An analyst note from JP Morgan has thrown a wrench into the valuations market for technology shares. And while the impact of the missive is being felt most sharply among public companies, its impacts could show up in the valuations of yet-private technology firms as well.
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The note changed the bank’s valuation perspective regarding a number of technology companies. In response to what CNBC described as a “wave of downgrades” from JP Morgan, investors pulled the rug on a few notable tech companies. Here’s a partial list of the damage from yesterday’s trading, after the downgrades were made public:
- Zscaler: -7.84%
- Datadog: -6.54%
- Cloudflare: -8.98%
You get the picture.
But what’s more important is that the note connected rising interest rates to an anticipated decline in the value of various technology shares. To wit: “With rates climbing, this adds risk to higher multiple software stocks trading over 20 times revenue,” per a CNBC quote of the note. (A longer list of upgrades and downgrades from the communiqué can be found here.)
If tech companies valued at more than 20x revenues see their valuations decline as rates rise, it would create a downward compression effect on tech valuations more generally. Put simply: If the tech companies with the richest valuations were dragged closer to a 20x multiple, it would slash the worth of nearly every tech company, period.
In basic terms, 20x would be a fucking catastrophe for the tech market. Companies like Shopify and Zscaler, worth around the 40x mark, per Bessemer data this morning, are among the top 10 most richly valued tech companies on the public market. To get them closer to 20x would mean that the effective buying price for >50% growth rates among public software companies would decline greatly. Software companies with lower growth rates would also lose value, as no one is going to pay similar dollars for less valuable assets.
What about startups? There’s a lot of optimism in startup valuations today because public comps are so strong. If Bill.com is worth 50x its current annualized revenue, it’s not that hard to argue that your startup that is growing faster deserves a similar or better multiple. But if valuations above 20x get compressed as rates rise, well, that logic falls apart.
This is a risk, twice. It’s a risk for startups that need to access more capital in the coming quarters if valuations decline broadly as rates rise because they will have to either take on more dilution than anticipated or cut burn — growth — to coast into a size that matches their pricing expectations. It’s a risk for investors that have been pumping capital into startups with pre-Series A revenue at Series B or Series C pricing on the anticipation that growth will continue forever at high paces and that exit prices — public market comps, effectively — will remain elevated.
If that last bit of reasoning unravels, there’s a lot of pre-unicorns and unicorns proper that could struggle mightily.
Of course, one analyst note doesn’t a trend make. But the dispatch comes around a few other happenings that matter:
- Tech valuations have already been on the decline, as we noted last weekend.
- Interest rates are now expected to rise in quarters, not years.
That combination is not a surprise. The huge growth in tech valuations was predicated on low rates making cash a silly thing to hold and the anticipation that accommodating monetary policy would continue at absurd levels. Take away those foundations and, well, the logic behind Bill.com at 50x its run rate is a bit insane.
A sharp decline ahead? No, but we’ll perhaps see multiples continue to tighten from both early-2021 levels and especially the marks of the summer euphoria.