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Fred Wilson (partner at USV and long-time blogger) had some good observations in his What will happen in 2023 blog post.

On the new fundraising environment (lower valuations and higher demands on startups to be funded) he writes:

“This new normal will lead to many flat rounds, down rounds, inside rounds, and rounds with a lot of structure on them. None of that is good, but the worst of those options is rounds with a lot of structure. I believe founders and CEOS and Boards should take the pain of a new valuation (flat, down, whatever) over structure.”

Structure (I interpret this as things like tougher terms in Shareholders agreement, additional approval rights, preferential options deals, additional board seats, aggressive preference rights etc) might feel better than a lower valuation initially for a founder, but I agree with Fred. If at all possible (enough money to execute the plan without excessive share dilution) it is better to go with a clean structure and a lower valuation than a complex structure and a slightly higher valuation.

Some very good comments on tech M&A by Rick Sherlund (vice chairman investment banking Bank of America, formerly top tech analyst at Goldman Sachs for 17 years).

The very high valuations in 2020 and 2021 make it hard to find willing sellers, as they see the current valuation (-80%) as too low. Rich points out that fast growing unicorns can get back to the same valuation in dollars as in 2020/2021 in an acquisition offer through high annual revenue growth (50%+), higher margins (after cost cutting), possibly lower US interest rates and bid premium (40%). All in all it sounds like end of 2023 or 2024 to see all that play out, and that if $100 million+ software companies can continue growing fast this year with a likely recession and cost cuts in their sales & marketing organizations.

In 2022 the focus of public market stock valuations went from revenue growth to profitability. This has impacted small and large technology companies, and layoffs started already last year (in Stockholm both Klara and Kry made cuts to their respective organizations). Now a second phase of layoffs are coming with Salesforce, Amazon and Vimeo announcing new layoffs in the last day.

An often used reason for layoffs have been something along the line of “we hired too many people due to the pandemic”. To some extent that is true (especially as the headcount growth from 2020 to 2022 has been 20 %+ at many companies), but the default mode for major tech companies for the last 10 years have been to hire additional staff if that can increase revenue growth.

As the trade off revenue growth/profit has changed, another part of the reason for the headcount cuts is that, for the time being, it is more important to increase profit margins than revenue growth to drive stock valuations. And stock valuations are important not only to shareholders, but to the companies themselves as they are paying staff in restricted stock units and/or options, and if that part of compensation gets cut 50-90 % it will likely impact retention of key employees.

If the founders of a startup manage to build an extraordinary software company that becomes very large (billions of dollars in revenue), at some point the company will be valued in-line with other mature, successful technology companies. Based on observation my rule of thumb that is a price/earnings ratio of circa 20.

The P/E ratio should be adjusted for growth rate, level of profitability, long-term prospects etc. This is not a small thing, especially considering that one of the most noteworthy things of the last 10-15 years is just how fast FAANG companies grew when they already had tens of billion of dollars in revenue.

And for smaller companies that haven’t reached ‘steady-state’ growth and profit margins, the P/E can reasonably be significantly higher both from lower than steady state profit margin and much higher growth.

In the earliest stages of a company’s lifetime, I don’t look at P/E or price/revenue but rather the likelihood (both operationally and funding-wise) of the startup becoming a large company and what characteristics it is likely to have at that point.

Bill Gurley interviewed by McKinsey Quarterly. ‘If you’re going to build something from scratch, this might be as good a time as in a decade’

Starting a startup now is probably better than in late 2021 or 2022.

Many tech companies used EBITDA (Earnings before interest, taxes, depreciation and amortization) or even Adjusted EBITDA as highlighted profitability measures. EBITDA excludes financings costs, taxes, depreciation and amortization and Adjusted EBITDAs exclude a bunch of other costs and generally are all over the place as Adjusted EBITDA is not an official GAAP (Generally Accepted Accounting Principle) measure. Safe to say, neither is a perfect way to measure profitability.

Following accounting principles and laws are one thing, but they alone are not the best tools to understand how valuable a company is or can be.

It is often said that the value of a company is the discounted value of its future cash flows. But neither EBITDA or net profit are actually measures of cash profit. And the often used free cash flow metric is not a GAAP measure, and thus different free cash flow formulas treat e.g. stock-based compensation differently. While stock-based compensation might be “non-cash”, it is an economic cost to current shareholders.

To get a better understanding of a company’s profitability one need to look at multiple measures. Unit economics (non-GAAP), gross margin, EBITDA, EBIT, Net profit, Free cash flow (non-GAAP) etc.

What weight an investor assign to each measure should differ depending on the type of investor. A small private investor in public stocks will view profitability in one way, a private equity fund buying a mature company in another, and a venture capital fund will think about it in a third way. To quote Charlie Munger “It is not supposed to be easy. Anyone who finds it easy is stupid.”

First day of 2023. My ambition is to write something everyday this year. Even if it might be both short and not terribly groundbreaking most days, I think writing something each day will lead to more interesting writing overall.

For startups in Stockholm and Sweden/Nordics at large, I believe 2023 will be quite a good year for companies raising pre-seed and seed rounds as a new fundraising environment establishes itself.

For Series A and beyond I think it will be messier as it will take longer (second half of the year) to establish a stable new baseline for valuations and terms. Especially as there will be a bunch of companies that raised on great valuations in 2020 and 2021 that will have to raise new capital. Many on worse terms and/or valuations than the previous round.

Mark Leonard founded Constellation Software, a serial acquirer of niche software companies, in 1995. Today it has revenue of more than 4 billion Canadian dollars and thanks to high revenue growth, strong margins and predictable growth by acquisitions is valued very highly.

Mark Leonard has kept a reasonably low profile, which makes his presentation at University of Toronto about business heroes and his learnings a rare and interesting read.

Jamin Ball writes Clouded Judgement, and is anything but, about SaaS and valuations and the last issue of 2022 included a wrap-up for the year. A chart of enterprise value divided with expected revenue for the next twelve month shows just how high valuations got in 2020 and 2021.

Inflation and higher interest rates have been two major triggers, but another factor why valuations of great tech companies are down 60-90 % in 2022 is that their valuations doubled to tripled from multiple expansion in 2020 and 2021 to very high levels.

Financial gravity exists, so what goes up will come down to more normal levels.

Have enough cash on the balance sheet to either get to profitability or to get to a compelling set of milestones that makes raising additional financing a “no brainer” — even in a poor market environment.

Roger Ehrenberg highlights one of the eternal truths, regardless of the market environment, for founders and CEOs building a startup: At any given point, make sure you have enough cash to take the company to profitability or build things that will allow you to raise capital before the cash runs out. This regardless of if you are six months from running out of cash or if you just raised $20 million and have 36 months of runway.

Roger’s longer post The Prepared Mind in the New Year is a good read.