It’s not just the first few days of a Freezbrury challenge focusing the mind on temperature. The January readings are in and it would be foolish to ignore a potential cooling effect in the start up funding world. The capital markets for large public companies have definitely become more volatile which, more often than not, can have a trickle-down impact on confidence. Lets’s take a look at the temperature readings:

  • Hot funds: Poster child of the technology boom, the ARK Innovation fund, is going to need a bigger boat. The Cathie Wood-managed fund added to its woeful 2021 performance (-22%) with another 20% decline in the first month of 2022. It was not alone, just a bit worse than…
  • Hot Assets: Cryptocurrencies had a poor January with Bitcoin losing 19%.
  • Hot Styles: Growth as a style had a rough month with a 9% fall which, not surprisingly, was replicated by the tech-heavy Nasdaq index with a similar plunge. But it’s not just technology taking pain….

Younger companies, represented in IPO ($IPO) and Small Cap ($IWM) indices, slumped by 20% and 10% respectively. Note these moves are happening in a single month of trading activity which, in the context of market history, is pretty violent stuff. However, the good news is that these market swoons are not based on any collapse in corporate sales or earnings. In fact, overall economic growth and earnings are growing at almost all-time-record speeds. Get your head around this little data point; last week Apple reported its Q4 revenues which were stellar ($124 billion) and equated to generating $15,000 worth of sales….. per second…throughout the entire 4th quarter. So, nothing wrong right now. But what about the future? That’s where valuations play their part.

Multiples of sales, cash flow, earnings etc used to value companies, big or small, have been on a steady march higher for years. These valuation multiples have been driving markets as well as the operational performance/growth of the companies. This is known as multiple expansion and it has been punchy. Last year was a bumper year of performance for private and public markets but some re-tracing of performance and multiples should hardly come as a shock. As an illustration, broader software company (SaaS) valuations have adjusted from a peak of 17.5x next-12-month revenues in November 2021 to about 10.5x in the final weeks of January 2022(source: TechCrunch). More intriguingly, and breaking a four year winning streak, revenue growth was not the strongest driver of share prices(correlation) in 2021. It was free cash flow which had a much higher correlation with share price performance ie profitability was the investor focus. So, for those raising funds in the coming months your credibility can be boosted by recognising the following:

  • Valuation multiples have decreased in recent months, particularly for loss making companies. Investors are looking at rising interest rates(and discount rates) and will expect founders to be cognoscent of wider market developments, and the impact on valuations.
  • Founders might be better advised trying not to maximise valuation and war chests, but rather focus on raising funds based on actual cash needs. Bluntly, the valuation today is not what matters but a sensible cash burn and route to execution and exit should be the founder focus.
  • Story telling is critical. Founders must place a laser-like focus on the problem the company solves and the rationale behind why customers will pay for the company’s service or product. And, the numbers in the story do matter – both on the top and bottom line. Note investors are shifting the focus to when/if there’s a return on capital so projections on margins, unit costs and cash flow are more likely to receive additional scrutiny in the coming months.

There is no need for founders and fund raisers to panic. Market pull-backs after a massive up year are actually a healthy development, and do help bring additional discipline and scrutiny to the investment process. That’s the investor shift to watch and then polish your story accordingly. The good news is that there’s lots of capital out there so do not be afraid to take the plunge. Good story tellers will always defy the temperatures….