The Existential Cost of Decelerated Growth

The Fate of Tech Companies Facing Growth Slowdowns

What becomes of technology businesses when their expansion decelerates and a greater emphasis is placed on achieving profitability before they attain massive size? The market's valuation of rapid growth is a critical question.

A strong initial launch doesn't guarantee perpetual rapid expansion for a technology startup. The majority ultimately find themselves in a moderate position – or even struggling. Simply stated, a greater number of tech companies achieve modest success or experience a slight decline after reaching a certain scale.

Understanding The Exchange

The Exchange provides analysis of startups, markets, and financial matters.

Access it daily on Extra Crunch or subscribe to The Exchange newsletter each Saturday.

However, investors universally desire companies that can sustain growth even after substantial scaling, overcoming obstacles like competition, economic challenges, and unforeseen difficulties. These are the companies that achieve valuations of tens of billions of dollars or more, rather than merely a few hundred million or a billion.

Conversely, technology companies – even those with healthy gross margins – can experience a swift contraction of their valuation multiples when growth falters. This often attracts opportunistic investors.

Recent Market Trends and the Growth Dividend

This dynamic helps explain recent market activity. As Dropbox faces increased scrutiny and joins Box in experiencing a public-market growth slowdown, companies like Braze, Gong, and Shippo are aggressively pursuing funding or publicly highlighting their growth rates.

The contrast between these two groups is evident, but a deeper examination is worthwhile. Let's discuss the growth dividend – or, alternatively, the inherent risks associated with decelerating growth.

The ability to maintain high growth rates is paramount for tech companies seeking substantial valuations. A decline in growth can quickly lead to a decrease in market confidence.

Investors are keenly aware of the correlation between growth and valuation. Companies demonstrating consistent expansion are often rewarded with higher multiples.

Ultimately, the market assesses not only current performance but also the potential for future growth. Sustained growth is a key indicator of long-term success.

The Imperative for Growth

Recent developments concerning Dropbox and an activist shareholder weren't unexpected. Its competitor, Box, is currently engaged in a prolonged dispute with its own activist investor. (Further details can be found here.)

The core issue driving scrutiny of Box centers on its slowing growth. The company’s growth rate has recently fallen into the single digits, prompting concerns about potential for improvement.

Dropbox is experiencing comparable challenges. While Q1 2020 saw growth of 18%, which was acceptable, Q1 2021 witnessed a decline to 12% – a reduction of approximately one-third. This deceleration is particularly concerning given the company’s less than 10% GAAP net margin.

My assessment remains independent of the specific product offerings of either company. They may possess excellent tools, services, and teams. However, from a financial standpoint, the capacity of both to demonstrate increasing profitability hasn't alleviated the pressure to stimulate growth. This is because a technology company lacking growth is, fundamentally, of limited value.

It’s uncommon for a technology company to generate sufficient dividends and operate within a stable market to become a significant cash-generating asset for investors. The dividend yields of even the most prosperous tech companies illustrate this point. Apple’s dividend yield is below 1%. Microsoft’s is similarly low.

Alphabet, Amazon, and Facebook do not distribute dividends at all. Consequently, even among the most highly valued technology companies, shareholder returns are primarily driven by share price appreciation and stock repurchases, which are closely related. Smaller tech companies, valued in the single-digit billions, lack the financial capacity for substantial buyback programs like their larger counterparts.

Furthermore, their slower growth rates mean that even a proportionally similar buyback initiative would generate less investor enthusiasm. Therefore, the principle of “grow or die” prevails. Alternatively, companies may face intense pressure from outside investors seeking to replace the founder-CEO and implement organizational changes. However, rapid growth offers a pathway to substantial success.

Recent Funding and Growth in the Tech Sector

Shippo recently secured another funding round, building on its earlier success. Having already raised $45 million earlier in the year with a valuation around $500 million, the company has now added $50 million, bringing its total valuation to $1 billion.

The company demonstrated significant expansion. During its initial funding round this year, Shippo reported that total shipping spend on its platform had more than doubled in 2020, and its growth rate exceeded that of the rapidly expanding U.S. e-commerce shipping market by a factor of three.

Customer acquisition was rapid. Within three months, Shippo’s customer base grew from 70,000 to 100,000. This swift expansion led to a doubling of its valuation and the largest funding round in its history, providing substantial capital for future endeavors.

Gong is also experiencing substantial growth. Currently valued at over $7 billion, the sales software company informed TechCrunch that its Annual Recurring Revenue (ARR) more than doubled between Q1 2020 and Q1 2021.

Furthermore, according to reports, the company’s growth rate is accelerating, projected to reach around 3x in the current quarter.

Increased funding and rising valuations are becoming commonplace. While some previously lauded startups face scrutiny, others are attracting significant financial investment, highlighting a notable contrast within the tech landscape.

Growth appears to be the key differentiator. The adage that growth can mask shortcomings holds true, but a more accurate assessment is that growth effectively eliminates concerns about other potential issues.

This growth also fuels a fear of missing out (FOMO), creating a protective buffer around a company’s valuation and shielding it from critical evaluation.

Braze also announced a significant milestone this week, reaching $200 million in ARR. TechCrunch previously covered the company around the $100 million ARR mark.

It took Braze just 18 months to double its revenue, and the company recently appointed a chief accountant. This suggests a potential Initial Public Offering (IPO) is on the horizon.

The company declined to provide further details regarding its financial performance to TechCrunch, but based on current trends, an IPO or a substantial funding round seems likely in the near future, unless the company is already cash-flow positive.

Only time will tell.