Panic in Startupland!
The story of startup guys who thought were riding a unicorn only to learn, later on, that they were riding a pig.
Startupland is in panic mode. Months ago, pundits lectured about the new normal; now, they are counting their losses. What happened?
The new normal was a bunch of things: 100x ARR fundraising multiple, IPO shares that doubled on the first trading day, cash flows considered a bad disease, large secondary round for founders and insiders, hedge funds flooding the later-stage market, meme stocks that 10x overnight, oversubscribed fundraising rounds every six months, acquisitions with over-valued stocks, and more strangeness I can't even recall.
The pundits argue that it was caused by an acceleration of the use of software after COVID. Work from home, Zoom calls, and quick digital transformation supposedly unlocked trillions of value. The software industry was bigger than ever, so valuations surged, and the revenue was supposed to match... in the future!
I was skeptical. I wrote in How to Beat the Market:
In a bull market, speculators believe that "this time is different" which leads to exuberance. A bubble is characterized by the fact that people believe that some new development will change the world, that patterns that have been the rule in the past, such as business cycles, will no longer occur or that the rules regarding valuation norms and standard of value and safety have changed. More often than not, the time is no different and the pendulum switches back.
My opinion is the following: central banks lowered the interest rate, flooding the market with money and creating unstoppable inflation and asset speculation. When cash value decreases fast, investors rush to find productive assets to preserve purchasing power. Too many trillion dollars chasing a few assets sent prices to the moon. Central bankers created a gigantic misallocation of resources - as they have always done since the dawn of time.
What is happening now? Central bankers increase the interest rate to fight sky-high inflation, causing the stock market to collapse. The Federal Reserve issued the biggest hike rate in two decades, and more rate rises are expected. Accordingly, tech stocks got hammered.
-80% for Zoom. Are you serious? The first metaverse company and the pillar of the remote economy! It hurts. Shopify at -80%? Aren't we supposed to shop exclusively online now? Robinhood's valuation is less than all the capital they have raised: wasn't day trading Dogecoin a sure thing? Peloton at -90%? Where are all the digital bikers? Is profitability a thing now? Did Tech Twittos lie to us, or what? ):
Let's talk numbers. The attentive reader will notice a sempiternal reversion to the mean. Multiples skyrocketed and are now coming back to a historical average. Nothing more. The "new normal" was bullshit talk similar to Yale economist Irving Fisher who predicted, on the verge of the great depression, in 1929: "Stock prices have reached what looks like a permanently high plateau" Well, thanks for the tip!
The multiple of the enterprise value on the next twelve months’ revenue (EV / NTM) went crazy. The median multiple reached 22x in late 2021, sending the cumulative market capitalization of all public SaaS companies to $2tn! The market has since cooled off, wiping out $1tn of market cap (!!) and reverting back to the mean with an EV / NTM of 7.2x.
Suppose a SaaS company trading at the median multiple: $1 of additional revenue added $22 of enterprise value back in late 2021. It meant companies were encouraged to invest or acquire up to $22 to generate $1 of revenue. Of course, 22 was the median, and some companies, such as Snowflake, traded at 93x. The high burn was praised, and investors pushed for more spending in this unprecedented environment. What could go wrong?
Today, $1 of revenue contributes to only $7.2 of enterprise value - and it keeps falling. Likely, companies didn't manage to adjust their burn rate to the sudden reversion to the mean. It means that they are destroying capital fast. What supposedly made sense yesterday is now totally dumb.
The classic mistake is to base business assumptions on an all-time high and speculative market. Last October, in “I Raise Therefore I am”, I wrote:
The high exit multiples of today drive higher fundraising valuation, but what if exit multiples go back to their historical average? The fundamental issue is that the company's fundraising valuation, terms - aka liquid prefs-, and burn rate won't adapt to the new exit environment. A lot of wealth will be destroyed that way.
What does it mean for the immediate future?
Fewer unicorns. The "new normal" unicorn was easy. Reach $10M ARR by burning tons of cash, raising at 100x ARR, and voila! A $1bn valuation in Techcrunch. Now, according to a prominent VC, Matt Turck: "to justify a $1B valuation, a cloud unicorn today would need to plan on doing $178M in revenues in the next 12 months if you apply the current median cloud software multiple (5.6x forward rev)." Well, it's finally not that easy to be worth $1 billion. By the way, you should follow Matt, who is smart and hilarious. His latest tweet:
Unit economics matters. If you have a high burn rate, low business efficiency, and a short runway... Houston, there is a problem! You just went from being the best in class to the worst in class. Pay attention; teachers changed the rule! Gross margins, net dollar retention, EBITDA, CAC, burn multiple... all that suddenly matter. A lot. When free money stops, businesses discover the underlying quality of their operation.
Startup bankruptcies. Keith Rabois put it simply: "If you have a high burn rate and have raised money at high prices, you're going to run into a brick wall very fast." The end of free money. Who could have imagined that? Startups with a high burn rate that don't manage to become profitable will die like all bad businesses. Expect a hiring freeze and mass layoff. It's the ruthless natural selection of capitalism.
Startups got capital killed. This one is subtle. If the startup raised at a crazy valuation, the cash is still here, but the equity might be worthless. It's the Uber, Dropbox, Oscar Health, Lemonade, Robinhood (etc etc etc) common scenario. For instance, Oscar Health raised a total of $1.6bn for a current valuation of $1bn. Many startups that raised money in the last two years will have the same fate.
Many VCs will go burst. In the investment biz, price matters. Pay too much, and you will never see your money again. Tiger Global, the daring "new normal" king, took a $17 billion hit on its investment- the biggest dollar decline for a hedge fund in history, according to FT. Ouch. Many VC firms will struggle to raise additional funds and close their door. Investments in venture funds are already dropping (-19% quarter-over-quarter according to CB Insights).
Wow, brutal learnings. Cash flows matter, burn matters, gross margin matters, churn matters, and valuation matters. Building a good business matters.
Hype Ratio = Capital Raised / Annual Recurring Revenue.
Burn multiple = Net Burn / Net New ARR
If these ratios are superior to 3 then there is a problem. It’s not uncommon to see startups with a 10+ ratio these days.
One day you were riding a unicorn only to learn, later on, that you were riding a pig!
Reversion to the mean is inevitable. I would say that it's a severe crisis only when multiples go below their historical average. Most people look at returns on paper without asking if the price makes sense in the first place. Price on fundamentals such as revenue or earnings means a lot, especially in their historical context. A few years of irrational exuberance don't make a market.
The crisis is, for now, pretty light. The 2008 crash sent the NASDAQ to a level last seen in July 1995! 13 years of stock appreciation were gone! Boum. Today's crash sent the NASDAQ to a level last seen... last year. Well. The market is still expensive.
So, how did we get there? Why so many people are surprised (and totally broke) by a classic reversion to the mean?
The irrational exuberance of a bull market and a reversion to the mean are common. What is striking each time is the willingness of market participants to bullshit themselves about a new paradigm to jump into the speculative market. A lot of investors and founders jump all in into the cliff. Why is that?
Part of the answer is greed and envy. I wrote in How to Beat the Market:
Greed is an extremely powerful force that overcomes common sense, prudence, and memory of painful past lessons. It's hard to stay prudent when every speculator around is enjoying significant profits. The combination of the pressure to conform and the desire to get rich cause investor to drop their independence and skepticism which leads to their capitulation by buying into the speculative market. Greed is a drug that affects the investor's rational thinking while envy forces investors to comply with the herd
The other part is the incentive, the powerful force that drives the world. Investors who gamble into the speculative market get short-term rewards such as high mark-ups thanks to later fundraising rounds that allow them to raise more money from LPs and enjoy more fees. Founders enjoy large cash-out and money to fuel their business regardless of the unit economics. It’s easy to compromise the long-term future to pocket a big cheque. What about buying a $133M mansion after having sold for $292M on the IPO day? Short-term payday, long-term hell.
Ok, what about the silver lining?
Good business will have the time of their life. Fast-growing, profitable startups will have the opportunity to buy out struggling competitors, invest in an environment where CAC will decrease, and hire people with fair compensation packages. Startups with positive cash flows are the cool kids again - until the next exuberance of course.
It will be fine. Stock market crashes come and go. It's a good reminder that the value of a business is the net present value of its future cash flows. Cashflows are king (I know... such a boomer mindset!)
This makes me even more admirative of Warren Buffett or Mark Leonard type of people. Strong-willed people who think for themselves and have the guts to resist short-term temptations. They are the ones ridiculed, the ones not invited to fancy dinners, the ones not covered in magazines, but they are the ones who win. They fight the institutional imperative, the peer pressure, preserve a margin of safety, and are fearful when others are greedy and greedy when others are fearful! There are the Intelligent CEOs.
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