The value of technology companies has fallen as the broader public markets have repriced themselves in light of COVID-19-related market and economic disruptions.
And as the public markets sort out the new value of a huge piece of global business, private companies are being shaken as well.
What happens in the public markets trickles into the private markets, so if we’re seeing the value of public tech companies fall, startups are going to take a hit. To understand that dynamic, we spoke with Mary D’Onofrio, an investor with Bessemer Venture Partners. She’s the right person to chat with about the links between private valuations and public share prices as she not only helps put capital into growing startups, she also helps run the Bessemer cloud index (now a partnership with Nasdaq, and trackable on a day-to-day basis).
As she’s versed on both sides of the public-private divide, we asked her how she values startups in normal market conditions and in more turbulent times like today. We also dug into how founders are reacting to the changing world that may no longer be as amenable to their business plans. Pulling from our conversation, D’Onofrio told TechCrunch that startups want to be valued like companies were a few months ago, while investors want to pay today’s market prices.
But enough introduction, let’s get to the conversation. This interview has been edited for length and clarity; thanks to Holden Page and Walter Thompson for help with the transcription.
TechCrunch: During our last conversation, we discussed how to value startups. You explained a method in which you consider the future value of cash flows. How do you value startups today versus how much you think they’ll be worth down the road?
Mary D’Onofrio: I think what’s important to know is that outside of a market disruption, which I think was the the nature of the question to begin with, cloud software tends to trade on revenue and revenue growth. Companies should fundamentally be valued on the present value of their future free cash flows. But I think with cloud software, in particular, there’s a prioritization of taking [market]share, and then applying a very long term healthy margin structure on a very massive revenue base once you get there, and generating cash then.
And so I think in bull markets, when capital is readily available, prioritizing growth makes a lot of sense because you want to capture as much share as you can. And then losses are also tolerable because the capital is available to fund that massive growth. And there are actual measurable metrics that validate that structure, with CLTV to CAC [customer lifetime value to customer acquisition costs] being one of them.
Fundamentally, though, the way that I like to think about valuing companies is what can it become in the future, and then discount that back to today insofar as private market valuations are concerned. There’s a little bit of a disconnect there between the public and the private markets because the public markets [are] constantly changing, constantly evolving, things are being priced at every given second. And there are also very short-term public market investors that are looking to reprice things constantly. As that future [earnings] potential for companies decreases — in the context of COVID-19, oil price shocks, whatever — [investors] see that those future free cash flows are diminishing and they’re going to price that in immediately.
We also spoke about valuing companies on a forward basis. You mentioned something along the lines of thinking about where a startup will be 12 months from now and then applying a multiple on that figure. Can you tell me more about why valuations are forward for startups and the mechanics of that process?
I actually think that this is the truth in the public markets as well. So [we] evaluate on forward growth because you’re looking at the future free cash flows; you’re not looking at what it is today, you’re looking at what it can be in the future, and if you’re looking to value the future, you need to in fact look at the future.
The other thing is that if I’m buying into a stock today, my earnings are only going to be discounted from tomorrow; I don’t actually get any value from the past, if that makes sense. And so in that sense, I want to look 12 months forward, or I want to look a certain period forward. As a private market investor, most of the time you end up paying about 12 months forward, but you usually think about it on a growth adjusted basis. And so insofar as multiples are concerned, if I think that it can grow immensely in the next 12 months, maybe I’m willing to pay a higher current multiple for it than if it’s not gonna grow quite as immensely.
I’m curious why not just think about it in terms of paying a higher multiple today, as opposed to a slightly smaller multiple on where the company may be one year from now, if you have the same kind of growth expectations today, looking ahead?
I hear what you’re saying. I think the disconnect is that when you’re paying that forward price, founders want to get credit for that, and that’s not going to be captured in the current multiple or the the current ARR.
Maybe an example is probably the easiest. If we’re at 100 million ARR right now and we’re going to get to 250 [million ARR in a year] maybe you price it 10 times that 250, but today that’s, you know, 25 times. […] So looking at it purely on a current multiples basis won’t bake in any of the future expansion that you’re anticipating for the company.
I’m not sure if I’m saying that in the most crystal-clear way. But it’s really that you want to make sure that you’re giving the company credit for their forward growth. And you can’t actually see that if you look at it purely on a multiple of current revenue, because what does it mean that I’m paying seven or ten times [ARR] or whatever. I’m actually looking a year ahead, six months ahead, 18 months ahead, depending on how generous you want to be and saying, hey, this is where I think it can be in this amount of time, let me give you credit for that. […]
The way I think about it is you want to give companies credit for their growth, and you want to give them credit for building that base off of which you can generate that massive future free cash flow. And looking purely today doesn’t give them that credit. Were you to price [against current revenue], there would be a disconnect between bid and ask, between you and the founder. And furthermore, you’d probably be undervaluing the company systematically.
And if you’re an investor in a competitive market, you certainly can’t do that because you won’t get the deals that you want. So you need to find a valuation that makes sense for both your model, and what market expects, and what the founder will accept. You have to hit all three.
Exactly. And the fourth criteria is making sure that that valuation still meets your cost of capital and your returns thresholds. And so to some extent there’s a little bit of a valuation game as well where — I wouldn’t call it disconnected from fundamental value — but there’s a certain extent to which your maximum price that you might be willing to pay today is really what do I think it can become throughout my hold period, apply my multiple there at exit, and then discount back to today by my cost of capital or by my cash return needs. And that would be your quote, unquote, max [valuation].
I’m curious, as an active investor, mostly in the later stage of things, how much attention, if any, do you pay what’s going on the public markets? And how fast does that change trickle back into the decisions that you’re making when it comes to pricing [private] companies?
I pay a lot of attention to public markets. As you know, I’m one of the authors of the the BVP-NASDAQ emerging cloud index. And so I pay a lot of attention. […] I think that the public market dislocations affect the public market prices immediately, but the private markets take a while to trickle in.
It’s the same dynamics, right? Earnings are reducing, and so as forecasts for earnings decrease [and] corporate budgets constrict, the present value of that company’s future free cash flows, the the earnings that it can achieve in the next year, is going to constrict. And so regardless of whether or not you’re a public or a private market company, your your value should decrease.
But in the private markets, things aren’t being priced all the time, things are being priced only once in a while, whenever a company needs cash or does a private financing. And so for the companies that don’t need capital, it’s only going to reprice if and when they do. And so in that sense, something that just priced, call it six months ago, you would argue that their value holds, because that’s how they’re going to continue to report. On a fundamental basis has it changed? Totally. But when you look at PitchBook or you look at any [private] market resource it’s going to have that exact same valuation it had six months ago.
Insofar as I am looking at it — and I think that this is really where the impact happens — I’m going to bake in that earnings reduction [that we’ve seen in the public markets], and I’m going to put an increased premium on profitability in a way that I might not have in more of a bullish market in which revenue was the primary evaluation criteria, or the primary evaluation metric on which I was valuing these cloud companies.
If you think [about] growth and profitability as being on a kind of swing, a little bit of a balance, I think [valuations have] shifted a little bit more from from being purely revenue-based to being a little bit more profitability-weighted. I’m prioritizing things like free cash flow margin. I’m prioritizing efficiency. A metric that I developed at Bessemer is called the Cash Conversion Score, which looks at our ARR [divided by] total capital raised to date minus cash. That kind of shows the ROIC [return on invested capital] on an incremental dollar [basis]. And that’s what I’m putting a premium onto.
More broadly though, what I think [the new reality] means is fundamentally as an investor, I’m assuming that earnings are compressing, so your revenue is going to be lower. And I’m also assuming a lower multiple at exit, [something] more reverted to a normalized multiple environment. So I’m underwriting to a lower exit multiple on lower revenue. […] And then on top of that, a lot of the game is basically looking at risk-adjusted prices and risk-adjusted weightings. And my downside weighting is going to be a lot higher than it might have been in more of a normalized market environment.
The stock markets have fallen about 30%, give or take, and people are pretty afraid. I don’t think anyone knows when this is going to end, or what impact COVID-19 will have on the economy domestically or globally. In a period of increased uncertainty like today, how do you come to conviction around a valuation for a startup that you might want to invest into, and does that number often line up in the bid-ask sense with what the founder had in mind themselves?
So I think the interesting part about the market right now is that while you’re right, the market has traded off materially and very quickly […] we’re just reverting back to historical cloud software multiples. Historically if you look at the emerging cloud index basket, it’s traded at seven times forward [revenue]. Right now we’re trading at eight times forward [revenue].
I do think that there’s a little bit of a premium that the market’s baking in because even relative to the components of the S&P more broadly [or] the Dow [Jones Industrial Average], cloud software does have some benefits, right? A lot of its contracted, [its] very low on supply chain sophistication, or complexity. And there’s also, on a relative basis, less exposure to healthcare, travel, energy, a lot of the things that have been affected right now. So cloud software is down, but other things are down more.
Insofar far as valuation is concerned, I think that my personal approach is that I am underwriting to exit multiples that are in line with historicals. I’m not looking at the 2019 multiples of 11 to 12 times forward [revenue] being the average across the cloud basket. I’m looking at seven times. And that’s what I’m assuming a normalized multiple environmental will be. And so insofar as I’m building a base case and trying to value a company and thinking on a risk-adjusted basis, what is my expected outcome? 7x forward [revenue] is how I’m underwriting it, if I’m thinking that a company is going to go public. An upside case might have an expanded multiple environment, but my base case will be based around a 7x forward multiple.
And I think that that kind of a framework, where you have a perspective on what the market should look like or should be trading like, is helpful insofar as you’re valuing today, because I look at what I think it’s going to be worth over my whole period, whether that be three to six years. [I can] look at what I’m exiting at, apply seven x multiple. And then I can discount back and say, what is that [worth] today?
Do entrepreneurs fear this lower multiple climate that you’re describing? Or are they like, okay, this kind of makes sense, things are getting back to normal, and agree with you on where prices should be?
I think that [with] entrepreneurs there’s a little bit of a disconnect, because entrepreneurs are looking at the multiples that cloud software companies growing 150% we’re getting in February, and they’re saying: I want that.
Why did that company that you funded price there, and why am I worth less now? And I do think that there’s a little bit of a disconnect right now between the bid and ask, because founders want historic prices and we want to pay current prices. And I think for a while, there will be enough capital in the ecosystem to either bridge good companies or companies that are best in class and just recently been funded. I don’t think that there’s going to be balance in the system until a couple of quarters from now and there are more companies that truly need cash that needs to approach the markets and take a market rate.
Did people think we were gonna stay at 12x to 13x? I mean, that always seemed elevated to me based on a lot of capital and a lot of expectations of future growth, but not a figure that was gonna persist. Did you see that lasting longer than it did, or did always feel a bit rich to you?
Very candidly, I think that obviously COVID-19 has been deleterious to the economy. But I don’t actually think that it’s fully played out insofar as earnings are concerned, in a way that’s actually representative yet.
And the only rationale for dropping by as much as we did in a month is that people thought that the market was overvalued beforehand. And COVID-19 was the catalyst, the straw that broke the camel’s back. Because I don’t actually think that COVID-19 has had enough time to impact the past 12 months or the future 12 months of earnings enough to have the market contract by 30% in and of itself. Do I think that it’s going to continue on? And in the next six months, it’ll prove how the market should have been contracted. But I do think that this is the straw that broke the camel’s back.
That’s a long-winded version of me agreeing with you that I think me and a lot of other investors thought that the market was overvalued. And this was the time to correct.
If you’re a founder and you’re concerned about the multiple you might get, you probably don’t want to raise an enormous new round of capital, because it might be a bit more dilutive than you’d like if the valuation is lower. Do you think we might see the next six months, later-stage companies pursue smaller bridge rounds to get into this period of uncertainty?
I think it definitely will happen because the impact of this kind of a recessionary period, or this bear market, is that the capital markets have dried up. And so companies that we’re going to either rely on the IPO markets, or rely on the private markets for capital, and we’re going to look to a lot of net new investors for capital, might not be able to access it as quickly or as readily as they thought [it would be] available.
And so the bridge [deal] is a way for them to effectively bridge until they can do one of those financings, until they have a little bit better sense of business continuity until COVID-19 is kind of fully played out, and we know what the new normal is. But I do think that the bridge is something that you’re going to see increasingly. Do I know how often it’s going to be disclosed? No. But I do think that there are a good number of companies that will be in a sufficient enough cash crunch to either look to their existing investors, or look to investors that they know very well, to bridge them through this time because fundamentally, cash preservation and cash runway I think is going to be the number one thing that people are trying to solve for through this this crisis.
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