fall, reducing FOMO. Some investors may in fact be “scared” by the environment, but more likely they are being pretty rational by waiting.

For example, a post-launch seed stage company in Chicago in 2021 might have raised $3M on $12M. An investor who liked the team and idea/market was likely to think, “okay, I can put $1.5M in now and own 10%. Otherwise, the next round is likely to be $8M on $25M if things go well, which is beyond me. Better to get in now.” Today that investor is probably willing to bet that the company will be back around in a year raising $4M on a flat $15M pre-money with more progress, so the VC will just wait. Alternatively, the VC might be attracted if the seed price was instead $2M on $6M.  This waiting, in turn, actually reduces demand and so prices. The circle will not be unbroken. 

Does any of this matter? Yes and no. Many companies need capital to grow fast at the early stages. Not everyone needs high valuations to boost their ego, though, and in the new paradigm, startups can raise smaller rounds to manage dilution at lower prices. The changing market could also mean depressed exit valuations, which make a big difference to founders and investors. However, calling the ball on an exit market many years from now is futile. 

The real challenge is that we can’t all go hide under a rock until money gets cheap again. At the beginning of the pandemic (before it turned out that tech would flourish), the advice was to cut burn significantly and survive. The expectation was that we could all emerge 6 to 12 months later with a common excuse and start growing again. While it turned out the excuse wasn’t needed, no such excuse exists this time around. The bar for performance stays the same; it’s just that we either have to take more dilution to use the same burn to hit the bar, or burn less to hit it. Both of these are hard in different ways.

Take a deep breath

After four months of market volatility, with half of the steep decline just in the last month, the conventional business wisdom has rapidly switched from exhilaration to one of doom and gloom. This is especially true in the tech economy and in startup land.

Here is the good news. When social sentiment is either extremely good or extremely bad, you can be certain that the truth falls short of the extreme. I am not the first to point out that social media and “professional” media channels magnify the already excitable human condition. A turning tide that exposes who is swimming naked also jars us into believing that the unlucky companies that now need to layoff employees and cut burn were doing amazingly well until the tide went out. Not so. Most of them have been swimming naked the whole time, or even walked naked to the beach!  

Burning too much capital to make too little progress is always a risk and symptomatic of an unhealthy startup, whether the market previously overlooked and rewarded perverse behavior with a financing round, or not. “The market” is not interested in doing that anymore.

The sugar high was wonderful. 2020 and 2021 were a once-in-a-generation opportunity for business model risk taking and liquidity, but now we’re back to the meat and potatoes of balanced cash burn and responsible growth. For the startups that bake this into their strategy, there is the added opportunity that talent markets will likely be more favorable in tech – and possibly beyond if there is a recession. This, after a ten-year run of tightening and then white-hot talent competition. It shouldn’t be lost on anyone that two of Chicago’s greatest growth stories of yore – Redbox and Grubhub – were built during weak labor markets of the financial crisis. In times of economic weakness, outsized resources and gains go to the victors.

I am also uncertain about the conventional wisdom that high interest rates will be terrible for the tech economy and startups. Yes, a high interest environment traditionally hampers companies and industries that require high levels of investment capital, because risk capital instead chases yield. That makes sense, but with very few pundits or operators ever having lived through a high interest rate paradigm (including me), it makes it easy to oversimplify (and to be naïve?).

As evidence of interest rate risks to tech, many point to crossover funds that funded the exuberant late-stage rounds of 2020 and 2021 now putting their pencils down in the private markets. Their reduced willingness to fund excessive pre-IPO pricing risk is just starting to reverberate down to mid and early-stage funding rounds. However there is a strong case that what we’re seeing makes sense after the pandemic and has little to do with interest rates. As Natasha Mascarenhas said for TechCrunch in “It’s not a startup reckoning, it’s a recorrection”:

Over the past two years, tech rightfully became more critical than ever for the services that it provided to the average human, whether it was empowering an entirely distributed workforce or helping us get access to health services via a screen. It also became vulnerable. Pandemic-era growth has always had a caveat: The tech companies that found product-market fit, and demand beyond their wildest dreams, are the same tech companies that knew their win was at least partially dependent on a rare, once-in-a-lifetime event that (hopefully) would go away one day.

While we’re still waiting for good 2022 private valuation data to form, public comps seem to support Natasha’s view. The BVP Nasdaq Emerging Cloud Index is a good public proxy (and canary in the coalmine) for where private market valuations may go. What we see is that public comps are normalizing to pre-pandemic trend lines…


BVP Nasdaq Emerging Cloud Index Performance

… and valuation multiples are back where we started.

EMCLOUD EV/Rev Valuation Multiples

BVP Nasdaq Emerging Cloud Index EV/Revenue

Of course, now is a moment in time, and trends may further deteriorate. Even if they do, my bet is that they rebound.

Apple, Google, Microsoft, Amazon and Intel hold more than $600B in cash. Google, Microsoft and Intel will keep acquiring (okay, Apple and Amazon do less of that) to maintain their moats, just as they’ve always done. The longer tail of tech giants like Salesforce, CISCO et al will too. The ultimate demand for new technology, business models and unique talent remains high.  

All of this is to say that things may not be as bad as they seem or what we hear. Nevertheless, plan for the worst; hope for the best! So we are coaching our teams:

  • Cash is king/queen: This isn’t a new refrain. Manage your burn and maintain runway. I love to see a SaaS business adding $1M in revenue for each $1M of cash burned – hard to do but easier if you burn less and grow a little slower. I also love seeing net burn below monthly revenue. So, if in a month you’re doing $100K in revenue and burning less than $100K that’s terrific. (Of course you also need to be growing to want to do that.) The days of burning $5M to get $1M in ARR or burning $500K in a month to produce $100K of revenue in that month are gone.
  • Manage your expectations: I met with an at-launch company last week and asked them how much they were raising. “5 on 35”. My response: “wuh?” As the market quickly shifts, it’s easy to lose track of the market or blow a conversation by being tone deaf. Consider that early-stage rounds will likely revert to the typical 20 to 30% dilution we used to see, and later stage rounds up to 20%+ from the 10% they fell to.
  • Beware the middling third: The top third of companies should continue to have funding opportunities, even if at reduced valuations. The bottom third will continue to need to sell out or shut down. The middle third is likely where things will change the most. VCs and founders were spoiled in the recent runup with many mediocre performances still earning follow-on rounds. This feels far less likely now, and companies in the middle third should instead seek solid exit opportunities or cash flow breakeven.

Good luck to all and remember that in the asymmetric performance curve of startups, iconic companies can and will be built during downturns.

The vaccines are coming; now what?

The arrival of several highly efficacious vaccines – whose rapid advent is itself a modern technological marvel – allows us to finally ask with more temporal certainty, “what’s next?” and “what’s next for tech?” While at the same time we hunker down and take precautions for what may yet be the most painful and dangerous months of the pandemic, we may now hopefully look to mid-2021 when a semblance of normalcy for our lives and all sectors of the economy is likely to return.

Just as we planned and adjusted when COVID hit, it’s time to do it again. Naturally the exercise is largely dependent on how a startup was initially affected by COVID and whether those trends will have inertia or fully abate. However, every startup needs to consider implications to cash and the longevity and viability of remote working in a less contagious world:

The few companies that benefited from COVID have to make bets on behavioral inertia.

Whether a D2C e-commerce brand or a telemedicine startup, each startup that benefited from COVID is asking the question, “how long will this last?”. In many cases, we expect modified behaviors to have permanence. It’s reasonable to believe that many consumers who recently crossed the abyss to online grocery ordering may want to remain there much of the time, or that remote employees will want to keep working from their new pied-a-terre in the country. In fact, many of these changes have taken structural form, including the flight to the suburbs and office down-sizing. Purchased homes and new leases have permanence. We also know that it won’t all stick. Zoom stock is down 27% from its peak a month ago as the light at the end of the pandemic tunnel emerges. While there is no single expectation that fits, VC Fred Wilson suggests that a 50% reduction in excess demand caused by a shock is a reasonable place to start in planning for the aftermath. If companies can flex that assumption in their model up to 75% and down to 25% while still achieving solid growth and efficient burn, that is a robust plan.

Not yet party time for everyone else

So for the companies that were deeply impacted by COVID or for those that were relatively unaffected, is 2021 going to be a party? Not likely. For example, the travel industry may take years to return to pre-pandemic levels. Some of this will be a result of lingering contagion or fear and some the result of entrenched behavior change. Even less affected industries are not likely to see a rapid jump back to pre-pandemic levels as demand and job recovery always take time. The exception may be in consumer goods and experiences, where an unprecedented increase in consumer savings rate over the last six months may portend a release of spending in 2021 when confidence and job prospects improve.  We are encouraging our most heavily affected companies to take it slow in 2021 and allow each increase in spend to prove itself with commensurate demand before taking on more expense.

Cash is still king

While venture capital didn’t experience the apocalyptic decline some predicted – and in fact had a banner third quarter this year – much of that favored a few late stage winners or COVID standouts. Moreover, the standards and milestones of success have not loosened because of COVID. Startups are still expected to at least double year-over-year to be fundable through Series B. That was uniquely difficult in 2020 and will remain so in 2021. Without a free pass on a bad year, most companies that limped through 2020 will have to preserve cash through 2021 as they slowly claw back towards growth. This will be very hard for most, and there may yet be casualties.

Remote people and culture are here to stay

By 2025, it may be that the most permanent vestige of the pandemic at startups is remote teams and culture. Before COVID, about 10 to 15% of companies we saw had majority remote teams. With that number now near 90%, we think it will settle in the 50 to 60% range in a few years. The barriers to productivity have largely fallen as we’ve all learned to work remotely, and the benefits of being able to hire anywhere, including on a contract basis, can make a startup more nimble. As a geographic focused investor, we’ve thought a lot about what that means for us. While we still believe our geographic focus brings network effects in our ability to find and help startups, we expect more of our investments to have a considerable remote workforce, albeit with a mid-content HQ. You have to host the holiday party somewhere!

While it is a relief to look ahead to a brighter 2021, we know that the next few months will be difficult for all, directly painful for many and tragic for some.  Let us all be safe and good to each other as we transit this last leg.

That new CARR smell

With politics and the pandemic hurtling towards a crescendo this week, I thought it would be a welcome distraction to talk about something equally as controversial… Contracted Annual Recurring Revenue (CARR). (The comparison is mostly a dark joke, so spare me any indignation.)

We started seeing CARR enter the startup lingo about five years ago, but typically only inside of enterprise software startups in their tracking of implemented revenue versus signed revenue. Then CARR started appearing in investor decks, then companies wanted to be valued as a multiple of it instead of ARR, then companies started talking about “verbal” Contracted Annual Recurring Revenue (VCARR). Oh boy.

Here is how we think about ARR and CARR and how they relate to each other:

Your current GAAP (recognized) monthly revenue x 12, excluding any transactional revenue

= ARR (very conservative)

+ transactional revenue that is highly certain to recur (example would be “metered” subscription models like say charging $1 per truck load in shipping)

= ARR (nominal)

+ additions to ARR expected in the next 6-12 months (or maybe before end of calendar year) that represent increases baked into contracts that are already implemented. This could include highly likely increases to recurring transactional revenue for certain models

= ARR (liberal)

+ “ARR” that is contracted but not yet implemented or billing, representing what will be billing immediately after it is implemented

= CARR (nominal)

+ increases to CARR that represent contracted annual price increases over time in contracts not yet implemented, including future “recurring transactional” revenue

= CARR (liberal)

+ contracts you think you have a verbal on

= VCARR (bullshit) = bullshit

We generally prefer the use of ARR (nominal) and CARR (nominal) both in working with our companies and in evaluating new investment opportunities. We prefer these versions because their constituent parts are more transparent and objective. The difference between them is also very clear. ARR is monthly revenue today x 12, and CARR is monthly revenue if we finished all implementations today and multiplied by 12. We loathe VCARR.

But don’t you want to take credit with your BoD or an acquirer/funder for everything you have signed? Of course, but if there are too many assumptions in the underlying structure of a metric, its veracity collapses, potentially requiring backtracking, reforecasting or undermining your story with a BoD or acquirer/funder. Using nominal definitions, it is okay to say our ARR is X today, but in six months, we already have Y baked in, representing contracted increases. Similarly, many companies will talk about TCV, which includes the value of multi-year contracts.

These days, we are seeing most companies valued by some multiple of ARR (nominal) or expected year end ARR (nominal). If the former, credit is usually given also for unimplemented contracts (CARR – ARR). If the company is later stage with a long history of successfully implementing contracts, there may be no discount on the multiplier used for the unimplemented contracts. For an early stage company say with $1M in ARR and $1M in unimplemented contracts (CARR = $2M), the discount on the unimplemented multiplier might be as high as 50%, given more uncertainty about implementation success.

What matters the most is that whatever metric you choose, it is clearly defined, transparent and able to be objectively measured. Otherwise your new CARR will smell fishy.