It’s a nasty day for asset prices.
Around the world, the stock market is selling off. Here in the United States, shares are following suit in early-morning trading. Tech stocks are taking fresh blows, and sentiment among the investing classes has cooled from chilly to frozen as last year’s ebullience gets a long-awaited reality check.
To understand the scale of the pain, let’s use a few stocks as indicators. Coinbase, which saw its value skyrocket to as much as $368.90 per share after its direct listing, kicked off trading today for less than $100 per share. Zoom, whose value soared to $406.48 in the last year, is now worth around $93 per share.
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The value of software shares more generally is no better. The Bessemer Cloud Index is off more than 50% from all-time highs set last November. In far less than a year, then, we’ve seen the value of tech companies peak, and then crater. The fall from grace has been rapid, but not even, as startups managed to keep treading water for months longer than their public counterparts. That’s changing.
The world of blockchains and digital assets is also under fire from investors, selling off sharply in recent days.
Doom, gloom and sadness all around? Yes, but not entirely.
The good news is that while prices are flatlining around the world for tech assets, we’re going to get a real shakeout in the coming quarters. It will be clarifying and will shine a light on a whole lotta claptrap. Call it joker detection. Let me explain.
From slowdown to shakeout
There’s no point in porcine cosmetics; we could be heading into a massive startup correction on the order of March 2020, but for a longer period of time, and with declines that wind up being larger in aggregate.
So what’s the upside? A decline in bullshit.
In a letter that Uber’s CEO sent to his staff over the weekend — CNBC has the scoop there — there was a lot worth chewing on, but one thing, in particular, stuck in my craw (emphasis TechCrunch):
In times of uncertainty, investors look for safety. They recognize that we are the scaled leader in our categories, but they don’t know how much that’s worth. Channeling Jerry Maguire, we need to show them the money. We have made a ton of progress in terms of profitability, setting a target for $5 billion in Adjusted EBITDA in 2024, but the goalposts have changed. Now it’s about free cash flow. We can (and should) get there fast.
Hot damn.
Why does a shift away from adjusted EBITDA matter? Because that’s been the profit metric that tech companies have touted in recent years. Why? Because it’s loose as hell. EBITDA, or earnings before interest, taxes, depreciation and amortization, was not enough of an adjustment for many tech companies. So they further bent the metric, ripping out share-based compensation.
Investors were content to buy adjusted EBITDA as “profit” because standards were low and growth demands were high. This era, per Uber CEO Dara Khosrowshahi, is over. Adjusted EBITDA is now understood to be what it always was — namely, poppycock. This means that companies trying to prove they’re viable enterprises won’t be able to simply break even in adjusted EBITDA terms. They will need to post strong free cash flow as well.
How does the change affect companies? Observe the following two entries from Uber’s latest earnings report (Q1 2022, emphasis TechCrunch):
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Adjusted EBITDA of $168 million, up $527 million YoY. Adjusted EBITDA margin as a percentage of gross bookings was 0.6%, up from (1.8)% in Q1 2021. This translates to 7.6% on a YoY incremental margin basis, as a percentage of gross nookings.
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Net cash provided by (used in) operating activities was $15 million, up $626 million YoY. Free cash flow, defined as net cash flows from operating activities less capital expenditures, was an outflow of $47 million, improving $635 million YoY.
So Uber has a more than $200 million gap between its adjusted EBITDA (positive) and its free cash flow (negative). That’s a steeper slope to climb, and Uber won’t be the only company faced with a harder set of profit metrics to hit.
Good.
It’s about time that tech companies stopped being able to rip share-based compensation out of their profit metrics. Why? Because all tech companies that get big wind up buying back their stock; in essence, then, adjusted EBITDA allowed companies to avoid counting a huge portion of their employee compensation as an operating cost, shifting the cost to the future, where they could hide the expense in later cash flow numbers, which also don’t ding profitability in income-statement terms.
This was annoying bullshit. Now it’s losing favor.
Harder grading is nothing to complain about if the teaching staff is merely moving from an ample curve to something only slightly less generous; Uber’s CEO cited free cash flow, not GAAP net income, after all.
What about unicorns?
This is the cohort of companies I am the most worried about. Startups that lack billion-dollar price tags may be able to raise at a flat price or extend prior rounds due to their smaller scale and therefore more limited capital needs. Public companies just have to weather the storm.
Unicorns, however, are expensive — and stuck. They are largely not profitable on an even adjusted EBITDA basis, meaning that they can’t pass old profit standards. For unicorns, the future is a series of interlinked challenges: They must grow (harder in worse economic conditions) while watching profitability (growing while conserving cash is hard) and avoiding fundraising to escape a painful repricing.
Good luck? The public markets were hot last year. As they were in late 2020. There was a wide-open IPO window. And most unicorns passed on the chance to go out. Well, you took a bet on black and the markets have come up red. Good luck on threading this needle.
It’s no shock that we’re seeing startup layoffs in a market where cash was once worth little and is today far, far, far from worthless. And this is just after a 50-bip bump from the Fed. Imagine what’s to come.
Paper unicorns are going to fold this year if their financial origami doesn’t yield something truly surprising.