2022 brought down the curtain on TINA, the concept that 'there is no alternative' to, in this case, the stock market. Near-zero interest rates for over a decade culminated in a speculative bubble that burst last year. The global central banking system revived the long overlooked concept of 'discounting' in a historic fashion, hiking interest rates to combat the confluence of both demand- and supply-side inflationary impulses. Time value of money is back: a dollar today is worth more than a dollar tomorrow. This abrupt shift had the greatest impact on the unprofitable technology companies valued on expected cash flow in the future. This group suffered from both the discounting effect and a flight to quality, the idea that capital will migrate to safer havens in times of uncertainty. What does this mean for those of us who work at or invest in unprofitable startups? Venture capital is not immune to a flight to quality. To a macro investor, a flight to quality might imply a migration from unprofitable tech to treasuries or gold, a shift from risky to riskless. However, there is an unmistakable flight to quality underway within the tech sector itself. 'Quality' simply takes on a new meaning in our context. Last year served as a reminder that not all revenue is created equally. The public narrative tends to treat tech as a singular mass, when in reality the sector encompasses a diversity of business models. While tech stocks were battered across the board, some segments, in particular cloud software companies, have fared much better than everything else in tech. Consider marketplaces. Compared to a year ago, the share prices of digital marketplaces have fallen by 78% on average versus a decline of 65% for software companies. At least six marketplaces* have lost 90% or more of their value. If the difference between 65% and 78% doesn't sound like a lot, consider this: those six marketplaces lost an incremental $12 billion in market capitalization because investors punished them more than software companies. As further evidence of the dislocation, in December 2021, a basket of marketplaces was valued at nearly the same multiple as software companies are today. Digital brokerages share a similar story: a basket of tech-enabled brokerages has fallen by 78% compared to a year ago. At its peak, Coinbase was valued at 9.2x LTM** revenue; today, it sits at 1.3x LTM revenue. Fintech companies have fared worse than software, too, declining by an average of 73% year-over-year. Software-based fintech companies like Flywire and Bill.com have held their value more than pure-play payments or lending businesses. Excluding fintech companies that monetize through software, the year-over-year decline for fintech companies resembles that of digital marketplaces and brokerages.
Why is this important? In the mania of 2021, when venture capitalists deployed capital like drunken sailors on the OpenSea, the nature of a company's revenue lost meaning. This mindset entered the lexicon: it became commonplace to refer to revenue as 'ARR,' or annual recurring revenue, regardless of whether the revenue was contractually recurring or billed in yearly increments. ARR became synonymous with 'run-rate revenue,' or simply the annualization of a given month's revenue. The conflation of contractually recurring and annualized revenue seeped into how a company's revenue was perceived and ultimately valued. The notion of quality of revenue was subordinate to growth and other factors. As tech company valuations came under greater scrutiny last year, investors no longer excused these careless definitions. A 'flight to quality' for the venture industry means a reversion to revenue models that are profitable and predictable. As investors look for companies to invest in this year, there will be a renewed focus on these fundamentals: · Profitability: High margins are better than low margins! Investors benchmark gross margins and operating margins. Ultimately, expected free cash flow dictates valuation. For the vast majority of startups that don't generate free cash flow, investors will focus on profitability of unit economics. · Predictability: A dollar with a greater degree of certainty is worth more than a dollar with a lower degree of certainty. A dollar that is contractual, recurring, and/or growing predictably should be valued at a higher multiple than a dollar that is not any of those things.
Companies that are neither profitable nor predictable faced the harshest reckoning in 2022. Looking forward, the perception of quality extends far beyond a revenue model. There are geographic and social implications, too. Which founders and regions will be considered safe in the next chapter of venture investing? The Bahamas seemed an acceptable if unconventional domicile until the FTX implosion. Will first-time founders, or founders who have atypical backgrounds or credentials, be disproportionately impacted in this environment? There is already some evidence to suggest so.
The only thing we know for sure is that real and perceived quality is more central to the investment process than it was before. The impact on which companies receive funding will be significant. *Carvana, Cazoo, thredUP, Vroom, TheRealReal, and Opendoor
**LTM stands for 'last twelve months'