Startup Risk: IPOs and Soaring Valuations

Concerns About a Potential Tech Correction

Recent surges in venture capital funding, a growing number of billion-dollar startups, and substantial revenue multiples for both private and public tech companies might understandably raise fears of a correction similar to the dot-com bubble.

However, many industry observers remain unconvinced that a repeat is imminent, and their reasoning is sound.

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The phrase "it’s different this time" is often met with skepticism, but a comparison reveals significant distinctions between the current tech boom and the dot-com era. During the initial internet boom, numerous companies with minimal or no revenue were listed on public exchanges at extraordinarily high valuations.

This resulted in a substantial accumulation of risk within the public markets, ultimately impacting individual investors when tech valuations experienced a sharp decline.

Revenue as a Key Differentiator

It is accurate to state that the majority of today’s highly valued tech startups generate considerably more revenue than their predecessors from the dot-com period.

However, the argument that company quality—specifically, the presence of revenue and the stabilizing influence of strong revenue multiples—has contained risk has gradually weakened in recent quarters.

Furthermore, a discernible trend indicates a decline in the quality of tech companies entering the public market, thereby increasing the risk exposure for all investors, not solely institutional ones.

This shift suggests a potential for increased volatility and a greater need for caution within the technology sector.

The Shift from Revenue-Lite to Revenue-Free Valuations

Two primary arguments have historically supported the notion that the inherent risk associated with current high valuations in the technology sector is not a significant concern. The first centers on the fact that these valuations aren't founded on speculation. The second highlights that the general public isn’t directly exposed to companies carrying substantial risk.

• Startup valuations are considered less problematic because public participation in potentially unstable companies is limited, and these companies generally demonstrate actual revenue generation.
• Public tech company valuations are viewed as safer because, despite public investment opportunities, their share prices are largely determined by substantial revenue streams.

This perspective appeared reasonable.

However, evolving market forces are rapidly diminishing the validity of these arguments, introducing increased risk into both private and public markets. Essentially, public investors are gaining greater access to higher-risk tech companies, and simultaneously, the degree of speculative valuation within the tech industry is expanding.

The public is now facing increased vulnerability.

Within the private market, public exposure remains generally restricted. Existing U.S. securities regulations largely prevent most individuals from investing in early-stage tech ventures. While crowdfunding presents a minor risk, it typically involves small investments representing a negligible portion of total funding for private companies.

Nevertheless, public funds are channeled into investment vehicles that actively allocate capital to startups—and they are doing so at escalating prices for diminishing profitability, as previously discussed.

The public’s risk is more readily observable in the public markets, where the enthusiasm seen in private markets is manifesting as public-market realities. Consider these instances:

• MetroMile secured significant funding as a startup, subsequently went public through a SPAC, and ultimately experienced a substantial decline in enterprise value before being acquired by Lemonade. Private investors may have realized profits, but the public likely incurred losses based on the company’s stock performance.
• Rivian—a company that produced only 12 vehicles last quarter and delivered 11—recently launched its IPO. According to Yahoo Finance, its valuation stands at $98.7 billion. Public investors now have the opportunity to invest in a company resembling a dot-com era narrative still awaiting its conclusion.

It’s possible that MetroMile represents an isolated case. And Rivian might successfully scale production and achieve a meaningful portion of its projected revenue and gross profit. However, these examples demonstrate a growing trend of expanded risk gaining a more prominent public presence.

Currently, those actively investing in the private tech market exhibit limited concern. This is understandable, given that tech valuations are near record highs and capital remains abundant. They appear successful, driving up investment values, seemingly convinced that tech multiples have reached a new, sustained peak.

Consequently, the most optimistic tech investors are willing to pay unprecedented premiums for startup equity. Reports indicate that private-market tech companies are achieving multiples around 100x—or even higher—in recent funding rounds. These deals are viable as long as subsequent investors provide further markups or the opportunity to transfer startups to the public market, which is currently receptive to expensive, yet unprofitable, tech companies.

Private investors are placing many tech startups in a position where they must pursue comparable, elevated multiples over the next several years, irrespective of market conditions—even upon going public. This situation could result in more IPOs where a significant discrepancy exists between a company’s revenue base and its anticipated valuation. This, in turn, could introduce even greater risk for public investors.

While companies emerging from the late unicorn phase are generally of higher quality than those from the dot-com bubble, the influx of capital is transforming what was once considered rich pricing into unrealistic pricing. Furthermore, the surge in SPACs bringing lower-quality companies public, combined with an increased IPO activity involving expensive former startups, means that ordinary investors are increasingly participating in this landscape. This inherently carries substantial risk.