Dear all,
It has been a little over one year since the Fed started increasing interest rates in May 2022, and what a wild year it has been for investors across the private and public markets. I had the privilege of attending three global conferences over the last two months – Milken, Scale Global and just last week SuperReturn Berlin – and this was a terrific opportunity to take a much-needed helicopter view of the new paradigm we are facing and explore with bright minds how to play as an investor a new game with new rules. If the seismic shift is general, one sector has been hit hard: Technology.
Yes, for the first time in a decade, macro matters to tech, and for those unprofitable companies whose earnings lie in the future, the continued increase of interest rates since last year has led to a steep decline in valuations in the public markets. The combination of rising interest rates and faltering public stocks have now filtered through the private markets, yet still only partially reflected in the numbers as many late-stage start-ups are (still) avoiding a funding round that could crystallize a lower valuation. With a direct consequence: as growth falters, there is a decrease in the number and quality of start-ups in which late-stage and growth investors can invest in now despite still record levels of dry powder.
Weathering the storm, the recent wave of generative artificial intelligence (GenAI) has largely captured investor interest, leading to sky-high market caps for industry leaders and start-ups across the GenAI tech stack. The 105m€ record fundraising of French start-up Mistral AI (just a few weeks old) and the $90m Series C of Synthesia, the creator of “AI-driven” avatars, in a gloomy environment, show the hopes placed on this new foundational technology.
There is one clear implication here: it is increasingly hard to assess the intrinsic value of a tech company. Over 2020-21 we saw exceptional increases in valuations (skyrocketing around Thanksgiving 2021), but factor-based investing favored a lack of discipline around cost structure and cash burn that was neither sustainable nor healthy.
In our view, valuations should rest on solid financial fundamentals and not solely on growth or hyper-growth but on a subtle arbitrage between growth and profitability to reach the well know bar of 40% in the Rule of 40, which applies to many tech companies except for DeepTech. It is still ok for a company to remain unprofitable at the sole condition of hyper-growth (i.e.,>40%). Otherwise, arbitrage around the cost structure to become profitable is imperative.
If the Rule of 40 helps map a new frontier between unprofitable tech companies whose growth is low and who are trading at just about 4 times NTM revenue and profitable companies experiencing hyper-growth and who are trading at 10 times NTM revenue, it is not sufficient to grasp the question of how to value these companies.
Understanding the quality and ownership of the IP is the first fundamental item. Proprietary IP matters and to some extent the valuations of GenAI companies like Mistral AI and Synthesia reflect the uniqueness of certain R&D skills to build the foundational technology.
The second essential item is understanding the “quality” of a company’s growth and margins. Valuation should not be based just on the historical % of growth but more on getting a conviction about its expected duration and magnitude. Understanding how many resources will be necessary to get there, and hence its efficiency, is of prime importance. This depends on the unique characteristics of the company and of common traits of its foundational tech model [i.e. marketplace, AI + ML + Data Application or Infrastructure, etc.].
Our obsession at the firm is helping investors assess the intrinsic value of high-growth and disruptive companies. To help, we unveiled at SuperReturn Berlin a proposed framework we built to evaluate the critical valuation drivers across a large scope of foundational tech models. With this tool, we aim to help our clients build a robust process to make the right investment decision. This is what the next months will be about. And this is terrific news. Have a great read!