The Impact of Risk on Valuation
The present technology valuation landscape, from the perspective of both investors and companies, is currently in flux due to several contributing factors that we will examine.
First is the emergence of a complex matrix of systemic economic risks, chiefly evidenced by inflation rising to a 40-year high. This is now being accompanied, and fought against, by a well-advertised stairstep increase in interest rates by the Federal Reserve. Risk factors also include global supply chain disruptions exacerbated by the COVID-19 crisis, as well as a firmly tightened labor market; and, not least, the compounded impact brought on by the tragic war inflicted by Russia on Ukraine. Taken together, these pressures have created a new risk landscape and repricing of capital that has sent tech valuations downward, and the impact is now being felt in various ways throughout the industry.
Looking a bit closer at some of these risk factors reveals several specifics worth noting. Among these are recent shifts in capital markets, including the rapid cooling-off of the once red-hot initial public offering (IPO) and special purpose acquisition company (SPAC) public exit markets. Additionally, the slowing down of the SPAC phenomenon has been further impacted by more enhanced oversight from the U.S. Securities and Exchange Commission. Data from Dealogic bears this impact out – year-to-date through March 2022, U.S.-originated IPOs totaled just 21 compared to 68 in the same period in 2021, with 2022 deal value a small fraction of what it was in 2021. For SPACs, the 2022 year-to-date total is 51, which is very light in comparison with 2021’s same-period total of 252. These notable exit events are down substantially year-over-year as the above-noted risks have caused market participants to reassess valuations for emerging growth companies.
Taken together, a new risk scenario has emerged. In 2021, with the Federal Reserve’s post-COVID zero interest rate policy and quantitative easing in play, along with substantial stimulus programs being distributed by the federal government and by many states, tech company valuations reached lofty levels with little or no resistance from investors, both in the public markets and in late-stage private venture funding. The combination of very accommodative policy, substantial private capital on the sidelines – dry powder – and a dynamic marketplace pivoting out of COVID (but still impacted at the supply chain level), helped set the stage for the inflationary landscape that has now replaced COVID concern as the primary risk landscape in the marketplace.
Capital Market Reaction
While the competitive labor market has been a plus for many in various segments of the workforce, and helped enable an evolved level of employee flexibility, the competitive landscape has created some additional pressure on technology companies who have faced continued pressure to recruit and retain talent in all departments, but especially in key segments such as engineering and sales personnel. With the capital markets showing a pivoted preference for profits rather than long-term growth, we are starting to see some high-profile tech bellwethers shift gears away from a hiring blitz and towards a more defensive posture. Examples include Uber, Netflix and Facebook’s parent company, Meta. One employment trend we may see take center stage is non-cash, or equity compensation, as both public and private companies may look to issue new options at potentially lower equity prices. Additionally, expect both established and emerging technology companies to shift towards profitable growth and more clear pathways for return on capital invested. The result may be seen in a reallocation, or potentially a decrease, in marketing spend, research and development, and the long-range planning of new products or facilities with less clear ROI profiles.
Despite these headwinds, the overall tech marketplace has several fundamental positives, and plenty to build on. The private capital markets remain a case in point. There is a record level of private equity and venture capital – dry powder – looking for an investment home, with private equity firms and venture capital funds poised to execute on targeted opportunities. Other alternative liquidity and funding sources directed to IPOs and SPACs will likely play a bigger role, including strategic or private equity mergers and acquisitions, or convertible/bridge financing to extend the runway without as much pressure on finding a price point. With the venture tech landscape having been a proven dynamic segment of the U.S. and, increasingly, global economy through several major cycles, the ongoing tug of war between risk and potential reward will continue to have strong proponents on both sides.
Focus on Fundamentals
The technology landscape is very dynamic, which can be both an opportunity and a challenge. With volatility and uncertainty entering the marketplace from a new set of risks, the importance of sound decision making, reliable financial reporting, and sage advice is much more critical. It is our experience that risk can be mitigated, and valuations maximized, by understanding the numbers – both historical and projected – reliably and in-depth. Financial reporting is not simply a compliance exercise, but an opportunity for numbers to tell a proper story, enable course correction and, ultimately, minimize risk in a developing landscape. Indeed, from our perspective as accountants and advisors with a long history of experience in the emerging technology space, a healthy mix of experience, innovation and entrepreneurship, together with the rigorous use of meaningful analytics, will enable executive management, boards of directors and capital investors to navigate the evolving risk landscape most skillfully.