I received data 48 hours ago from Pacific Crest which shows valuations of SaaS companies in a sharp decline.
Given 90% of our investments are into software companies, this is very relevant and I forwarded the data to a few of the entrepreneurs we work with. One of them emailed me back and asked:
What do you think is going on? How does this change our playbook?
Here is my response and I thought I'd share it here. But also need to mention I did make some edits since it was slightly more customized for the CEO that asked the question.
1. First, some companies have been whiffing on earnings and their outlooks are short of what Wall Street has been expecting (based on guidance from management). Fast forward, the models get revised and their share prices get annihilated. The ones that meet (or even beat) get swept up and get hit too (or stay somewhat steady..this is rare).
Second, we have been screaming to our LPs and many of our companies that the market is frothy. We have strongly encouraged those that needed to raise to do it asap. We think most valuations were WAY out of whack so none of this came as a surprise to David or me. The chart I sent is proof. Our quarterly reports for the last 2 years talk about it. And at our LP meeting last year, we focused SUPER HARD on it.
2. Going forward, VCs will be more selective, the A players (defined by quality of entrepreneur/business/market) always get funded (and potentially get a premium multiple). The Bs probably get funded but at a more market multiple, Cs and below don’t get funded (and this is the way it should be). This obviously shifts even more if the market continues to go down. Meaning the Bs also don’t get funded and the As get funded but no premium.
3. Companies that closed funding at the peak (this includes you) even with close to perfect execution, could see flat rounds. Why? Because the “new normal” valuation metrics have changed. We are already seeing this with one of our companies that wants to raise and a VC firm is offering flat to last round because market dynamics have changed. The entrepreneur points to all the progress. The VC can point to the “new normal” valuation ranges.
Things I would think about going forward (no matter what):
1. One of our software entrepreneurs always says he wants to make sure his customers are “delighted.” Would our customers say the same? “Delighted” = pretty solid lock in. I say this leading into #2
2. Is the burn controllable? What happens in another hard downtown. Will (the market we sell to) be soft? What happens if capital sources dry up completely? Can we hunker down and be a cash flow neutral business (if we had to).
3. Be a hawk on watching spend and make sure BIG bang for the buck.
4. Consider a strategy that uses this capital to get to cash neutral. Gives you potentially more leverage (you don’t need the money). Proves to the market you can get there if wanted. Then use the next round (10-15m?) to pound away at growth again, etc.