This post shares a collection of thoughts on what I’ve variously heard referred to as “the tightening,” “the unwinding,” “the unraveling,” or “the great reckoning” — the already-in-process but largely still-coming deflation of technology-oriented stock valuations, particularly in consumer-oriented companies and particularly in those that took large, late-stage private financings.
The Four Horsemen
Here are four key signs that trouble has already arrived:
- The IPO as down-round. Square, Box, and Hortonworks all went public at valuations less than their last private financings.
- The IPO as last resort. Box is the best example of this, and while I can’t find any articles, I have heard numerous stories of companies deciding to go public because they are unable to raise high-valuation, late-stage private money.
- The markdowns. Fortune ran a series of articles on Fidelity and other mutual funds marking down companies like Snapchat (25%), Zenefits (48%), MongoDB (54%), or Dataminr (35%). A unique feature of Bubble 2.0 is publicly-traded mutual funds investing in private, VC-backed companies resulting in some CEOs feeling, “it’s like we went public without even knowing it.”
- The denial. No bubble would be complete without strong community leaders arguing there is no bubble. Marc Andreessen seems to have taken point in this regard, and has argued repeatedly that we’re not in a technology bubble and his firm has built a great data-rich deck to support that argument.
The Unicorn Phenom
If those aren’t sufficient signs of bubbledom, consider that mainstream media like Vanity Fair were writing about unicorns and describing San Francisco as the “city by the froth” back in September.
It’s hard to talk about Bubble 2.0 without mentioning the public fascination with unicorns — private tech companies with valuations at $1B+. The Google search “technology unicorn” returns 1.6M hits, complete with two unicorn trackers, one from Fortune and the other from CBInsights. The inherent oxymoron that unicorns were so named because they were supposed to be exceptionally rare can only be lost in Silicon Valley. (“Look, there’s something rare but we’re so special, we’ve got 130 of them.”) My favorite post on the unicorn phenom comes from Mark Suster and is entitled: Why I Effing Hate Unicorns and the Culture They Breed.
As the bubble has started to deflate, we now hear terms like formercorns, onceacorns, unicorpses, or just plain old ponies (with birthday hats on) to describe the downfallen. Rumors of Gilt Groupe, once valued at $1.1B, possibly selling to The Hudson’s Bay Company for $250M stokes the fire.
What Lies Ahead?
While this time it’s different is often said and rarely true, I do believe we are in case when the unwinding will happen differently for two reasons: (1) the bubble is in illiquid assets (private company preferred shares) that don’t trade freely on any market and (2) the owners of these illiquid shares are themselves illiquid, typically structured as ten-year limited partnerships like most hedge, private equity growth/equity, or venture capital funds.
All this illiquidity suggests not a bubble bursting overnight but a steady deflation when it comes to asset prices. As one Wall Street analyst friend put it, “if it took 7 years to get into this situation, expect it to take at least 3.5 years to get out.”
Within companies, particularly those addicted to cheap cash and high burn, change will be more dramatic as management teams will quickly shift gears from maximizing growth to preserving cash, once and when they realize that the supply of cheap fuel is finite.
So what’s coming?
- Management changes. As I wrote in The Curse of the Megaround, big rounds at $1B+ valuations come wrapped in high expectations (e.g., typically a 3x valuation increase in 3 years). Executives will be expected to deliver against those expectations, and those who do not may develop sudden urges to “spend more time with the family.” Some CEOs will discover that they are not in the same protected class as founders when these expectations go unmet.
- Layoffs. Many unicorns are burning $10M or more each quarter. At a $10M quarterly burn, a company will need to layoff somewhere between 200 and 400 people to get to cashflow breakeven. Layoffs of this size can be highly destabilizing, particularly when the team was putting in long hours, predicated on the company’s unprecedented success and hypergrowth, all of which presumably lead to a great exit. Now that the exit looks less probable — and maybe not so great — enthusiasm for 70-hour weeks may vanish.
- Lawsuits from common stockholders. Only recently has the valuation-obsessed media noticed that many of those super valuations were achieved via the use of special terms, such as ratchets or multiple liquidation preferences. For example, if a $100M company has a $300M preference stack and the last $100M went in with a 3x preference, then the common stock would be be worthless in a $500M sale of the company. In this case, an executive with a 0.5% nominal ownership stake discovers his effective ownership is 0.0% because the first $500M of the sale price (i.e., all of it) goes to the preferred shareholders. When people find they’re making either “no money” or “car money” when they expected “house money,” disappointment, anger, and lawsuits can result. This New York Times story about the sale of formercorn Good Technology provides a real example of what I’m talking about, complete with the lawsuits.
- Focus will be the new fashion. Newly-hired replacement executive teams will credit the core technology of their businesses, but trash their predecessors for their lack of focus on core markets and products. Customers unlucky enough to be outside the new core business will be abandoned — so they should be careful to ask themselves and their vendors whether their application is central to the company’s business, even in a downturn or refocus scenario.
- Attention to customer success. Investors are going to focus back on customer success in assessing the real lifetime value of a customer or contract. People will remember that the operative word in SaaS is not software, but service, and that customers don’t pay for services that aren’t delivering. Companies that emphasized TCV over ARR will be shown to have been swimming naked when the tide goes out, and much of that TCV is proven theoretical as opposed to collectible.
- Attention to switching costs. There is a tendency in Silicon Valley to assume all markets have high switching costs. While this is certainly true in many categories (e.g., DBMS, ERP), investors are going to start to question just how hard it is to move from one service to another when companies are investing heavily in customer acquisition on potentially invalid assumptions about long-term relationships and high pricing power.
Despite considerable turmoil some great companies will be born from the wreckage. And overall, it will be a great period for Silicon Valley with a convergence to the mean around basics like focus, customer success, and sustainable business models. The real beauty of the system is not that it never goes out of kilter, but that it always returns to it, and that great companies continue to be produced both by, and in cases despite, the ever-evolving Silicon Valley process.
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This post was inadvertently published on 12/23/15 with an incomplete ending and various notes-to-self at the bottom. While I realized my mistake immediately (hitting PUBLISH instead of SAVE) and did my best to pull back the post (e.g., deleted the post and the auto-generated tweet to it, created a draft with a new name/URL), as the movie Sex Tape portrays, once something gets out in the cloud, it can be hard to get it back.
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Once again, a great article reflecting on the reality of the tech marketplace. Thanks Dave.
Thanks Michael and bonnes fetes.
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Fantastic article and one I think is spot on, especially wrt the slow unwinding. This is also going on against a global backdrop of recession which is on the horizon here in the US as well.
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How do you think this aged, I wonder? Cheers!
Hard question to answer in compact form, but I’ll try. I think the over-arching reality is that in a world of nearly-free capital money flows into equities seeking returns, an allocation of that money flows to private equity / VC and you end up with investors with tons of cash to invest which creates an environment where private valuations are up and rounds are bigger than ever.
I have never liked referring to startups by valuation as opposed to employees or revenue for the simple reason that multiplying all shares by a preferred share price assumes an (ratchet-free) IPO where the preferred converts to common on an even basis. In scenarios other than that the common — as many common shareholders of struggling companies have learned — the preferred and common can end up with a very different value. So while I don’t like it, it’s nevertheless commonplace and not going to change.
On valuations, as mentioned in my 2021 predictions and other posts, I can see factors on both sides of the current unprecedented SaaS valuations. The summary is I think we have both structural change that is resulting in higher multiples and asset price inflation. The former would not change in a bubbl burst, the latter would. To be concrete, it a typically pre-current-environment multiple was 5-8x and today that’s 22x, does reversion to the mean imply dropping back to 5-8x or something else. (Lower if you believe in over-correction.) My hunch is you drop back to something in between because these companies are accelerating growth at scale (the best ones) and can all get much, much bigger than I think anyone ever thought. Software really is eating the world. And the is world. Bigger TAM = higher value.
One of the best points I made was that private illiquid markets basically can’t “pop” in the same way that public markets do where big (e.g., 20-30% drops) can occur over a short timeframe. Personally, one think I like about owning venture funds is that I never, even in bad times, even thinking about “selling” because you can’t. Kind of a built-in stabilizer.
There has probably been less management turnover than I’d have guessed, but remember there are two types of CEOs out there: founders and hireds. We live in a founder-friendly time (where that friendliness may well extend to control provisions) so I think founders are hanging on pretty well, despite the pressure bought on companies by high valuations. Hired CEOs are more replaceable and while I’ve not seen stats, I’m sure they’re flipping at a higher rate and a big round brings more risk to them than a founder.
I’d look to my most recent thoughts (e.g., the 2021 predictions post) for what I’m currently thinking on this stuff. As always, remember I am not a financial analyst, don’t do buy/sell, or any of that stuff as in my license agreement and my FAQ. I’m just a guy with an opinion and that opinion has been for several years that software valuations are quite a bit higher than historical medians and that reversion to the mean usually occurs — unless there are macro and/or structural factors that interfere.
Agree with all this. Thanks, Dave.