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This is part of our series on SaaS valuations and IPOs. Read the other two posts in the series about understanding SaaS Valuations and trends in tech IPOs.

The startup investment market is in a period of irrational excitement. A correction will come, sooner or later, and you should be on your best behavior. Mark Suster, on Both Sides Of The Table, detailed this two weeks ago. It’s been discussed in detail elsewhere too.

The core of the argument is that the rush of money into the tech sector has pushed company valuations up much higher than they would be otherwise. In particular, two sources of non-venture capital investors are joining startup investing at unprecedented rates. For one, since 2009, the number of deals with participation from a corporate investor has almost doubled from 25% to 44%, now the largest source of startup funding. Just this week, Intel announced that its in-house venture capital group will invest $500 million into tech companies in 2016. That’s almost a 40% increase from this year.

updated-corporate-fundings

In the past five years, the number of deals featuring corporate investment has risen 76%. Image from Both Sides of the Table.

The other source of growth is accelerator programs that are opening up inside of bigger companies and research universities that want the first crack at the next hot company. They’re looking to follow the example of Stanford, which owned just .6% of Google at its IPO, and later sold for more than $330 million. Institutional investors like these are also contributing to the rapid growth of valuations. 

Receiving money from investors excited about your growth prospect isn’t bad on its own though, so why does anyone care?

It’s because many of these companies have achieved their stunning revenue or user growth through poor business discipline. As a result, these companies are attracting massive private valuations that will be hard to make solid. It’s fine when a private investor values your free user growth very highly and bids aggressively, but the public markets are going to look for clear financials and GAAP revenue.

The Correction Is Inevitable, The Timing Is Uncertain

At some point, whether their investment was purely financial or partially strategic, these companies, funds, and investors will come looking for their returns. Organizations will find that the public markets demand business models that can support themselves, rather than growth on the back of a financial model that pushes them further into the red.

Software as a Service organizations in particular, with their heavily front-loaded cost structure and customer acquisition cost, need to pay particular attention to this fact. The growth of their business depends on being able to regularly attract new capital to keep growing. Businesses that pursue growth without a functional model may end up looking more like Homejoy than Google.

The Correction May Already Be Starting

Billion+ Companies Are Already
Exiting At Reduced Valuations

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2014 exits at lower valuation than previous round
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2015 Exits at lower valuation than previous round

Source: Both Sides of the Table

There are signs that this slowdown may be starting already. The IPO market has cooled off dramatically. Companies looking to exit and return significant money to their investors are finding it impossible to match the aggressive valuations they received privately: 71% of 2015’s billion-dollar plus IPOs are trading below their asking price. Watching this happen sends a chill through the rest of the market looking to launch soon. There have already been stories around the fear and uncertainty created for upcoming offerings, like Square and Dropbox. Even an IPO that equalled their last valuation would be a disappointment to later stage investors looking for a profit.

I don’t think it will pop and there’s nothing left. But I think I can imagine a funding environment where Slack as it currently exists would be valued at a $1 billion.

– Stewart Butterfield, Slack CEO

This concern has permeated the Valley so deeply that even Slack, the most recent company to join the billion dollar club after raising $280M in twelve months, has adopted the fear. Slack’s CEO Stewart Butterfield said on Tuesday night that he wouldn’t be surprised to see half their valuation disappear in a day. That’s certainly something to be wary about.

Mark admits (and we agree) that this market correction has been predicted for at least two years now, and hasn’t come yet – but at some point funds will come due and LPs will come looking for money, so it will happen. Don’t get caught with your fingers in a company with bad business sense when that happens.

Staying In Control: A Few Tips

While the valuations of other companies are firmly outside your control, you can do more to keep your business under control. Plan your growth and company with a purpose, and a financial model that ensures you can make money off each new customer coming in the door. This might seem obvious, but it could be the key that separates you from businesses that come apart at the seams under scrutiny. And if you take one lesson from the last season of Silicon Valley, don’t over-raise and inflate your valuation beyond what you can use – the next set of growth targets will be that much higher.

Insight Squared
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