As inflation rises there will be a tightening of money supply and higher interest rates to control it. This causes a repricing of assets and, in particular, high-growth tech stocks. The median public company software valuations dropped from 12x forward revenue to 5x or less—an almost 60% decline.
The decline of public company valuations creates downward pressure on startup valuations. A startup whose valuation was 100x forward revenue (ARR) should expect that to be brought down significantly closer to their comparable public company valuations with a slight premium for faster growth (more like 10-15x).
This has big implications for running a startup during a recession. Availability of capital will go down as VCs make fewer deals, more selectively, and with lower valuations. Many companies will run out of cash and fail to raise additional rounds of financing. YCombinator recommends founders cut expenses and plan for 24 months without additional fundraising.
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Running a Startup During a Recession
Startups are a microcosm of the economy and we can observe that things are changing quickly towards a recession footing. The effects of inflation on valuations are readily apparent, but we also see that things were too good to be true and investors and late stage companies exploited it.
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Crossover Investors Monetize Late Stage Startup Valuations
Like many financial services hedge-fund crossover investing makes money by charging fees for assets under management. They bring in more investors by showing gains in the market. In late stage startup investing, this creates the incentive to inflate valuations. By deploying larger amounts of money faster than traditional venture capital, hedge-fund crossover investors can win deals and push the valuation higher in subsequent rounds showing higher and higher paper gains.
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Growth in Tech During the Pandemic Was Not Permanent
Prices of tech stocks soared during the COVID-19 global pandemic in part due to growth. Investors were paying 100x ARR multiples for some tech companies. However, that growth was not permanent and we are seeing tech stock prices revert to the mean.
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Burn Multiples Are a Way of Managing Growth Efficiently
A burn multiple is the amount of cash burned by annual recurring revenue (ARR). For example, if a company burns $10MM to add $30MM ARR the burn multiple is 3.0x. Higher burn multiples are worse and imply the company will run out of money faster. This is a better measure of overall efficiency compared to LTV/CAC because it encompasses all costs (burn).
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What Founders Should Know About Interest Rates
Between 2008 and 2021, the market was operating under zero-interest rate policy (ZIRP). That changed in 2022 back to historically normal interest rates (5-6%) set by the Federal Reserve.