What connects the stock market contraction to startup valuations?

In an analysis of the market, Justin Kahl and David George of Andreessen Horowitz showcase data on how public companies have seen their revenue multiples shrink by an average of 60%, with large sector variability.

They use this central data point to suggest how startups should navigate the downturn, with the primary objective of climbing back to their previous valuation. But are valuations really down? For all startups? If so, why, and what can we expect in the short and mid-term?

What connects stock market contraction to startup valuations?

Startup valuations are only loosely connected with the stock market. Risky, early-stage companies acting on a non-significant number of customers have little correlation with the bigger picture. However, there is still a link, and it is worth analyzing.

Valuations are, or should be, a reflection of risk and return. These parameters are only slightly affected by the erratic and unpredictable behavior of the stock market. The main factors affecting the sell-side (startups) during a market downturn are greater difficulty in closing enterprise customers and lower likelihood of a large exit through a corporate sale.

But when we look at the buy-side, things are more dramatic, which explains why lower stock prices are a more pressing concern for investors than for startups.

On the buy-side, the companies that invest in VC funds generally have their shares traded on an exchange or are a pension or mutual fund, which see the value of their holdings diminish significantly due to lower share prices.

This is the most critical impact of downturns: Venture capital funds will have a more challenging time raising money to invest, which translates into less capital being available to founders.

However, it will take months (probably up to a year) to see the impact of this on the startup market.

Of course, knowing this, VCs will adjust their portfolios and try to invest less per ticket in the hope of benefiting from being the only ones with available capital when things get tight.

Let’s take a second and look at these two sides in depth, starting with the buy-side.

The buy-side

Corporate venture capital

The first money that disappears as stock prices fall is that of corporate venture capital. Already under pressure from shareholders, public companies will withhold long-term bets on the startup sector.

This will decrease the money available for VCs and acquisitions. Lower share prices also mean capital is more expensive for large corporations, which will not issue new shares to raise more liquidity to conduct investments.

The role of mega VC funds and their status

Over the last couple of decades, two venture funds have played a large part in modernizing venture capital and bringing valuations to a fair level: SoftBank’s Vision Fund and Tiger Global. These two companies are responsible for about $200 billion invested in startups over the past five years. They have also been responsible for many early-stage investors’ exits, thus creating a lot of liquidity in the global startup market.

So how are they doing now?

Vision Fund

SoftBank has always walked a thin wire held up by high leverage and an ambitious, visionary leader. In the current market, concerns about its survival are mounting. To its credit, it has survived several risky episodes in the past. However, counting on SoftBank for midterm funding rounds or early-stage investor exits is a risky bet.

Tiger Global

More moderate than its Japanese counterpart and more accountable to governance, Tiger Global seems to be reducing its capital deployment from the highs of 2021, but it always seems geared toward capturing opportunities. Its thesis of digital being underpriced is now known, so I’m positive startup valuations will not change substantially. More on this later.

Their impact on VC funding

These large investors will likely stop providing the incredible liquidity to later-stage startups as we have seen them do in the past year.

In previous crises (2008, 2001), public companies and pension funds took a few years to start pouring capital into VCs and startup acquisitions again. This is likely to happen this time as well.

As the downturn endures, startups that require large amounts of cash will go again to the public markets to raise it. This will, of course, happen faster if and when the stock market recovers.

The sell-side

We know that the buy-side is likely to be cash constrained. Should this be a concern for valuations?

Lower capital availability does not necessarily mean lower prices. Indeed, it could just mean a decrease in the number of funded startups while valuations stay the same.

Every valuation model assumes a fairly elastic supply of capital. So if the ideas are correct, the price is right, and if there is alpha to be made, the capital should be available.

Let’s analyze startups with these assumptions in mind.

Has anything substantial changed in the risk-return equation?

For valuations to change, something substantial must change in the risk-return equation.

In the past three years, COVID-19 brought so many changes to people’s perception of internet services that it is difficult to imagine them being reversed by the first market downturn.

Furthermore, the risks involved in startup investing, startup growth and SaaS business models are more widely understood. Therefore, it is difficult to imagine startup prices reverting completely to pre-COVID levels.

However, some factors are changing the outlook, and thus the return, of startups for the foreseeable future: The lower propensity of enterprise clients to purchase startup services and the diminished likelihood of startup exits to corporate buyers.

These factors will definitely have an impact on valuations, but should this impact be as large as what public companies’ stock prices are going through?

A correction is in the works

Setting aside the primary assumption of capital elasticity lets us perform a more complete analysis.

The correction of valuations is not a correction from high rational valuations but from irrational ones. The hype COVID brought to the internet sector spawned revenue multiples of 100x and investments that were happening too quickly with too little due diligence.

These are not symptoms of a rational and value-driven market. These behaviors will definitely be corrected by the current downturn in public company prices. We will get back to rational valuations, improved further by our more advanced understanding of startups’ and the internet’s potential and risk.

This contraction is likely to impact startups that have raised or were hoping to raise while on the thin ice of inflated multiples. For most early-stage founders, a greater emphasis on rational, evidence-based valuations may end up being a net positive.