Risk Drunk & Stumbling: Why Markets Are Finally Sobering Up
“If we’ve learned anything from the past market cycles, it’s that the fundamentals eventually matter, and all revenues are decidedly not created equal”
A thirteen year bull run fuelled by cheap credit has come to a decisive end. Public tech companies valued at frothy forward revenue multiples began coughing and sneezing back in October 2021. Private companies and capital markets have now caught a cold.
The fact we need reminding that fundamentals like profitability “eventually matter” confirms that things got out of hand. We have seen bubbles burst before, so perhaps Shakespeare said it best : “What’s past is prologue”. This business cycle was characterised by low interest rates and an unwavering belief in the power of new technologies to remake the world. To figure out why we are turning a leaf and beginning a new chapter we need to go beyond the broad brushstrokes of a macroeconomic analysis, although there is no harm in quickly recounting an abridged version here:
- The war in Ukraine is causing economic headwinds and is fuelling levels of inflation not seen in 40 years. For the month of May 2022 the Eurozone average was 8.1%, the USA 8.5%.
- This means further interest rate hikes are almost definitely on the horizon, which will increase the cost of borrowing.
- Higher inflation and interest rates both act as dampeners on consumer spending, which means that growth stocks and startups reliant upon discretionary consumer spending (i.e. home food delivery, streaming services, even Big Tech) will see demand for their goods and services fall as consumers tighten their belts. In the case of Fintech stocks, and more specifically, BNPL, even if demand doesn’t immediately dry up, unsustainable borrowing is bound to show up in lagging indicators like loan defaults as some customers choose to “pay later” to combat higher prices. Only to realise they can’t afford to.
- In addition to all of this, a more negative economic outlook and more uncertainty means debt and equity markets have effectively shut up shop, although there will be a “flight to quality” i.e. already successful, profitable, growing companies that represent a much lower investment risk. This means many mid to low quality companies that employ thousands of people will need to implement “cost saving initiatives”. Some call it a shake out. Its real name is survival of the fittest.
This last point is worth dwelling on. I just re-read it aloud and surprised myself. Investors now prefer profitable, well run and growing companies that are more likely to survive hard times and therefore represent a lower investment risk?!?
If you are skeptical, please don’t take my word for it. CEOs of companies renowned for incinerating cash in the pursuit of market dominance have come out and said the same. (Incidentally many of these companies were the generous benefactors of a millennial lifestyle subsidy that sold a range of services from on-demand taxi and e-scooter rides, to discounted food delivery and holiday rentals, co-working spaces, gym passes and dry cleaning at below cost in a bid to “make the world a better place”). But I digress.
Here is Uber CEO, Dara Khosrowshahi in an all staff email:
“It’s clear that the market is experiencing a seismic shift and we need to react accordingly […] In times of uncertainty, investors look for safety […] Channelling Jerry Maguire, we need to show them the money. We have made a ton of progress in terms of profitability but the goalposts have changed. Now it’s about free cash flow. We can (and should) get there fast”. (My bolding).
And here Gorillas CEO, Kagan Sumer:
“Over the course of the last 24 months trillions of dollars have been injected into the economy, which created a tremendous growth wave for the world. Everyone was a winner, everyone had access to capital and all companies had high valuations [...] Two months ago the markets turned upside down, and since then the situation has continued to worsen. Very rapidly, greed in the markets was replaced with cautiousness. And tech companies, especially low or negative margin tech companies, are facing a very strong headwind. The result of this new reality is that wealth and money are being transferred to low risk profitable businesses.” (My bolding).
Finance Acronyms
It’s impossible to fully grasp what Khosrowshahi and Sumer are saying unless we understand that the valuation of a private company is the Net Present Value (NPV) of its future cash flows.
The most common method for calculating this is a Discounted Cash Flow (DCF) analysis. This makes a series of assumptions about the future revenue growth, costs and cash flows of a business. Revenue growth assumptions are usually in the 150–300% YoY range. According to PitchBook Data the 15 year average Required Rate of Return (RRR) for Growth Stage companies is around 15%.
The Weighted Average Cost of Capital (WACC) can also be used to model out a P&L. Were you to do this, you would see that a WACC increase of even 2–3 percentage points leads to a significant drop in DCF valuation. In this worked example from Daan Loening (hat tip) an increase in WACC from 14% to 17% leads to a whopping 40% decline in DCF valuation ($209m to $128m):
The same principle applies to decacorns like Klarna, which saw its record breaking European Fintech valuation of $46 Bn revised down to $30 Bn, a -35% haircut.
Risk Free
Irrespective of what valuation method you use, the Risk Free Rate plays an important role. This is a theoretical rate of return equivalent to what an investor would receive if they put their money elsewhere i.e. a risk free 10 year treasury bill. Therefore riskier bets like early stage companies will need to perform better to meet the same investor RRR expectations in a higher interest rate environment. This is the crux of it. Higher interest rates act as a downward drag on revenue multiples because the cost of borrowing increases. Or put differently, the opportunity cost of incinerating cheap cash to fund growth increases.
Let’s take the example of a fictional Series B SaaS company that generates $50m Annual Recurring Revenue (ARR) and is valued at $1Bn, a 20x forward revenue multiple. It’s revenue multiple has now been recalibrated to a more sober although still enviable 10x. Other things being equal, it now needs to make $100m ARR to maintain the same valuation. But ambitious YoY growth expectations don’t disappear, these also need to be met! Ergo, #UnicornLife just got harder.
Risk Drunk
Until very recently (let’s say the end of March) growth capital had been chasing a limited number of high potential targets with massive TAMs, sumptuous projected growth rates and proprietary technology that ticked all the right boxes #AI, #deeptech #web3, #DeFi blah blah. The large amounts of dry powder in the market meant that valuations got bid up from seed stage to IPO. Valuation inflation, if you will. The quip that “the first board meeting after a round is the new due diligence” may be exaggerated but contains a grain of truth.
The Big Five
Seen through a due diligence lens, market exuberance meant fundamentals were often ignored, FOMO took hold and 10x valuations handed out like free beer at a new WeWork office opening. Anyone who has been on a safari tries to spot the big five. Here are my “big five” business fundamentals:
🐘 Defensibility : moats that make your business difficult to copy and create sustainable competitive advantage. Copycat businesses quickly erode pricing power and drive commoditisation risk, which means a race to the bottom and a race to scale, which in turn implies lots of cash, an empty oil drum, a pack of matches, petrol and a path to profitless prosperity.
🦁 Operating margin: can this thing be profitable in the near future and when do the unit economics come good? By definition big assumptions underlie many early stage investments. But some are bigger than others. Uber thought it would have 75,000 autonomous vehicles on the roads and be operating driverless taxi services in 13 cities by 2022. Utter folly. If strong operating margins rely on new technology and massive regulatory change the risk to future profitability should be reflected in a lower revenue multiple. In an age of fake it til you make it capitalism it often had the opposite effect.
🐃 Scalability with high marginal incremental profitability, in other words you experience economies of scale where Cost of Goods Sold (COGs) declines as you grow. Network effects add rocket fuel to your growth curve and your investors get to use their favourite emoji 🚀
🦏 Predictable and forecastable revenue. Volatile businesses are less easy to forecast and plug into a DCF analysis, meaning there is less certainty around when positive cash flow might be reached, if at all. So in this instance predictable revenue should be rewarded with a revenue multiple premium.
🐆 High organic demand that doesn’t require massive marketing spend to buy or rent customers. Customer lock in, or my preferred term, “loyalty”, is a knock on benefit of providing a valuable service which customers are willing to pay for (note “pay” and “for”). Too many growth businesses fail due to unsustainable Customer Acquisition Costs (CAC) and low Customer Lifetime Value, usually because the product ain’t that good, or no one wants it when it ain’t dirt cheap.
Emblems of a crazy age
Masayoshi Son’s Vision Fund may have swung to a loss of $20.5 Bn earlier this year, but he has given us slides of inimitable artistry. His prancing, multicoloured unicorns express a boundless potential. AI, I hear them nay, AI. All I know is that I one day hope to own the NFT.
His status as an emblem of startup excess (2010–2022) is surely cemented by the time he beckoned Adam Neumann into his limousine and implored him to be “ten times more crazy”. Every time I imagine it I smile and am a little happier.
Hot on Son’s heels is Kathy Wood of ARK innovation ETF fame. New York Magazine offers this unimprovable description:
“To hear her talk was to feel your mind liquefy in a clickbait-like flood of dopamine-inducing buzzwords — her portfolio a cornucopia of self-driving cars, crypto, genomic cancer cures, AI, streaming, and gaming. She told risk-drunk investors exactly what they wanted to hear. In her view, it seemed, tech stocks only went up and to the right”
Champagne and cocaine
Cheap money and charisma are the champagne and cocaine of capitalism; they create bubbles, overconfidence and embellished stories. Excessive consumption also leads to an eventual come down, self loathing and need for more. When exaggeration goes too far and visionary founders get in too deep, the final destination is fraud e.g. Wirecard, WeWork, Theranos, Nikola, Ozy, Headspin and NS8 come to mind. (The last on this list was a fraud prevention company, pretty ironic, but also very meta).
So what have we learnt? For one, that the tide is out and a startling number of companies have been swimming naked. But like tides, markets are a cyclical phenomena that will always promise to lift all boats. We will certainly find ourselves in frothy waters again, and we will certainly see boats sailing too close to the wind. Some will float, some will sink and some will need to bail water overboard. So, although there is no equivalent to Archimedes’ principle for investors and founders (i.e. a simple formula that explains why objects float or sink ), there are business fundamentals that eventually matter and that we would be wise to remember.
