Software Valuations: Is the Era of Ultra-Rich Numbers Over?

JP Morgan Analyst Note Impacts Tech Valuations

A recent analyst report originating from JP Morgan has introduced considerable turbulence into the market for technology stock valuations. While publicly traded companies are experiencing the most immediate effects, the repercussions could extend to the valuations of privately held technology businesses as well.

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The analyst’s assessment has altered the bank’s perspective on the valuation of several technology companies. Following what CNBC characterized as a “wave of downgrades” issued by JP Morgan, investors reacted by selling off shares of several prominent tech firms. The following list details some of the losses incurred during yesterday’s trading session, subsequent to the public release of the downgrades:

• Zscaler: -7.84%
• Datadog: -6.54%
• Cloudflare: -8.98%

This illustrates the extent of the market response.

Crucially, the report established a connection between increasing interest rates and an expected decrease in the value of various technology stocks. Specifically, the note stated, as quoted by CNBC, “With rates climbing, this adds risk to higher multiple software stocks trading over 20 times revenue.” (A comprehensive list of the upgrades and downgrades detailed in the report is available here.)

Should technology companies currently valued at more than 20 times their revenue experience valuation declines as interest rates increase, it would initiate a broad downward pressure on tech valuations. Essentially, if the most highly valued tech companies were to be revalued closer to a 20x multiple, the overall worth of nearly all tech companies would be diminished.

Implications for the Tech Market

A 20x revenue multiple would represent a significant setback for the technology market. Companies such as Shopify and Zscaler, currently valued around 40x revenue according to Bessemer data, are among the most richly valued tech companies publicly traded. Reducing their valuations to 20x would substantially lower the effective purchase price for public software companies demonstrating growth rates exceeding 50%. Software companies exhibiting slower growth would also see their value decrease, as investors are unlikely to pay comparable prices for less valuable assets.

How does this affect startups? Current startup valuations benefit from strong public market comparables. If Bill.com is valued at 50 times its current annualized revenue, it’s reasonable to argue that a faster-growing startup deserves a similar or even higher multiple. However, if valuations exceeding 20x are compressed due to rising interest rates, this rationale becomes untenable.

This presents a dual risk. Startups requiring additional capital in the coming quarters face the prospect of either accepting greater dilution than anticipated or reducing their spending – and therefore growth – to align with their pricing expectations if valuations decline generally. Investors who have been injecting capital into startups at valuations typically associated with later funding stages (e.g., pre-Series A revenue at Series B or Series C pricing) are also at risk, as their investments are predicated on the assumption of sustained high growth rates and elevated exit prices – specifically, public market comparables.

Should this underlying assumption prove incorrect, a substantial number of pre-unicorn and unicorn companies could encounter significant difficulties.

It’s important to note that a single analyst report does not necessarily indicate a broader trend. However, this dispatch coincides with other relevant developments:

• Tech valuations have already been trending downward, as we previously observed last weekend.
• Interest rate increases are now anticipated in the coming quarters, not years.

This convergence of factors is not unexpected. The substantial growth in tech valuations was predicated on low interest rates, which made holding cash unattractive, and the expectation of continued accommodative monetary policy. Removing these foundational elements renders the justification for valuations like Bill.com’s 50x run rate questionable.

A precipitous decline is not necessarily imminent, but we may see multiples continue to contract from both early-2021 levels and, in particular, the peaks of summer market exuberance.