Steve Landzberg
Over the last decade, private companies, in the areas of SaaS and Marketing as well as venture capital firms have been firmly focused on essentially one set of metrics: Drivers of Growth. Growth in customers, annual recurring revenue (ARR), pricing and retention had become almost exclusively the drivers of value. Venture firms have focused on total addressable market (TAM) and the assessment of a management team to successfully execute on a roadmap to achieve growth. Economies of scale have, over the years, always been believed to be the holy grail for growth companies. It has not been that profitability didn’t matter; but rather such profitability could readily take a back seat (in fact sometimes even in the proverbial trunk!) so long as growth was achieved, and preferably accelerated growth (often without regard to the cost of such growth).
Fast forward to the emergence of the world from the COVID pandemic (we hope and trust!), supply constraints and bottlenecks, inflation, and higher interest rates have become the common vernacular. Heretofore, the central banks around the world have been focusing on CULTIVATING sufficient inflation (i.e. avoiding deflation; the ultimate death sentence of an economy). Here in 2022, fighting inflation has become paramount. Correspondingly, we find ourselves in a persistent increasing interest rate environment with central banks around the world who are no longer the “friend” of not only the markets generally, but also growth investors.
Those companies that can demonstrate not only that profitability will ultimately be achieved, but perhaps most importantly, that profitability will be achieved now or soon (vs much later in the life cycle of the growth company), will command the attention and interest of growth investors
Higher interest rates are the “enemy” of growth investors. Franchise value is a function of the Net Present Value of a company’s cash flows from now to “Infiniti”. All things equal, values decline in a higher and increasing interest rate environment. And raising early-stage capital becomes that much more difficult. Those companies that can demonstrate not only that profitability will ultimately be achieved, but perhaps most importantly, that profitability will be achieved now or soon (vs much later in the life cycle of the growth company), will command the attention and interest of growth investors.
The impact of all this has been proven out in the public markets in recent months as we’ve seen that software and services sector valuation multiples have sold off 30% from highs in recent months, reflecting the significant impact of rising rates on growth companies.
ScaleHouse also keeps a close pulse of the private equity markets. The “adjustment” due to higher rates has likely been not quite as severe as the public markets. We estimate a decline from peak valuations of approximately 20-25% on average for private growth companies.
What are the key takeaways of all this? Our message in advising our clients is this: as always, growth and achieving scale is paramount to receiving a high valuation. But equally important is demonstrating that your business economics are sound, that there is a clear roadmap to profitability, and that profitability is achievable in years, not decades. These are the keys to a successful capital raise.
At ScaleHouse we’re experienced in helping companies not only optimize performance, but more importantly, in developing a roadmap to optimize company value and outcomes for stakeholders. Reach out to us to learn more.