Startup Valuation: Will the Selloff Cause a Shift?

Market Downturn Impacts Stocks and Crypto

Financial markets are currently experiencing declines. The U.S. stock market began the day with losses, as major indexes decreased in value – the S&P 500 is down 2.3%, while the Nasdaq Composite has suffered a more significant drop of 2.7%.

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For startups, cloud-based software companies are particularly affected. These businesses, which deliver software as a service (SaaS) through public cloud infrastructure, are facing substantial setbacks, with a key index currently down 3.33%.

However, the volatility in the decentralized finance (DeFi) space is even more pronounced. Major cryptocurrencies are experiencing sharp declines, adding to losses accumulated over the past week. Here’s a summary of recent performance:

• Bitcoin: A decrease of 3% in the last 24 hours, and a 20% decline over the past week.
• Ether: A 7% drop in the last 24 hours, with a 30% loss over the last week.
• Cardano: A 7% decrease in the last 24 hours, and a 32% decline over the past week.
• Sol: A significant 11% drop in the last 24 hours, and a 39% loss over the last week.

The current market conditions are causing considerable losses for traders who had leveraged positions in decentralized assets. Recent purchases may now be underwater, and those who aggressively bought the dip are facing even larger losses. It’s important to prioritize well-being and remember the constructed nature of monetary systems during times of financial stress.

These market events are beginning to influence late-stage startup valuations. Mary D’Onofrio of Bessemer Venture Partners, a frequent contributor to The Exchange, discussed the selloff last week, prior to today’s further declines.

Impact on Startup Valuations

D’Onofrio focuses on growth-stage investments, making her observations particularly relevant. Essentially, the impact of the public market downturn is starting to translate into a reset in private market valuations, though with a time lag. Earlier-stage startup investments are less likely to feel the effects immediately.

Consequently, some early-stage deals may be finalized at prices that appear unsustainable in the near future. It's crucial to remember the substantial amount of capital venture capitalists have recently raised:

• Two Israeli venture capital firms have secured nine-figure funding rounds.
• a16z is reportedly seeking a record-breaking $4.5 billion fund dedicated to cryptocurrency investments.
• FTX is allocating $2 billion for investments in the crypto space.
• Blossom Capital recently raised $432 million in funding.
• Additionally, a16z recently completed a $9 billion raise for investment purposes, and Norwest secured a significant funding round a few weeks ago.

This creates a growing disconnect between market realities. Consider this headline regarding the Indian technology market:

Conversely, here are a couple of headlines presenting a different perspective:

It’s important to note that this analysis isn’t intended to focus solely on the Indian startup market. Rather, it highlights the contrasting news being reported by our correspondent, Manish Singh, and the widening gap between public market anxieties and private market optimism.

Looking Ahead

What can we expect moving forward? We are beginning to hear indications of increased price discipline from some venture capital firms. However, a more significant shift may be underway.

Asset Valuation: A Shifting Landscape

Historically, investors prioritized growth over profitability. Consequently, a growing number of companies were assessed using price/sales ratios, effectively valuing them as multiples of their revenue. This represents a departure from traditional methods.

When I initially studied securities and investment strategies, the price/earnings (P/E) ratio was the dominant valuation metric. Companies were primarily valued based on a multiple of their earnings, not their revenue.

The Potential Return to Profitability-Based Valuation

While adjusted EBITDA can be substituted for GAAP net income within a P/E ratio, a broader shift back to profitability-based valuations seems plausible in the near future. This approach is inherently more conservative.

Such a change could trigger a reevaluation of numerous companies, potentially leading to price adjustments that some may find unfavorable. A renewed focus on P/E ratios would inherently reward profitable businesses.

This, in turn, has the potential to reshape investment strategies and priorities, impacting companies of all sizes, including startups.

The Disconnect Between Revenue and Profitability

The market has, at times, assigned valuations typically reserved for high-margin, recurring-revenue software companies to firms with lower margins and less predictable income streams. These discrepancies have often resulted in market corrections.

However, the question arises: why has Zoom experienced a return to its pre-pandemic stock price? It’s possible that investors are now prioritizing profitability over short-term growth projections.

This signifies a move towards valuing companies based on P/E ratios rather than P/S ratios. Zoom’s shares have declined approximately 75% from their peak. Improved net income could potentially mitigate this decline.

Current Market Dynamics and Challenges

My belief in this valuation shift is still developing. Coinbase, despite being profitable, is currently facing challenges due to its strong correlation with cryptocurrency trading volumes.

Decreasing cryptocurrency values negatively impact Coinbase’s trading revenue, even with a history of net income. Anticipated negative growth rates can outweigh past profitability.

Looking Ahead

The precise future remains uncertain, but mounting losses are forcing a reassessment of corporate valuation rules. Many companies, including startups, may struggle to adapt to this new environment.

The market is effectively rewriting the rules, and not all companies will thrive under the revised regime. A focus on sustainable profitability will likely become paramount.

• P/E Ratio: Price-to-Earnings ratio, a valuation metric.
• P/S Ratio: Price-to-Sales ratio, a valuation metric.
• EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization.
• GAAP: Generally Accepted Accounting Principles.