Tech Investing — Navigating a Bumpy Period
Authored by Greg Emerson and Ted Wiles
The past twelve months have been a wild period in the world of technology investing. Consider these developments:
· The NASDAQ Composite Index hit an all time high in November — and then tumbled >25% to a 52-month low
· After a prolonged surge in the Tech IPO market, valuations and volumes have dropped sharply. Q1 2022 IPO volumes are down 50% vs Q1 2021. This is in marked contrast to the historic increase in tech IPOs in 2021, when venture-backed startups going public had an aggregate valuation of $543B
The performance of the private investment tech market is mixed:
· Private equity-backed LBOs remain strong. Though the market can be difficult to track quantitatively, those of us operating “on the line” are seeing consistent deal flow and healthy valuations.
· Many of the largest Tech Investors are looking opportunistically at multi-billion dollar take private deals; for instance, Thoma Bravo’s recently took Anaplan private in a >$10 billion transaction.
· The VC Series A/B funding market remains robust.
· Growth stage investing (Series C/D/E) has slowed, with H1 2022 looking to be a significantly slower period than H2 2021. As evidence, Tiger Global — one of the most significant forces in late-stage growth technology equity investing over the past few years — recently announced a shift in focus to Series A/B VC investments.
Making sense of all this
We set out to cut through the confusion and fashion a coherent explanation for the direction that technology investing is taking now — and provide some clarity about how it will likely evolve. We started by unpacking the public side: Based on changes in market caps, it appears that public equity investors have lost their appetite for growth at all costs and increasingly value companies that are focused on stronger business fundamentals. And although we recognize a portion of the selloff can be explained by rising interest rates, a rising rate environment does not explain the severity impact we are seeing. Consider the chart below — which admittedly is a radical simplification of a complex and dynamic ecosystem — but still makes a strong point.
This was clearly a rough year for the entire Technology market — the S&P 500 grew 13% during this same period — but there is also a marked difference in performance across segments.
The segments of the market that have been really battered are those that have prioritized growth over profitability. Now, clearly investors still like growth given the multiple premium for high growth vs. low growth tech. But it is our view that investors are finally beginning to question the economic fundamentals of some of these business models. The reality is for most high growth and low profit technology businesses there are two distinct business profiles:
· Profile 1: fundamental unit economics (LTV:CAC, Payback period) are profitable and leadership is making an intentional choice to invest earnings in Sales and Marketing and Product / R&D to further strengthen market position. In other words: if the business stopped growing today it would start printing EBITDA, but it is the best use of investor capital today to prioritize growth.
· Profile 2: fundamental unit economics are unprofitable and leadership is using growth as a mechanism to mask performance. In other words: if the business stopped growing today it would not print (much) EBITDA.
As GAAP metrics make unpacking fundamental unit economics quite difficult (especially in recurring revenue heavy businesses with backloaded economics when growth is high), we believe investors are grouping the two profiles together and punishing both.
This helps explain why Private Equity investing and the LBO markets remain so resilient — PE Investors are well known for insisting on strong operational discipline, supporting both growth and earnings. And the sort of due diligence PE Investors routinely conduct (and level of data access they get in this diligence) enables much better visibility into fundamental business economics. Although some element of valuation adjustment reflecting rising rates is likely warranted in the PE markets, the type of businesses PE funds buy and sell very naturally fall into those segments of the market least hard hit by the public market selloff.
This also explains the increased enthusiasm for take-privates. Many PE investors have advanced operational playbooks that extract EBITDA while maintaining growth. There is meaningful opportunity to take a company private, turn around the EBITDA position, and then relist at the multiple “premium” that comes with stronger economics.
The narrative is further supported by looking at the distribution of market cap evolution across the software archetypes:
- The upper end of distribution has performed similarly for both high- and low-margin samples; suggests investors believe selection of companies can still “turn on” profitability.
- In contrast, low-profitability sample primarily has seen significantly “deeper downside” as investors flock to quality.
What does this mean for Technology Leaders?
For executives within the Technology companies themselves — particularly those that have seen their multiples slashed over the last few months — the message is clear: clean up your economics without compromising your growth. For some this may seem like an impossible trade-off, but the reality is there are a wide variety of levers technology executives can pursue to break this compromise: pricing, sales and marketing efficiency, gross and net customer retention initiatives, etc. Publicly traded technology companies who have seen their multiples drop can either spearhead these initiatives themselves or look for a PE Partner to take them private and run the operational overhaul. Growth stage companies must similarly embrace more operational discipline within their business models while also preparing for potentially longer funding rounds with increased scrutiny on business economics.
The real comfort in all of this is the robustness of the VC market: long-term investor appetite for Technology remains strong. Early-stage valuations are adjusting to future expectations around IPO, and later stage rounds are experiencing a temporary pause as founders who raised last year are reticent to sign up for a “down round”. Regardless, it is clear investors believe in the near infinite potential for technology to enhance and optimize both business operations and consumer experiences all while delivering outstanding margins and substantial earnings over the customer lifetime. Technology investors and executives should maintain their confidence in the category, while recognizing that some fundamental clean-up of the business model is long overdue.
Backup: Segment definitions and key performance data:
