Q1 2022 started off with growing uncertainty and volatility in the public markets and decline of 23% in the technology heavy Nasdaq index. Although the market isn’t challenged as it was in previous crashes, the underlying constituents are more revealing than the index itself.
Median public company software valuations, the bread and butter of Israeli high tech, have dropped from 12x forward revenue to 5x or less since its highs of October 2021, representing an almost 60% decline.
Naturally, the private market follows the trends set by the capital markets. The decrease in valuations of public tech companies, which are the ultimate buyers of venture capital, affects private transactions pricing, although the effects are not immediate.
What are the immediate consequences of the public market volatility?
a) Difficulty in retaining employees — companies are struggling to use their stock option packages as a retention mechanism for current and future employees. Many employees realize that their company will not realize the growth and the multibillion valuations which makes their option packages de facto “out of the money”.
b) Emergency cost cutting initiatives — Many board of directors are now discussing the possibility of layoffs to reduce expenditure and extend the runway of a company. This is typically done when companies anticipate difficulty raising capital and choose to reserve cash for periods well beyond 12 months.
c) Increased focus on profitability — companies that do not meet the right growth/profit proportions (“rule of 40”) are no longer trading with high multiples on the Nasdaq. Companies are increasingly adopting a healthy move from “growth at all costs“ back to profitable growth.
How long will take for the private markets to adjust to the new public valuations?
The valuation correction will have an effect both on private company valuations and funds:
a) Private market valuations are based on private transactions that are only “marked to market’’ when a company raises a funding round. These rounds typically occur every 18 months (the typical runway a company secures in order to reach the next milestone).
b) Regarding LP interests’ valuations, GPs are required to re-evaluate their portfolio positions only once a year based on their LPA requirements, but in certain circumstances GPs will choose to make corrections voluntarily.
Venture Capital funds are adapting their strategy
Many pre-IPO funds and crossover funds have halted their investment activity, with notable players continuing to invest but only deploying capital at lower valuations / earlier stage opportunities.
The investment pace of GPs has also changed from once deploying entire funds in 1–2 years to now utilizing the entire investment period allowed by the fund’s LPA. We also estimate that banks will reduce their capital call credit lines to GPs, which have shifted in the last two years from traditionally financing one transaction to now serving as a loan for the deployment of entire funds in some instances.
GPs are also required to make hard choices in today’s market. For example, should they stop backing their failed investments and stop investing good money after bad money. This process could help reserve necessary capital for their outperforming investments. This dilemma can create a market of “haves”, the ones with strong backing from investors and “haves not”, those who did not raise from large funds with deep pockets.
Light at the end of the tunnel
Although the decrease in valuations, and fears from a recession are severe, there are signs that mitigate the negative developments:
a) Gartner, one of leading business intelligence services, is projecting that worldwide IT spending will reach a total of $4.4 trillion in 2022, an increase of 4% from 2021. According to a vice president at Gartner: “This year is proving to be one of the noisiest years on record for CIOs, geopolitical disruption, inflation, currency fluctuations and supply chain challenges are among the many factors vying for their time and attention, yet contrary to what we saw at the start of 2020, CIOs are accelerating IT investments as they recognize the importance of flexibility and agility in responding to disruption”.
Dry powder — In contrast to past market corrections, we are witnessing the highest levels of “dry powder” in history, i.e capital commitments to VC funds by LPs that have not been called yet, which translates to, presumably continued flow of liquidity to successful VCs. Although this should not be over exaggerated as in past instances, in moments of despair, LPs have succeeded in withdrawing their capital from funds, or furthermore, GPs simply stopped their investment activity altogether.