The SaaS Selloff: What's Happening?

The Impact of Tech Stock Declines

When unfavorable news regarding technology stock prices emerges on platforms like Twitter, it often prompts responses featuring extensive historical charts. These charts aim to contextualize recent downturns. It’s a common reaction, though sometimes unnecessary, as the ability to view long-term trends is generally understood.

Understanding Market Sentiment

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The frequent assertion that tech stock selloffs are insignificant is often rooted in either disingenuous reasoning or underlying anxiety. Further examination of this perspective will be provided shortly. However, the recent downward trend in tech stock prices – particularly within the software sector – is a significant development.

Valuation Shifts and Their Implications

This significance stems from the fact that software stocks are approaching what is technically defined as a bear market. Furthermore, even companies demonstrating rapid growth are experiencing a considerable reduction in their valuations.

Consequently, public valuation multiples – crucial benchmarks for privately held unicorn companies and emerging startups – are contracting. This contraction indicates a changing investment landscape.

Venture Capital and the Tipping Point

Has this shift in valuations reached a level sufficient to curtail the current surge in venture capital activity? It is unlikely at this precise moment.

However, the market may be approaching a critical juncture – a potential tipping point – sooner than many anticipate. The evolving valuation environment warrants close observation.

Here's a breakdown of key considerations:

• Declining stock prices directly impact investor confidence.
• Reduced valuations affect fundraising opportunities for startups.
• The current trend suggests a potential moderation of the VC boom.

Public market performance serves as a leading indicator for the private markets. Therefore, monitoring these trends is essential for understanding the future of startup funding.

Recent Market Declines in Cloud Computing

The performance of the Bessemer Cloud Index is publicly available through the WisdomTree Cloud Computing Fund, effectively a tradable representation of the index’s constituent companies.

Having peaked at $65.51 last month, the collective market capitalization of this group of software businesses has decreased to $53.00 as of today. This represents a reduction of 19.1%, falling just short of the 20% threshold typically defining a technical bear market.

The index is nearing bear market status, therefore.

However, the downturn isn't uniform across the board. As investment analyst Jamin Ball highlighted this morning, the negative performance is concentrated within a segment of software companies:

These figures, previously recorded as 39%, -9%, and -17% on November 19th, demonstrate a substantial decrease in the valuation of rapidly expanding software firms, even while their more conservatively growing counterparts experienced a more moderate correction.

Evidence of this market correction is readily apparent. Consider the following examples, excluding any fluctuations from today’s early trading:

• Okta’s share price concluded yesterday at $198.08, a decline from its previous high of $294.00.
• Atlassian finished yesterday’s session at $357.21, down from a peak of $483.13.
• UiPath’s closing price yesterday was $43.93, significantly lower than its high of $90.00.

Although technology stocks have seen a modest increase today following some initial volatility, this gain is insufficient to offset the recent declines. A temporary rebound does not diminish the impact of a substantial downturn.

These declines are particularly significant given the substantial valuations assigned to startups throughout their development, from initial funding rounds to unicorn status and beyond, and even after becoming publicly traded. This is because a considerable number of private investors are anticipating that their startup investments will ultimately result in successful IPOs with favorable revenue multiples. Should public technology stocks fall, and consequently compress revenue multiples for comparable companies, these private entities may encounter difficulties in securing funding at attractive valuations, potentially hindering their growth or even halting it.

Such a scenario might seem extreme, especially considering the prolonged nature of the current bull market. However, a correction will eventually occur that cannot be immediately reversed, providing the market with further periods of inflated multiples.

Prior to this week’s downturn, conditions had already begun to shift. Ball’s analysis included the following observation regarding the trading week of November 26, 2021:

Currently, we are likely approaching the lower end of the median SaaS revenue multiple observed in 2021. Further declines could erode the substantial gains realized during the pandemic-driven trading surge of 2020.

At that point, the rationale behind venture capitalists investing in startups at high revenue multiples will be called into question. Some of the current valuations are undoubtedly based on the assumption that SaaS companies have reached a permanently elevated level. This may be the case, but it is also possible that this assumption is incorrect.

We have previously discussed the factors driving the increasing prices of software companies and the associated risks. We are now on the verge of witnessing the testing of investment strategies supported by hundreds of billions of dollars in capital. This test is not yet fully underway, but it is rapidly approaching. Monitoring the markets is crucial.